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Generally, REITs grow their earnings just like any other corporation, either by raising the rental rate or reducing expenses, i.e. administrative and operating by being more effectively and efficiently managed.
REIT managers create value to unitholders by increasing their distribution per unit and capital gains through the appreciation of their underlying asset values.
A REIT’s growth can be classified into two categories: organic growth and inorganic growth.
Organic growth means growth within the existing properties or capital the REITs possess. This type of growth is safer as it is less risky, but it is often slower as it only relies on the existing assets to generate growth. Hence, there is a limit to how much a REIT can grow under this approach.
There are three ways to achieve organic growth:
Inorganic growth refers to the acquisition of new properties or investment in property development. This requires additional capital through either debt or equity financing. No inorganic growth can be achieved through its retained earnings alone. Inorganic growth exposes investors to higher risk, and may cause price volatility; however, the growth can be rewarding.
Two types of inorganic growth:
#4 Acquiring New Properties – This approach is very common in REIT investment strategy. Managers actively seek quality property assets that can increase distribution per unit for their investors.
#5 Green Field Developments – “Green field” refers to undeveloped property. REIT managers are allowed to invest in undeveloped properties from the ground up. MAS has recently increased its development limit from 10% to 25% of the REIT investment portfolio.
The growth options mentioned will lead to either the increase of a REIT’s net asset value of its real estate, and hence be reflected through price appreciation, and/or result in higher distribution per unit.
A REIT manager often aims for yield accretive acquisition to increase the distribution per unit for its existing investors.
REITs Investor as the part-owner
In fundamental analysis viewpoint, a unitholder is the part-owner of the real estate assets of the REIT. Hence every dollar gain in its underlying assets should theoretically be reflected in the share price over time. That explains why get rewarded when the properties increase in value.
Supply and demand to consider
In the short–term, price movement is often determined by the expectation of the market. When the sentiment is good, the prices will rise, whereas when it’s bad, the prices will plunge. Investing for the long-term allows investors to ride out the fluctuation of prices and be rewarded though the intrinsic value of the underlying assets.
Here are some of the fundamental ratios and matrices that are commonly used by investors and media to report on a REIT’s valuation.
Net Asset Value (NAV), is, in short, the current value of the REIT based on its total assets (largely properties) minus its total liabilities (mostly debt) and divided by its total outstanding units.
This formula gives you the NAV Per Unit, which is stated in most stock chart.
In laymen’s terms, if the REIT has to sell off all of its properties and other assets, it will use part of the money to pay off all of its liabilities. The remaining balance is what the unitholders would get. And a higher NAV usually means “higher value.”
Price to NAV:
For comparison purposes, NAV is an absolute metric which does not tell us anything about its valuation (cheap or expensive).
To know whether the valuation is considered cheap, we have to weigh it against the market price.Here’s how we got the ratio Price to Book: NAV divided by unit price: A P/B of 1 means the price is trading at the same value as its book value.
A P/B of higher than 1 means it’s trading at a premium; lower than 1 means it’s trading at a discount.
Distribution is the cash REITs use to pay investors from the earnings of their rental income. To know how much you are getting, you can simply use the following formula: number of units times the distribution per unit (DPU).
REITs generate their revenue through the rental income of their properties. This income is then less operating expenses (including the trustee’s fee, the property manager’s fee, and the REIT manager’s fee). The remaining balance is called net income/loss.
After that, 90% of the net income will be distributed to investors in the form of a distribution.
Again, distribution per unit(DPU) is an absolute figure that do not tell us whether the amount of distributed cash is considered attractive or not. To find out, we need to weigh against the market price of the REIT by using: Distribution Per Unit and divided by the REIT price to get distribution yield.
Some may use the price they paid for its denominator to determine their distribution yield on cost.
Distribution yield is both the function of the numerator and the denominator.
The numerator being the DPU which is a fixed historical variable, and the denominator being the price of the REIT that changes on a daily basis.
Because of its fixed and variable elements, distribution yield will always look high during a market downtrend and low when the market is trending up. Hence, distribution yield is an indicative yield, as it does NOT consider the outcome of a REIT’s DPU cut during bad times, or raised during a market boom.
A better way to look at it is to consider what the DPU is for the following year, rather than, “OH, the distribution yield is 6%, so I’m going to get 6% back next year if I invest in this price now!”
Cap Rate is the rate of return of the real estate property; it also known as “property yield.” It is a very commonly used ratio to describe property returns. To calculate the cap. rate we use: property net dividend by property value.
Cap Rate is an indicator of a property’s rental generating ability; it tells us the quality of the building’s and/or management’s ability to command higher rents. A high cap rate can mean a high net income produced from the property, or it can mean the fall in property value (e.g. cap rate compression).
It’s worth noting that the cap rate must be used for apples-to-apples comparisons; comparisons against similar sectors are more meaningful than comparisons of retail buildings against industrial warehouses, for example.
Cap. rate vs distribution yield(What’s the different?)
Cap rate is on the property level, as it indicates the income yielding ability of the REIT’s underlying asset which is derived from the net income of the property and its asset value by the valuator.
Whereas, distribution yield is on the REIT’s level, as it indicates the income-yielding ability of the portfolio of properties which are derived from the DPU pay-out and REIT market price.
Distribution yield is often varied from the average cap rate of the REIT’s properties, because market pricing for a REIT is based on expectation. In contrast, property value is based on its ability to generate rental income that is determined by the valuator(more common approach than cost-comparison method).
Besides that, the use of income support can increase a REIT’s distribution pay-out more than the actual rental income collected from its properties.
This will inflate the DPU. Hence, investors have to aware that in this situation the additional DPU is coming out of the REIT’s balance sheet rather than its tenants. Since you are the part owner of the REIT, it’s effectively coming out of your own pocket!
The Gearing Ratio tells us how much debt the REITs are taking in proportion to their equity level. Capital is the lifeblood of a company; without capital(cash), the company will cease to exist. Capital comes in two forms: equity and debt.
The different between equity and debt
Equity is the capital the company gets in exchange for shares. Hence there is no obligation for the company to repay its money.
Debt on the other hand is what the company gets in capital by borrowing money from a lender i.e bank in exchange for an interest payment and future capital redemption. Hence there is an obligation for repayment and interest payment.
Because of such obligation it comes with the risk of defaulting. One way to determine this risk is to look at the company debt in comparison to its total equity.
In the case of REITs the gearing ratio will be: Total debts divided by total assets multiplied by 100.
A 30% gearing ratio also known as Debt-to-Asset implies that 30% of the assets(properties) are financed by debt, with the remaining of 70% by equity(unitholders).
All REITs are only allowed to have their gearing ratio up to 45%.
“In addition, the leverage limit imposed on a REIT will be increased from 35% to 45% of the REIT’s total assets, but a REIT will no longer be allowed to leverage up to 60% with a credit rating. These proposed changes will provide a REIT with greater operational flexibility to rejuvenate its maturing portfolio of assets.”
What does high gearing mean?
High gearing means higher interest expenses, which can reduce distribution pay-out since more interest has to be paid prior to distributing it.
Since interest rates are expected to rise, interest sensitive REITs are those that have a debt profile largely consisting of a variable interest rate component. For fixed interest rates, debt it will be immune to such rate hikes. So what’s the trade-off? Fixed rate debts often come with higher interest rate because of the lender opportunity cost during rate hike.
The below are some of the common qualitative factors to look out for before deciding whether to invest in a REIT. Investors need to be aware that property is a very cyclical asset, as it is susceptible to the changes of the economy.
#1 Macroeconomic & Industry Trend Shift - Macro factors such as interest rates, GDP, tourist arrivals, changes in MAS regulations, and inflation rates can affect the REIT’s future rental income as well as its property value.
Industry trends can shift as well. For example, the shift towards digital shopping for electronic goods has caused sales to drop for electronic retailers. REIT managers adapt by shifting the shopping concept towards services and F&B rather than competing head-on. This explains why most shopping malls are now largely occupied by restaurants.
#2 Quality of Management – A good REIT manager creates value to the unitholder by growing the DPU and/or NAV of its property assets. Managers may seek yield accretive acquisition opportunities as well.
Investors need to assess whether the past acquisitions were value creating or destroying (i.e. overpaying for an acquisition).
For organic growth, good REIT managers are ones that are able to maximize occupancy rate and increase rent when the economy is booming.
For REITs that have cross-border exposure, a quality manager will be able to effectively manage forex risks through proper heading.
#3 Sustainability of Distribution - Retail investors love REITs with high yields, but never question the sustainability of these yields.
A REIT manager will often use income support to artificially inflate the yield on newly listed REITs or acquisitions to make them yield accretive. However, once the “support” is expired, the yield may return to its actual property net income, and the DPU may be cut.
Also, unusually high yields may be caused by the large drop in share price, which can seem to be an attractive number.
#4 Weighted Average Lease Expiry (WALE) – This is a metric used to measure the likelihood of a particular property’s risk of being vacated, which reduces the property’s net income and DPU.
WALE can be based on the average rentable area or the rental rate with lease term.
Tenant #1: 25% of rentable area with 5 years of lease term
Tenant #2: 25% of rentable area with 2 years of lease term
Tenant #3: 50% of rentable area with 10 years of lease term
WALE will be: (0.25*5yrs) + (0.25*2yrs) + (0.5*10yrs)
= 6.27 years
A REIT with a higher WALE is considered to be safer than a REIT with a lower WALE because the risk of vacancy is reduced. On the other hand, a lower WALE can also be a good thing when the market is booming because it allows the manager to capitalize on the hike of rental rates on new leases.
In short, you want WALE to be high during a market downturn and low when the market is rising.
#5 Debt Profile – This is the proportion of long-term vs. short-term debt, fixed vs. variable interest rates, and the debt covenants.
Paying out 90% of its net income means that refinancing for debt will always be needed. Hence, investors need to consider whether the refinancing will lead to a higher cost, as well as the risks that the REIT will face in the event that debt is unable to be refinanced and they must resort to raising equity for debt redemption.
#6 Alignment of Management Interest - Most SGX-listed REITs have a sponsor, and REIT management in most cases is a subsidiary of a sponsor. This means there is a high risk of potential conflict of interest, as a sponsor may offload its inferior assets to the subsidiary.
Another is the basis of the manager performance fee. Using assets value as a basis may motivate managers to aggressively acquire new assets for the purpose of attaining a higher performance fee by increasing their asset value rather than increasing DPU.
#7 Management Investment Objectives - Each REIT has its own growth strategy, exposing it to different forms of risk. Some REITs prefer to grow organically by increased rental rates and asset enhancement, which are perceived as less risky and may be suitable for investor who prefer lower volatility.
Others may actively seek acquisitions to expand their portfolio, and cash calls may be frequent. Investors have to be prepared to participate in the growth. REITs like SunTec even go for over-border expansion! In this case, investors have to consider forex risks, country regulations, culture, etc.
Here are factors that you might need to look out.
Most REITs are “sponsored” by a property developer. The developer builds a property and sells it to their REIT. To ensure that the shareholders of the REIT approve the purchase of the property, they jack up the yield by giving income support to ensure that the acquisition of the property is “accretive” to the DPU of the REIT.
Income/rental support is a guarantee of a minimum level of distribution pay-out to investors, usually for the initial few years of the acquired properties or REIT listing. It is therefore expected that distribution yield is often “supported” to a level that is competitive enough to attract public investors.
The idea is this: In the initial years of a developed property, it would be unlikely to have all its rental space occupied. The fastest way to fill up its occupancy is to offer a discount to its potential tenants at the start.
All fair and it makes business sense, but the problem comes when REITs pay out their distribution based on the “supported” rental income rather than the actual income collected from the tenants, reasoning that the future revised rental will meet its “supported” rental income.
For example, with income support, REITs can pay a distribution amount of $20M despite the actual property net income being only $15M.
So where does the extra $5M comes from? You probably guessed it, the REIT’s own pocket!
And should the future revised rental be less than the “supported” rental, the REIT will be forced to cut its distribution pay-out as the result of the lower net income.
Big Gap between Capitalization Rates vs. Distribution Yield
One quick way to know whether the DPU is heavily inflated by income support is to look at the gap between the distribution yield and the cap rate. If the difference is as wide as, say 50%, then it’s better to dig in further and make sure you understand the implications in the event that the reversed rate falls short of the income support level before you invest.
Yield Accretive Acquisition
A REIT manager will always want its acquisition to be yield accretive, i.e. have increasing DPU after acquisition, because only with accretive acquisition can the manager convince the unitholders to vote for approval.
Even the evidence from the underlying assets does not support it.So determine the future DPU based on the growth of cap rate rather than the projected distribution yield presented by the manger.
Bobby Jayaraman, the author of Building Wealth Through REITs wrote to MAS to review the use of rental support
Unwanted Cash Call
It is not uncommon for REITs to raise equity through private placement and rights issues due to their limited retained earnings because of the mandated 90% of net income distribution.
However, the question retail investors need to ask is not whether a cash is call good or bad, rather what is the reason and purpose behind it, and does it enhance or destroy unitholder value.
Right issues allow existing investors to participate in the growth of the REIT at a discounted price, usually for the acquisition of property. Investors need to determine whether the acquisition price is fair, and whether it adds value to the unitholder by increasing DPU.
Or, is it simply helping the sponsor to offload its inferior property, paying off debt because the REIT is unable to get its loan refinanced, or just to puff up its balance sheet to make it look stronger.
Private placement refers to raising capital outside of the exchange to significant investors who want to invest a large amount of capital in the REITs. Due to the size of the investment, the units will usually be offered at a discount. Think of it as a bulk purchase.
Markets usually react to the amount of discount the REITs offered with some variance, because the additional shares issued will dilute the existing investors’ proportion of shares in the REIT unless the investors take part in the additional issuance (which is not possible because this is a private issue).
However, if the additional capital raised can be reinvested to its business and in turn generate more net income, then it may offset or even create additional value for its existing unitholders.
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