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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Not all REITS are good enough to invest in.

You must learn to avoid investing in sub-par REITS.  These have:
1.  overly high level of debt, and
2.  inconsistent or declining income for distribution.

Here are 6 screens for finding the best REITs:

1.  High distribution yield (at least 5%)
A low distribution yield (less than 5%) tells you that the REIT is currently too expensive to buy.

2.  History of consistent growth in DPU.
You need to ensure that the REIT you invest in has a history (at least 4 - 5 years) of consistent increase in their distribution per unit (DPU) (i.e dividend per share).

3.  High expected DPU growth in the next 1 - 2 years
You have to ensure that the REIT you buy is expected to generate increased income and distribution in the next 1 - 2 years.  This comes from expected increase in property prices, increase in rental or acquisition of new properties.

Cyclical REITs like office, industrial and residential REITs should not be bought when the economy is entering a recessionary phase.  This is a time when these property prices and rental income are expected to decline.  They should only be bought when the economy is recovering from a recession or in an expansionary phase.

4.  Low gearing ratio (< 40% )
Since REITs must pay out 90% of their income in dividends, most REITs can only acquire new properties by taking bank loans.  When a REIT takes on too much debt, it exposes itself to interest rate risk and even defaut risk (when it is unable to service the repayments).

5.  REIT stock price is fairly valued
As an investor, you would want to buy a REIT at a time when its price is below its NAV (undervalued).  Such opportunities arise when there is a lot of pessimism in the market.  At the same time, when the price has risen too high above its NAV (overvalued), you may want to avoid buying the REIT.

6.  REIT must be on a confirming uptrend.

DPU = Distribution per unit.



Ref:  Adam Khoo

The Six main types of REITs

There are 6 main types of REITs

1.  Office REITs - own and operate office buildings
2.  Retail REITs - own and operate retail properties like shopping centres and shopping malls.
3.  Industrial REITs - own and lease out industrial properties that include light industrial properties, factory space, warehouses, business parks and distribution centres.
4.  Hospitality REITs - own and lease properties to hotels and serviced residences.
5.  Health Care REITs - own health care facilities that are leased to health care providers like hospitals, nursing homes and medical offices.
6.  Residential REITs.- own and operate multi-family rental apartment buildings as well as manufactured housing.

Health care and industrial REITs have the highest yields but the lowest potential for capital gains.
Retail, residential and office REITs have relatively lower yields but greater potential for price appreciation.
Office, hospitality and industrial REITs are highly sensitive to the economy (that is, their business performances are cyclical).

Understanding the expected trade off between potential capital appreciation and yield across classes of REITS.

Different classes of REITS
1.  Retail/Mall
2.  Office/Commercial
3.  Hospitality
4.  Industrial
5.  Health Care


Comparison of yield across various REITS
1 < 2 < 3 < 4 < 5

Comparison of Potential for Capital Appreciation across various REITS
1 > 2 > 3 > 4 > 5



Understanding the expected trade off between potential capital appreciation and yield across classes of REITS.

The retail or mall REITS tend to favour capital appreciation in the value of the underlying assets.

• Malls are hard to duplicate and scarce.  
• In an asset inflation situation, the underlying mall property would increase in value faster than other classes of REIT with the attendant appreciation in the price of the REIT share.  
• The trade off would be lower distribution yield.  
• Since malls REITS are highly demanded, the price of the REIT share often increases to such an extent to reduce the yield on the REIT.

On the other end, the health care REIT seems to give the highest yield but trades off its potential for capital appreciation.

• It is easy to conceive that a health care REIT will not have much capital appreciation in its assets if it has a 15 year fixed lease with an operator for its assets.  
• For example, in a particular such REIT, any increase in rent is undertaken only once and year and only at the same rate as the CPI to keep track with inflation.  Even if the asset increases in value substantially, the REIT will not receive any additional income for the increase since it has signed fixed long term leases with the operator.  As such capital appreciation is capped.  
• On the other side of the equation, the health care REIT is able to pay very consistent and high yields to the unit-holders.  
• Health care REITS are as close to being recession proof as any other class of REIT would allow (assuming the operator does not default).  
• Since health care is by its nature also less prone to cycles compared to offices or industrial business, health care REITS are well recommended in period of grave economic uncertainty.  

Ref:
Value Investing in REITS by Attlee Hue

So how would you value the REIT's business?

1. Book Value
The book value or net asset may not also fully value the REIT as a business operating to maximise the stream of rental and other forms of income derived from the property.  So one should not entirely simply rely on the book value.  Value investors however often would be reluctant to pay for a REIT at a price higher than the NAV unless there is immediate prospect of the NAV being re-valued# once a new valuation is conducted.

Book Value = Value of each of the properties + Value of its other assets (cash, inventory and receivables) - Liabilities

2. Property Yield
The property yield shows the earning power of the properties within each of the REIT's portfolio.

Property Yield = Net Property Income / Property valuation x 100

3. Distribution Yield
Distribution yield gives an indication of how much return you would expect from the REIT on an annual basis from the distribution.

Distribution Yield = Distribution per Unit / Price paid for Unit  x 100.


[#The REIT owns the various properties which would be valued by professional valuers at least once annually. Valuers will often provide a value of each property on the basis that the REIT is a going concern i.e. that the business of the REIT is functioning normally and is not forced by distress to sell the property.]


APPROACH TO REIT VALUATION

Why would you want to invest in a REIT?
You want to accumulate a string of properties with your money and allow them to be managed by a professional manager.

What would you want from your portfolio of properties?
1.  You want to enjoy capital appreciation from the property.  You can achieve this easily by owning the properties.
2.  You want the revenue that the properties might generate.  This revenue is necessary to pay all the property expenses including the mortgage and also to provide for you some return to compensate you for the use of your capital that you have ploughed into the properties. For this, you have to calculate the Property Yield and the Distribution Yield.

What further information do you need to make an intelligent decision?
The Distribution Yield tells you your return if the tenants continue to occupy the premises and pay their rent and rental rates stay the same.
1.  What happens if this happy scenario is affected by economic turmoil?
2.  If the property vacancy increases or rental rates drop, can the mortgage still be serviced by the earnings?

Tower Reit - Return on Retained Earnings

Tower Reit
Year		DPS		EPS		Retained EPS
2002
2003
2004
2005
2006		0		7.5	a	7.5
2007		9.3		8.5		-0.8
2008		9.5		9.9		0.4
2009		9.4		10.7		1.3
2010		9.5		10.6		1.1
2011		10.7		11.9	b	1.2
2012
Total		48.4	c	59.1	d	10.7	e
From	2006	to	2011
EPS increase (sen)			b-a	4.4
DPO			c/d	82%
Return on retained earnings			(b-a)/e	41%
(All figures are in sens)

Starhill Reit - Return on Retained Earnings

Starhill Reit
Year		DPS		EPS		Retained EPS
2002
2003
2004
2005
2006		2.5		5.6a		3.1
2007		6.7		6.9		0.2
2008		6.9		6.9		0
2009		6.9		6.9		0
2010		6.5		6		-0.5
2011		6.5		4.9	b	-1.6
2012
Total		36	c	37.2	d	1.2	e
From	2006	to	2011
EPS increase (sen)			b-a	-0.7
DPO			c/d	97%
Return on retained earnings			(b-a)/e	-58%
(All figures are in sens)

Boustead Reit - Return on Retained Earnings

Boustead Reit
Year		DPS		EPS		Retained EPS
2002
2003
2004
2005
2006
2007		3.7		10.6	a	6.9
2008		10.9		11		0.1
2009		11		11.2		0.2
2010		9.4		12		2.6
2011		10.2		13.7	b (E)	3.5
2012
Total		45.2	c	58.5	d	13.3
From	2007	to	2011
EPS increase (sen)			b-a	3.1
DPO			c/d	77%
Return on retained earnings			(b-a)/e	23%
(All figures are in sens)

Rights issues by REITs a tough sell?

Rights issues by REITs a tough sell?  
Written by Chua Sue-Ann     
Monday, 12 December 2011 11:26  

KUALA LUMPUR: It remains to see whether investors will warm up to recent proposals by Malaysian real estate investment trusts (REITs) to embark on rights issues for fundraising.

This comes as Hektar REIT and AmFirst REIT separately proposed rights issues in recent months. The former is doing so to fund new asset acquisition while the latter is seeking to reduce its bank borrowings. CapitaMalls Malaysia Trust (CMT)  also recently told The Edge Financial Daily that it is considering a rights issue to raise fresh capital.

Analysts and market observers said it is generally undesirable for REITs to embark on rights issues as investors expect dividends from REITs instead of having to plough in more capital.

“Effectively, they are asking investors to spend more on their stock in these uncertain market conditions,” said a property analyst.

However, judging from the price performance of both Hektar REIT and AmFirst REIT, investors have not reacted negatively to the news. This, surprisingly, is in contrast to investors’ harsh treatment of Singapore-listed REITs that embarked on rights issues.

According to analysts, the reason why Malaysian REITs are now turning to rights issues to raise funds, instead of the usual way of borrowing or unit placement, could be because their gearing is already near the 50% threshold (of total asset value) permitted for a REIT to borrow, or that the capital they seek to raise is larger than what can be achieved with a placement exercise.

In Hektar REIT’s case, its gearing ratio is 43.4%, just below the 50% limit, based on its total debt of RM347 million and total assets of RM799.47 million as at Sept 30. AmFirst’s REIT’s gearing as at Sept 30 was 39.8% based on total borrowings of RM419.6 million and total assets of RM1.053 billion.

On Dec 8, Hektar REIT proposed a renounceable rights issue to raise gross proceeds of about RM98.4 million. Proceeds from the rights issue will be used to partially fund the acquisition of two shopping malls in Kedah for RM181 million cash.

Hektar REIT added that it would also obtain bank borrowings of up to RM87.1 million to purchase the assets. Note that it held cash and cash equivalents of RM21.3 million as at Sept 30.

The REIT has yet to finalise the actual number of rights units and entitlement basis will be determined later based on the final issue price of the rights unit. 

Hektar REIT added that it will procure a written irrevocable undertaking from its substantial unitholders to fully subscribe for their entitlements, failing which underwriting arrangements would be made.

AmFirst REIT’s proposed rights issue, set on a three-for-five basis, is expected to raise gross proceeds of about RM218.8 million, based on an illustrative issue price of 85 sen per unit. The proceeds are to be used to pare down borrowings.
 
CapitalMalls Malaysia Trust, which also manages The Mines shopping mall, recently said it is also considering a rights issue to raise fresh capital. 

AmFirst said the rights unit issue price is expected to be fixed at a discount of no more than 20% to the theoretical ex-rights price of the unit. “The discount on the issue price of the rights unit is intended to reward unitholders for their continuous support of the fund,” AmFirst said.

Thus far, investors have not reacted negatively to the REITs proposal to conduct rights issues. The unit prices of both Hektar REIT and AmFirst REIT are still traded near their peaks.

“It could be because the unit prices are currently near historical highs, and more interestingly, at the current high prices they still offer rather good yields as well [Hektar REIT at 7.6% and AmFirst at 8.6% historical yield], so unitholders are happy,” said a market observer.

Other than that, he explained that there is still strong demand for REITS in times of market volatility, especially among institutional shareholders. 

“Pavilion REIT has gained 13.6% since last week’s IPO to RM1, and the yield is now only 5.7%. So, the management of REITs thought maybe a rights issue is a good idea,” he said.

The scenario is different in Singapore.

K-REIT Asia, a unit of the Keppel Land group, saw its unit priced plunge 9.7% to S$0.857 sen on Oct 18 after it announced plans to raise S$976.3 million (RM2.4 billion) through a 17-for-20 rights issue. Most of the funds raised by the REIT will be used to buy a 87.5% stake in Ocean Financial Centre (OFC) from its parent Keppel Land Ltd.

It was reported that investors didn’t like the pricing for the OFC deal, and the fact that it was a related party deal. It wasn’t entirely because K-REIT Asia had proposed to acquire it via rights issue funding.

“At the end of the day, REIT managements have to justify why they have to do a rights issue to ask for more money from the unitholders. While institutional shareholders are okay with a rights issue, it could be a turn-off for minority shareholders,” said a market observer.

How To Analyze Real Estate Investment Trusts

Posted: May 7, 2011

David Harper

Contact | Author Bio

ARTICLE HIGHLIGHTS

• A real estate investment trust is a real estate company that issues common shares.
• An REIT must agree to pay out at least 90% of its taxable profit in dividends.
• REITs are analyzed like stocks, but the depreciation of property is considered.

A real estate investment trust (REIT) is a real estate company that offers common shares to the public. In this way, an REIT stock is similar to any other stock that represents ownership in an operating business. But an REIT has two unique features: its primary business is managing groups of income-producing properties and it must distribute most of its profits as dividends. Here we take a look at REITs, their characteristics and how they are analyzed.

Tutorial: Exploring Real Estate Investments

The REIT Status

To qualify as an REIT with the IRS, a real estate company must agree to pay out at least 90% of its taxable profit in dividends (and fulfill additional but less important requirements). By having REIT status, a company avoids corporate income tax. A regular corporation makes a profit and pays taxes on its entire profit, and then decides how to allocate its after-tax profits between dividends and reinvestment; an REIT simply distributes all or almost all of its profits and gets to skip the taxation.

Types of REITs

Fewer than 10% of REITs fall into a special class called mortgage REITs. These REITs make loans secured by real estate, but they do not generally own or operate real estate. Mortgage REITs require special analysis. They are finance companies that use several hedging instruments to manage their interest rate exposure. We will not consider them here.

While a handful of hybrid REITs run both real estate operations and transact in mortgage loans, most REITs focus on the "hard asset" business of real estate operations. These are called equity REITs. When you read about REITs, you are usually reading about equity REITs. Equity REITs tend to specialize in owning certain building types such as apartments, regional malls, office buildings or lodging facilities. Some are diversified and some are specialized, meaning they defy classification - such as, for example, an REIT that owns golf courses. (For more insight, see 5 Types Of REITs and How To Invest In Them.)

Analyzing REITs

REITs are dividend-paying stocks that focus on real estate. If you seek income, you would consider them along with high-yield bond funds and dividend paying stocks. As dividend-paying stocks, REITs are analyzed much like other stocks. But there are some large differences due to the accounting treatment of property.

Let's illustrate with a simplified example. Suppose that an REIT buys a building for $1 million. Accounting requires that our REIT charge depreciation against the asset. Let's assume that we spread the depreciation over 20 years in a straight line. Each year we will deduct $50,000 in depreciation expense ($50,000 per year x 20 years = $1 million).

Let's look at the simplified balance sheet and income statement above. In year 10, our balance sheet carries the value of the building at $500,000 (a.k.a., the book value): the original historical cost of $1 million minus $500,000 accumulated depreciation (10 years x $50,000 per year). Our income statement deducts $190,000 of expenses from $200,000 in revenues, but $50,000 of the expense is a depreciation charge.

However, our REIT doesn't actually spend this money in year 10; depreciation is a non-cash charge. Therefore, we add back the depreciation charge to net income in order to produce funds from operations (FFO). The idea is that depreciation unfairly reduces our net incomebecause our building probably didn't lose half its value over the last 10 years. FFO fixes this presumed distortion by excluding the depreciation charge. (FFO includes a few other adjustments, too.)

We should note that FFO gets closer to cash flow than net income, but it does not capture cash flow. Mainly, notice in the example above that we never counted the $1 million spent to acquire the building (the capital expenditure). A more accurate analysis would incorporate capital expenditures. Counting capital expenditures gives a figure known as adjusted FFO, but there is no universal consensus regarding its calculation.

Our hypothetical balance sheet can help us understand the other common REIT metric, net asset value (NAV). In year 10, the book value of our building was only $500,000 because half of the original cost was depreciated. So, book value and related ratios like price-to-book - often dubious in regard to general equities analysis - are pretty much useless for REITs. NAV attempts to replace book value of property with a better estimate of market value.

Calculating NAV requires a somewhat subjective appraisal of the REIT's holdings. In the above example, we see the building generates $100,000 in operating income ($200,000 in revenues minus $100,000 in operating expenses). One method would be to capitalize the operating income based on a market rate. If we think the market's present cap rate for this type of building is 8%, then our estimate of the building's value becomes $1.25 million ($100,000 in operating income / 8% cap rate = $1,250,000). This market value estimate replaces the book value of the building. We then would deduct the mortgage debt (not shown) to get net asset value. Assets minus debt equals equity, where the 'net' in NAV means net of debt. The final step is to divide NAV into common shares to get NAV per share, which is an estimate ofintrinsic value. In theory, the quoted share price should not stray too far from the NAV per share.

Top Down Vs. Bottom Up

When picking stocks, you sometimes hear of top-down versus bottom-up analysis. Top-down starts with an economic perspective and bets on themes or sectors (for example, an aging demographic may favor drug companies). Bottom-up focuses on the fundamentals of specific companies. REIT stocks clearly require both top-down and bottom-up analysis.

From a top-down perspective, REITs can be affected by anything that impacts the supply of and demand for property. Population and job growth tend to be favorable for all REIT types. Interest rates are, in brief, a mixed bag. A rise in interest rates usually signifies an improving economy, which is good for REITs as people are spending and businesses are renting more space. Rising interest rates tend to be good for apartment REITs as people prefer to remain renters rather than purchase new homes. On the other hand, REITs can often take advantage of lower interest rates by reducing their interest expenses and thereby increasing their profitability.

Capital market conditions are also important, namely the institutional demand for REIT equities. In the short run, this demand can overwhelm fundamentals. For example, REIT stocks did quite well in 2001 and the first half of 2002 despite lackluster fundamentals, because money was flowing into the entire asset class.

At the individual REIT level, you want to see strong prospects for growth in revenue, such as rental income, related service income and FFO. You want to see if the REIT has a unique strategy for improving occupancy and raising its rents. REITs typically seek growth through acquisitions, and further aim to realize economies of scale by assimilating inefficiently run properties. Economies of scale would be realized by a reduction in operating expenses as a percentage of revenue. But acquisitions are a double-edged sword. If an REIT cannot improve occupancy rates and/or raise rents, it may be forced into ill-considered acquisitions in order to fuel growth.

As mortgage debt plays a big role in equity value, it is worth looking at the balance sheet. Some recommend looking at leverage, such as the debt-to-equity ration. But in practice, it is difficult to tell when leverage has become excessive. It is more important to weigh the proportion of fixed versus floating-rate debt. In the current low interest rate environment, an REIT that uses only floating-rate debt will be hurt if interest rates rise.

The Bottom Line

REITs are real estate companies that must pay out high dividends in order to enjoy the tax benefits of REIT status. Stable income that can exceed Treasury yields combines with price volatility to offer a total return potential that rivals small capitalization stocks. Analyzing an REIT requires understanding the accounting distortions caused by depreciation and paying careful attention to macroeconomic influences.

by David Harper, CFA, FRM

In addition to writing for Investopedia, David Harper, CFA, FRM, is the founder of The Bionic Turtle, a site that trains professionals in advanced and career-related finance, including financial certification. David was a founding co-editor of the Investopedia Advisor, where his original portfolios (core, growth and technology value) led to superior outperformance (+35% in the first year) with minimal risk and helped to successfully launch Advisor.

He is the principal of Investor Alternatives, a firm that conducts quantitative research, consulting (derivatives valuation), litigation support and financial education.

Read more: http://www.investopedia.com/articles/04/030304.asp#ixzz1hP7YdcJp