A Better Way to Invest in Properties – REITs

Date: July 17, 2009

by Roger Tan, SIAS Research

“Investing in properties will not go wrong!” is a claim that I often hear from investors. There are many benefits to investing in properties such as capital growth potential, rental income, and inflation hedge.

However, there are issues when investing in properties. Firstly, properties are not divisible. You cannot buy just 10sqf from a seller who is trying to sell his 2000sqf office space. Secondly, properties are not homogenous. The value of two adjacent office space can differ because of facing and “feng shui”. Thirdly, properties are illiquid. You cannot expect to sell your property overnight. It will take time to market your property and find a buyer. Finally, there are cost in renting and maintaining the property. The property owner will have to incur time, not only cost (brokerage and legal), to upkeep and rent out the property. Furthermore, rental income is taxable. This further reduces the benefit of owning properties.

The Advantage of Investing in Properties through REITs

Real Estate Investment Trusts (REITs) add value to investors by solving these issues. By owning properties and issuing “units” on these properties, REITs effectively “homogenized” the property investment since each unit is a proportionate claim of the cash flow produced by the overall assets owned.

The “unit system” also made the properties divisible. Investors can decide on the number of units they wish to purchase instead of being tied down by the need to purchase a fix size area. By making properties divisible and homogenous, REITs allow investors with limited funds to structure and enhance their investment portfolio through better diversification.

By listing units on the stock exchange, REITs allow investors to buy and sell their investments easily. This reduces the liquidity issue of property investment and at the same time increase price transparency.

Because properties in REITs are managed by professional managers, investors no longer need to spend time to negotiate rents and maintain the property. Furthermore, REIT managers are usually incentivized to enhance the rental yield of the properties. Therefore investors would often see managers implementing innovative strategies to maximize the rental yields of their assets.

The benefits do not end here. REITs income is not taxable if they meet certain criteria and dividends paid to individual REIT investors are also not subjected to tax – an advantage not available to direct property owners.

Governance of REITs

The regulation of REITs is different from a usual company in a few ways. Firstly, REITs can pay dividends from operating cash flow rather than from operating profits. These cash flows that can be used to pay dividends to investors are known as “distributable income”.

Secondly, REITs must pay at least 90% of its distributable income as dividends. This enhances the transparency of the REIT and also reduces the financial slack that management can keep.

Thirdly, the leverage threshold that REITs are allowed to undertake is 35% for REITs who did not obtained a credit rating and publicized it and 60% for those who have. This is to ensure that REITs cannot use too much debt to enhance their yields and put investors at risk.

What’s in it for the Property Companies?

There are also benefits for property companies who may be the REIT creators themselves. Before REITs, property developers who built commercial buildings had to own and manage the properties to earn the returns from their venture. This reduces their resources available to be channeled to their development business. With the advent of REITs, property developers can now focus their resources on property development and leave ownership of the property to REITs investors.

Property developers can also improve their key financial performance ratios by removing these large assets (and also liabilities if any) off their balance sheet and into the REIT’s books. They could even extend their revenue source by providing management services to REITs; thereby improving revenue mix.

Risks in Investing in REITs

Like most investments, REITs are not risk free investments. The unit price of REITs fluctuates as investors react to information and transact in the market. Furthermore, since dividend is derived from the amount of rental REITs can collect from their property investments, the amount of dividend is not assured and can change according to the economic conditions.

Because REITs can deploy leverage, REITs can face financial distress when value of their properties fall below the loan-to-value (LTV) covenants. Moreover, banks may choose not to refinance the REITs when the loan comes due. This adds further uncertainty especially to REITs who are highly geared.

What Factors to Look Out For In a Good REIT?

So, what factors do you need to look out for when choosing a REIT? In my Business Times article published on 11 Jun 09, I have stated the following factors.

“First, a REIT’s ability to raise funds especially in times of turmoil will determine its ability to thrive and survive. This is an important factor. In good times, most REITs will enhance their yields through higher leverage but only well managed REITs will be able reduce this leverage in challenging times. Without this ability, badly managed REITs will find it difficult to refinance or raise sufficient equity to repay its loans, putting them in danger of liquidation.

The quality of the asset is another important factor and REITs that own properties beyond just Singapore alone would be a plus. There has been too much emphasis put on dividends and too little on the assets itself. Investors must bear in mind that they are buying the underlying assets when investing in REITs – the dividends are result of the ownership and management of the assets.

However, good assets can produce poor returns if poorly managed. The quality of the managers is therefore another important factor. Good managers will continuously enhance the yield of the assets and use appropriate debt-equity mix at all times. Sudden fall in rental revenue, rental collection issues, and below average rental yields are some signs of poor management quality. These REITs should be avoided totally.

Finally, investors must check if a counter is a REIT (such as CapitaMall Trust) or a business trust (such as IndiaBulls Property Investment Trust). Both business trusts and REITs are created to allow unit holders to receive dividend payments from the operating cash flow instead of accounting profit. However, only REITs are required to pay 90% of distributable income to unit holders. There is no such requirement for business trust. Investors should therefore look closely at what they are picking to ensure the counter they choose is in line with their investment intention.”