Horizon.my

I have been a fan of REITs for some time now. It’s a great asset class and can provide meaningful diversifcation in an investment portfolio.

But I’ve never really thought about investing in REITs until recently.

REIT is not an asset class that will give you Super Returns. If you can get 12-15% per annum compounded for a couple of years, you’re doing great. This is partly because they have a much lower risk profile compared to stocks.

Now that REITs have fallen so much from peak, I believe that achieving 12-15% pa compound is becoming more realistic.

So today I will share with you some of the things I look at when analysing a REIT.

Firstly I look at the numbers. Strangely enough I don’t look at the properties in great detail, this comes later only if the numbers stack up. Also there aren’t that many REITs in Malaysia yet, so if you follow the sector a little you will generally know a bit about some of the properties to start with.

Some important things to consider

1. Does it have a good distribution yield
2. Is it geared excessively
3. What is the REIT’s debt funding cost
4. What is the Interest Cover
5. Management Cost
6. NTA, property valuation and underlying rental yield
7. Underlying earnings & PE ratio
8. The Properties – which sector, asset quality, tenant expiry profile

Since this article is quite long, I will publish it in two parts.

Distribution Yield
This is a good place to start. Yield is basically the annual Distribution Per Unit paid by a REIT divided by its current market price. For example in the case of Starhill REIT, it distributed 6.9 sen in total for the year 2008. Against its unit price of 76 sen currently, the yield works out to be around 9.1%.

Yield is important, generally the higher the yield the better, however we do need to look at several other factors:

1. Is the income distribution stable? Some REITs have very high yields, for example ATRIUM’s yield is currently 13.5%. However there’s a reason for this… one of its main tenants is vacating its Shah Alam property and because Atrium only has four properties, this will impact its income distribution.

2. Asset Class – what is the REIT investing in? In general the safest form of property assets are large regional shopping centres which dominate a population catchment area. This is because such assets are rare, barrier to entry is high and competition is limited as compared to say an office tower or industrial warehouse. An income stream anchored by such properties is highly secure.

3. Is the Yield driven by borrowings? Some REITs are able to borrow money at a cost of 5-6% per annum or even less. On the other hand, they can buy commercial properties which return an income of 8-9% per annum. If a REIT funds a property acquisiton with debt, it has potential to increase its net income and distribution without additional equity from investors.

Distribution Yield based on the latest data is found in our Investor Database – see above example

To save you time, we also include a ratio known as Average Borrowing Cost in our Investor Database. It is calculated as Interest Expense divided by the Average Borrowings (current year borrowings plus previous year borrowings divided by 2).

Gearing & Interest Cover
Personally I’m not too comfortable with REITs that borrow too much money. How much borrowings is too much? The SC limits a REIT borrowings to no more than 50% of its total assets. Personally I’m more comfortable if it’s less than 50% of total equity or 30% of total assets. It all depends on your risk appetite as an investor.

Note: It is important to distinguish what REITs mean by “gearing”. Usually they refer to gearing as Net Borrowings divided by Total Assets. In this website, it is calculated as Net Borrowings divided by Total Equity. This is to be consistent with how we use the term “gearing” for Non-REITs.

Experience from more developed countries such as Australia has shown that REITs can collapse even if its gearing is just 50% of total assets. Typically at the end of a bull run, property prices are inflated and rents are unrealistic. As a result grearing is understated and it doesn’t take much of an interest rate rise to sink a huge REIT.

Interest Cover is a good ratio which you can use. Basically Interest Cover is the number of times Earnings exceeds Net Interest (Earnings excludes Interest Income, Interest Expense, Property Revaluation Amounts and Unusual Items).

I consider an Interest Cover of 5x to be borderline and preferably should be at least 7x to be safe.

For example, a REIT with slightly higher borrowings such as AXREIT has an Interest Cover of 5.7x compared to a more conservatively geared REIT such as Starhill REIT which has Interest Cover of 15.8x.

You can use our Investor Database if you can’t work out how to calculate Interest Cover.

What Drives a REIT?
REITs typically have very little organic growth potential because rents can only go up by so much each year. REITs depend a lot on structured financing and acquisitions to deliver yield accretion to investors.

This is a double-edge sword, especially if debt funding is used to buy properties.

The REIT Manager’s fees are usually based on the fund size and transaction value. It is in their interest to grow fund size and hence their fee income. In more developed countries, some REIT managers have chased property acquisitions at all cost and it has cost investors dearly.

It is important for investors to scrutinize property acquistions carefully. You would do well to decide whether an acquisition is really done for the benefit of the Fund or the Manager.

Continued in REIT Investment Basics 2