By Huang Zixun
A Real Estate Investment Trust (REIT) is an investment fund that pools investors’ capital to own and operate real estate properties. After deducting management fees, the income generated from leasing or renting out those properties is then redistributed to the investors in the form of dividends, with the technical term being distributions. Most REITs specialise in managing one form of real estate, with notable sectors being commercial, industrial, retail, and healthcare.
Why REITs?
Graph of average 5-year forward distribution (dividend) yield of the FTSE ST REIT Index. Source: OCBC Investment Research
One unique factor of REITs would be the legal requirement to distribute at least 90% of its taxable income, resulting in a relatively higher dividend payout ratio as compared to equities, which is a key selling point for investors. As seen in the graph above, the 5-year average forward distribution yield for Singapore mainboard-listed REITs (S-REITs) amounts to 6.3%, as compared to the equities-heavy STI average of around 3.8%. This high distribution resulting in higher dividend income would be especially attractive to dividend investors pursuing a long term buy-and-hold strategy.
In addition, REITs offer investors an opportunity for increased portfolio diversification. Since REITs are publicly traded, they enable investors to have a more liquid form of property investments instead of direct property ownership. Furthermore, the vast majority of REITs own and operate multi-property portfolios which reduces investors’ risk of relying on a single property’s performance. With REITs being professionally managed by property management companies, many investors buy into REITs to reduce unsystematic portfolio risk.
What Factors Influence REIT Price & Distribution?
Despite the benefits, there are some factors that investors need to keep in mind before making any investment decisions. The factors can be broadly categorised into external market and internal risk factors.
1. Market & Industry Conditions
Similar to equities, REITs’ prices are affected by market demand and supply conditions. This can represent investor sentiment about general market conditions, such as bull or bear markets. It can also reflect property market changes, such as if the government were to raise or lower property taxes. REITs that hold properties centred on a specific industry would also be affected by industry-specific developments, such as retail slowdowns affecting retail-centred REITs.
2. Interest Rates
Focusing on one specific market factor, one of the more underrated factors affecting REIT performance and distributions would be interest rates. For equities, rising interest rates would normally lead to lower stock prices, as investors are incentivised to put their capital in bonds due to the relatively higher yield for bonds and perceived lower risk. This causes a lower demand for equities which causes a resulting fall in equity prices. For the same reasons, this drop in price is also true for REITs in the short run.
Correlation of REITs returns with rising interest rates. Source: Nareit
However, in the long run, as seen in the graph above, REIT returns are on average, positively correlated with interest rates. One reasoning behind this is that rising interest rates are indicative of a healthy economy. REITs would thus have their occupancy rates increased due to higher business confidence, and they would also be able to increase rental rates for those tenants. This causes their revenues to rise which results in higher average rates of returns. As such, during interest rate hikes, even though REITs fall in price initially, they increase long-term shareholder returns, and vice versa.
3. Income/Distribution Risk
Keeping in mind that the key differentiating factor of REITs from equities is their relatively higher dividend income generated, the value of REITs thus highly depends on their distribution yield. As the distributions are not guaranteed and can vary, REIT investors face a form of income risk. In fact, in the unfortunate event that the REIT suffers a net loss, dividends may not be paid out at all. Thus, the distribution yield itself represents the REIT’s long-term profit sustainability, and is a highly important factor in determining the share price and fair value of the REIT in question.
4. Refinancing Risk
Due to the 90% rule mandating that REITs need to distribute the majority of its profits to shareholders, they would not have large amounts of cash reserves. This causes REITs to have a high reliance on borrowed capital such as bank loans. This high rate of borrowing leads to higher interest rates in the long run due to their increased leverage risk, and causes potentially lower distributions due to reduced income. Furthermore, if a REIT is unable to generate sufficient capital to service its loan repayments, it may be forced to sell off the properties if they are mortgaged under the loan, thus reducing the asset’s value.
5. Concentration Risk
This relates to how many properties are under the REIT’s management, as well as the depth of their tenant mix. REITs that hold fewer properties and have a smaller group of tenants are easily affected by any changes in market developments, whether positive or negative. To give an example, the SGX-listed Lendlease Global Commercial REIT has a relatively high concentration risk with only 2 properties under management: Sky Complex in Milan and 313@Somerset in Singapore. The COVID-19 pandemic resulted in Milan being one of the worst-hit areas, as well as a fall in demand for retail in Singapore. This resulted in a drastic fall in the unit price by around 46% in the span of just 1 month.
What To Look Out For?
Based on the overview of some of the external and internal factors affecting REIT price and distribution, here are 3 main elements that an investor can use to analyse the value of a particular REIT.
1. State of the Economy & Industry
In general, a stronger economy is better for REITs as it ensures the financial health and stability of their tenants thus improving the REIT’s profitability. As mentioned earlier, interest rate changes in particular affect REITs significantly. Thus, investors should keep an eye out for the overall health of the economy as well as any interest rate changes.
S-REITs Holdings by Country & Industry. Source: SGX Research
From the figure above, the majority of S-REITs operate in multiple countries, meaning investors often have to consider the economy of more than one country. Furthermore, industry-specific factors are also important for an investor’s consideration due to the varied property sub-segments that REITs have. For example, for hospitality REITs, investors need to look at the tourist growth outlook for the countries the REIT’s hotels are in. Doing research on these broad economy and industry factors can help investors identify opportunities and reduce the likelihood of being caught out by sudden changes.
2. Quality of Portfolio Holdings
Zooming into the more specific micro factors, before investing, investors need to have an understanding of both the value and sustainability of the REIT’s income stream from each of its holdings. Firstly, to ensure the REIT has a high-value income stream, investors should analyse if those properties are in a high-growth location and sector. REITs with properties in prime locations and in a fast-growing sector would have higher tenancy rate and income, allowing them to increase their distribution yield and make them more attractive to investors.
Secondly, one metric commonly used to analyse if the REIT has a sustainable income stream would be the Weighted Average Lease Expiry (WALE). This is measured by weighting all tenants’ remaining lease in years with either the tenants’ occupied area or rent. This metric is commonly used to assess the likelihood that the property holding will go vacant. In general, the higher the REIT’s WALE across its properties, the more certain its profits are in the short-medium term. However, it is important to note that commercial REITs usually have a shorter WALE as retail tenants usually commit to shorter leases compared to companies leasing out office or warehouse space.
Overall, understanding the underlying quality of a REIT’s property holdings can enable investors to choose REITs with lower redistribution and concentration risk. This would likely translate to long-term sustainability of distributions and capital growth.
3. Fundamental Analysis
Typically, this is used to assess a stock’s fair value. For REITs, 3 key metrics can be used to perform a basic fundamental analysis to assess the REIT’s attractiveness relative to the market average.
Firstly, the distribution yield directly impacts investors as it determines their income stream from the REIT. This means it is often the foremost metric investors use when making investment decisions for REITs. Furthermore, it gives an insight to the overall financial health of the REIT as REITs with higher distribution yields usually have higher profitability. The average distribution yield for S-REITs is around 5-7%.
Secondly, the gearing ratio is an important metric to determine a REIT’s long-term financial health. This measures the ratio of a REIT’s debt to its total assets, and for S-REITs, there is a maximum regulatory limit of 45%. In general, investors prefer lower figures as it signals lower refinancing risk for the REIT. For S-REITs, the average gearing ratio is around 32-38%.
Thirdly, Net Asset Value (NAV) can be compared with the REIT’s price to form the Price/NAV ratio. This ratio is used to assess whether a REIT is priced fairly relative to its valuation. Price/NAV below 1 signals undervaluation, while a value above 1 signals overvaluation. In general, investors consider a healthy figure to be around 0.8-1.2. However, a Price/NAV of less than 1 may be indicative of certain forms of distress or poor outlook which means the REIT is not undervalued in reality.
Conclusion
Overall, REITs are attractive to investors because of the reliably high dividend yields compared to equities. However, just like individual equities, they are susceptible to many risk factors as well and depending on the REIT, would constitute moderate to high risk investments. Investors looking at a lower risk vehicle for REITs could hence consider REIT Exchange Traded Funds (ETFs) such as the Lion-Phillip S-REIT ETF as non-systematic risk is diversified away.
Meanwhile, investors looking at individual REITs should undertake due diligence and research before committing to any investment decisions. This article’s explanations regarding the influencing factors and aspects to look out for can serve as a primer for decision making, but are not meant as an exhaustive list. Every investor’s portfolio composition and risk appetite is different, hence the ultimate deciding factor for investors should be how much the REIT can value-add to their portfolio.
References:
REITs Concept & Definitions – https://www.moneysense.gov.sg/articles/2018/10/understanding-real-estate-investment-trusts-reits
Investor’s Guide to REITs – https://www.reit.com/sites/default/files/media/PDFs/UpdatedInvestorsGuideToREITs.pdf
Benefits of REITs – http://news.morningstar.com/classroom2/course.asp?docId=145579&page=2
REITs Pros & Cons – https://portal.iocbc.com/products-services/reits.html
S-REITS Overview – https://www.reitas.sg/singapore-reits/overview-of-the-s-reit-industry/
OCBC S-REITS Overall Analysis – https://www.ocbc.com/assets/pdf/media/2019/singapore%20reits%20-%20a%20shelter%20for%20the%20doves%20and%20uncertainties.pdf
STI Average Dividend Yield – https://www.straitstimes.com/business/companies-markets/annualised-total-returns-of-92-over-10-year-period-for-sti
REITs & Interest Rates – https://www.reit.com/investing/reits-and-interest-rates
REITs & Interest Rates – https://www.cnbc.com/2018/05/30/rising-rates-it-may-be-time-to-buy-not-sell-those-reits.html
Equities & Interest Rates – https://www.thebalance.com/how-rising-global-interest-rates-impact-international-stock-markets-4158038
Risks of REITs – https://www.poems.com.sg/market-journal/understanding-3-key-risks-of-reits-and-adding-s-reits-to-your-portfolio/
SGX Research REITs Charbook – https://www.reitas.sg/wp-content/uploads/2020/02/SGX-Research-SREIT-Property-Trusts-Chartbook-February-2020.pdf
Weighted Average Lease Expiry (WALE) – https://www.reitsweek.com/2013/05/weighted-average-lease-to-expiry-wale.html