3 Big Risks Investors Must Know About A Real Estate Investment Trust

By Stanley Lim Peir Shenq, CFA

The Singapore stock market is home to some of the largest real estate investment trusts in the region. REITs such as Ascendas Real Estate Investment Trust (SGX: A17U), CapitaLand Mall Trust (SGX: C38U), Mapletree Logistics Trust (SGX: M44U)and Mapletree Industrial Trust (SGX: ME8U) all have a market capitalisation of over S$2 billion each.

Land is a very valuable commodity in Singapore given that it is a tiny island nation. Moreover, REITs in Singapore tend to offer high yields as well, relative to the broader market.

But, REITs are far from being a risk-free investment. Investors need to understand how REITs are structured in order to gain better awareness of the risks involved. Here are three big risks that I’m watching with REITs.

Lack of a safety net

REITs are required by regulation to distribute 90% of their taxable income each year as distributions to enjoy tax-exemption. That would explain why most REITs tend to have high dividend yields.

But, this means that REITs are not able to build up a cash reserve to strengthen their balance sheets and protect themselves against any adverse economic conditions. The need to distribute most of their income would also mean that REITs lack the cash reserves to invest in more properties to grow their distribution.

Therefore, it is common to see REITs issue rights or conduct private placements as a way to raise more capital from time to time. For an investor, there’s a risk that your investment in a REIT may get diluted when it conducts such corporate exercises.

Interest rate risk

The aforementioned inability of REITs to conserve cash would also mean that they’d have to depend on debt for financing. REITs with significant debt on their balance sheets may be facing interest rate risk.

In the event that interest rates rise, this may cause a hike in a REIT’s interest expenses. In turn, the amount of distributable income that the REIT can generate might drop significantly, thus negatively impacitng the distribution yield of a REIT. When this happens, the unit price of a REIT may be affected as REIT-investors may dispose of it in search of higher yields.

Use of short-term debt

Generally speaking, the bulk of a REIT’s assets are properties that can last for decades or even centuries. In other words, a REIT’s assets are mainly long-term in nature. But, the borrowings of most REITs are relatively short-term, with typically less than 10 years to maturity.

As such, this creates a type of asset and liability mismatch, in the sense that REITs are using short-term liabilities (debt) to finance long-term assets (properties). In fact, REITs have a constant need to refinance their borrowings while holding onto the same assets.

In the event of liquidity drying up, such as during the Global Financial Crisis of 2008-09, a REIT may be caught in a dangerous position of being unable to find any refinancing options when its debt comes due. If that happens, the REIT would most likely have to undertake a huge rights issue or private placement – at a deeply discounted unit price to boot.

In this scenario, an investor in the REIT may see his or her stake diluted sharply (from a large private placement) and/or be required to fork out a large sum of money (from a rights issue) to reinvest in the REIT and save it from financial difficulties.

Foolish Summary

REITs can be great investments. But, investors should be aware that a great investment opportunity does not mean that it is risk-free. Understanding the key risks of REITs would give an investor an edge when it comes to managing his or her investment portfolio.

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