As the global financial crisis continues to deepen, I continue to dig deeper into my wallet to do some shopping. What struck me is that there are many SGX-listed stocks that are trading below their Net Asset Value, and many of such stocks belong to the category of REITs.
Disclaimer: the author is not vested in any REITs
A short synopsis on REITS
Real Estate Investment Trust (REIT) is basically a collective investment scheme where funds are raised through an equity fund raising, and the money is then placed in the hands of managers to invest in high quality real estate. The rental income and returns from such real estate investments are then distributed back by a certain mandatory percentage to all the investors in the form of dividends. In essence, for the retail investor, investing in REITs is like investing your money in a small part of a large property like
Key Characteristics of REITs
In a way, REITs are like mutual funds – a large pool of investors concentrate a pool of money in the hands of a few managers who will invest in real estate on their behalf. However, the key difference is a much higher level of transparency and accountability: (1) all transactions of the REITs are made known publicly, but transactions of the mutual fund managers are not made known to the public (2) the management of the REIT is made known and any changes in key appointment holders are to be made known publicly, but for mutual funds, the managers are faceless and nameless.
Funding Model of REITs
As almost 90% of the rental income is mandated by law to be distributed back, and 10% and less is retained, it is impossible for REITs to grow organically through internal cashflow generation. Therefore, REITs are only constrained to raise funds in a few ways:
(1)
Each of these options have their own disadvantages and limitations. As the retail investor, you have to be savvy about REIT’s funding model.
For (1), sale of properties that have appreciated in value means that the management must have identified other real estate opportunities to invest the excess cash, or else it will be distributed back to the shareholders in the form of dividend. This will mean that the asset base of the REIT is drawn down.
For (2), increasing the borrowing means that the risk free rate (or opportunity cost) per share correspondingly increases. Also, a greater sum of interest payments are made to the bank regularly. However, if the management is able to use the leverage to increase the dividend per share and net asset value, then this is a good option.
For (3), I view it as the least desirable of all the options. Suppose when the stock market and economy is having a downturn, opportunities for bargains abound and it is perhaps the best time to buy properties. But because share prices then are depressed, a lot more shares have to be issued to raise the same amount of capital, this in turn, brings about a greater dilution to existing shareholders’ holdings.
If you are a retail investor who is not keen to continually increase your investment holdings, equity fund raising is the greatest bane of them all. For you to participate and maintain your percentage holdings and the dividend rate, you will have to invest more money by subscribing to the new shares. If you choose not to participate, your per share asset worth is diluted, and your dividend rate is reduced. To the layman this can just mean, “Just put more money in, I will return you with a higher dividend. But if you don’t, your dividend rate will naturally have to decline due to dilution”
Therefore, for this option, the management should have a very compelling reason to raise such funds to purchase these assets.
From my perspective as a retail investor, the more desirable options are (1) and (2).
Debt Structure
One point to note about REITs is the debt structure. This is a critical determination factor on whether the REIT will face cashflow or financing problems in the next few years. Typically, the REITs will take up long term debts that are due after several years. The area of concern is whether, the REITs target for a 'bullet repayment', or a gradual instalment repayment. If it is a bullet repayment, which normally is a very large sum that the REIT cannot afford to pay down, the REIT will be faced with three options again: (1) raise funds through equity issuance, (2) sell off one key asset to pay off the loan, (3) extend the debt with the bank.
Further to what was raised in the previous paragraphs, (1) and (2) are heavily dependent on the economic conditions during that point in time where we know it's uncertain. If the industry is doing very badly, the REITs may have problems selling off their assets at good prices to pay off the loans.
Another critical factor for REITs is the credit rating by external agencies. This is because banks use the credit rating to determine if they have to tighten or loosen the loans to the REIT. Due to the high debt leverage of REITs, and low level of current assets, in the event that banks lose confidence on the REIT manager, what we will witness is a 'run on the REIT' and the REIT will have to bankrupt itself by quickly selling off all its long term assets to pay off the bank liabilities.
Valuation of REITs
Without this comforting factor of “directors will swim and sink with the rest of us”, there is ample room for them to mess around the financial regulations to their own selfish interest and at the expense of the trust of the retail investor. For example, if the cashflow generation from the assets are detected to be weak, the management may decide on a stopgap measure like issuing more shares on the pretext of raising funds for acquisition, but the funds are then used to be distributed back to shareholders in the form of dividends.
The valuation of REITs will have to place a strong emphasis on measuring the quality of the management, and detecting any incoherence in policies.
Over and above existing financial indicators like Net Asset Value (NAV) per share, Distribution Per Unit (DPU), dividend yield, Leverage Ratio, Debt structure, Cashflow, we have to examine the track record of the managers in the following aspects:
(a) The number of times management sought to raise capital through issuance of shares or increment of debt, and has this over time translated to higher DPU and higher NAV. Also, take particular notice of whether the assets purchased through equity issuance are contributing significantly to the asset worth and DPU with high occupancy rates.
(b) The ability of the management to identify good property investements, and to convert them into profits by selling off, and then using the money to buy into other properties.
Variations of REITs
One interesting variant of REITs are shipping trusts. The key difference is that the funds raised are used to purchased ships for chartering, instead of buying land and property. Likewise, the rental earned from chartering are then distributed back to the shareholders.
But there are a few primary differences: (1) the ships bought by the shipping trusts have a fixed service life of 20~30 years. This means that the ships are subjected to depreciation in value over time, until it becomes scrap. This has to be factored in the valuation (2) do not expect the asset value of the ships to appreciate significantly in the secondary market. Unless there is a dire demand for ships, I do not expect that these ships can always be sold off at a profit to other shipping firms. (Perhaps locally listed shipping trusts like Rickmers Marine and First Ship List Trust may prove me wrong)
Concluding remarks
REITs can be good alternative investment vehicle, what really matters is that one must have performed your due diligence to discern a high quality REIT from a low quality and dubious entity. With the convenience of the stock market, the value investor can exploit the wild gyrations of the stock market to his advantage by buying in at low prices. At low prices, the corresponding dividend rate is increased.
For further reading on REITs, do check out Wikipedia.
As usual, YMMV.
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