A Cursory Study of Real Estate Investment Trusts (REITs)

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 Suntec City mall.

Key Characteristics of REITs

REITs allow the general public to enjoy all the benefits of owning a property at a small cost, and at the same time, enjoy the liquidity of a listed stock.

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

Companies are either funded by equity or by debt. For REITs, it is not unusual to find that they have a very high debt leverage i.e. REITs use large sums of short term borrowings mixed with funds raised through equity to purchase high quality assets and generate cashflow through rental income.

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) Sale of properties that have appreciated in value

(2) Borrow through either long term of short term debt

(3) Issue new shares and raise funds from the public

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

In light of the characteristics of REITs, the dimensions in valuation and areas of focus in carrying out analysis varies slightly from that of the usual publicly listed stock. This is primarily because directors of REITs are paid a management fee and normally do not have a significant vested interest in the REIT itself.

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.

The Lurking Dangers behind Structured Investment Products

I read with great interest, when Straits Times posted the article on how a certain structured product of High Notes 5 in DBS is currently facing the problem of an imminent dissolution due to the collapse of Lehman Brothers. To understand more about structured products, you may read http://www.askdrmoney.com/Analysis_Structured_Explained.htm

Brilliant marketing + investment products = Beware of the devil in the fine print

I do not deny the benefits of leaving your money in the care of professionals and experts, but the biggest gripe is most if not all structured products use clever marketing words to mislead and imply statements that are not true, and the disclaimers are always written in the smallest font in the last line of the brochure. Words like "9% payout on 1st year..." does not necessarily mean you will receive an investment return of 9%, but rather 9% is tapped from your initial investment and repaid to you.

Sadly, so many people take things at face value, make uninformed decisions and always end up on the losing side of the deal.

There's a brilliant website that read and analyzed several structured products of Singapore Banks. You may want to read them at http://www.askdrmoney.com/Analysis_Structured_Bank_Products.htm

So, if you ever want to consider investing in structured products, think again.

Gold: Insurance for your wealth

Investment in gold deserves a mention in this blog, because gold is an important asset class from the perspective of a wealth insurance, but usually this is not known and not considered by people generally.

Disclaimer: This article merely expresses the authors views and are not recommendations for action by the reader. YMMV.

Concept of money as a medium of exchange
Before we talk about gold investment, allow me to talk a little on background of money. Some explain money as "Money is what money does", which means that money is a medium of exchange. In the good old days, money notes is designated to be a promissory note of guarantee and as a means of convenience to replace physical gold as the currency. It was a medium of exchange that allows one to trade between different items using a common denominator of value, and over time, the entire world economy grew to depend on money as its lifeblood.

The Bretton Woods system
As the world progressed into modern times and global trade and commerce started to bloom, it was recognised that there's a need to establish a common policy for international monetary management. The Bretton Woods system was established in 1944 as a set of rules of commercial and financial relations among the major industrial nations. It was also in the same time period that an international regulatory financial body like International Monetary Fund (IMF) was established. The primary feature of the Bretton Woods system is that the nations are obliged to peg their currency at a certain fixed rate to gold with a 1% spread between the buy and sell rates. It was a good and stable system that is in a way backed by physical gold. For the world's dominant leader, the US dollar was pegged at USD35 per ounce of gold.

However, by early 1970s, US's participation in the Vietnam war accelerated inflation, and for the first time in modern history, the nation as a whole began running a trade deficit. The reasons for an accelerated inflation can be attributed to a massive consumption of resources and the government began to finance this consumption by printing more money notes. As this war went on, people started to swap their dollars for physical gold. Because of excess printing of money by the US government, nations began demanding US to fulfil its promise to pay, by a conversion of dollars into gold. This came to a tipping point where US's gold coverage deteriorates from 55% to 22% and it represented the point where holders of the dollar lost faith in US's ability to cut it's budget and trade deficits.

Collapse of the Bretton Woods system and emergence of the floating currency
In 1971, the United States devalued its currency from USD35 per ounce of gold, to USD38 per ounce of gold. In 1972, it reached USD70 per ounce. In 1973, the Bretton Woods currency markets closed and subsequently reopened as a floating currency regime where the dollar is no longer pegged at a fixed rate to gold. Today, the exchange rate stands at startling rate of USD823 per ounce of gold and this is expected to rise further.

Fiat money and the risks of hyperinflation
As United States grew to became the modern day economic powerhouse, the dollar became the de facto currency that many countries view as gold. The dollars became a favourite denomination for countries to keep in their vaults as foreign currency deposits.

And as the circumstances in the world evolved, it somehow becomes apparent to me that our world's economy now hinges on fiat money - money is designated as a medium of exchange because the government said so. It runs purely on the confidence in the government, and holds no intrinsic value. For the world's economy to fall apart, all it takes is for a critical mass of people to lose faith in their government's currency and began collectively raising prices mindlessly. Humans have the herd instinct, once the confidence is shaken, things can spiral out beyond control like what happened in Zimbabwe, where money completely loses its effectiveness as a medium of exchange. (read here)

Gold: insurance of wealth against runaway inflation
Gold is an asset class that will not lose its effectiveness as a medium of exchange because of the underlying intrinsic value and limited global supply. It is an excellent form of liquid asset class that can help insure us against a currency fallout. The risk of a currency fallout is remote, but it is there and as a rational human being, I will want to guard against such a catastrophic situation. Let me draw an analogy: we buy life insurance even though the risks of death and critical illness are statistically remote - for the simple reason that we want to preserve our state of wealth and minimise impact on our loved ones if something unfortunate strikes. Likewise, buying some gold can help to preserve our hard earned wealth and standard of living should an unfortunate case of currency fallout strikes. Although very unlikely, I do not completely rule out that possibility. And if ever a currency fallout does happen, I want to know that I can still use ounces of physical gold to sustain my daily needs.

Buying how much gold is enough then?
Historically, when hyperinflation occurs and prices rise beyond 1000%, gold prices will also rise more than 1000%. A good rule of thumb to start with is that we should probably strive to build 10% of our net worth in gold. So in the event of hyperinflation, gold price can be expected to rise such that we can still retain 100% of our current net worth.

Methods on investing in gold
We can invest in gold in basically 3 different forms. Either physical bullion, paper gold certificates, or Exchange Traded Funds. If you think of buying gold, it can be acquired in the form of physical bullion from official websites like http://www.kitco.com/. The online market also allows one to sell off gold. Just a comment on physical bullion: the bigger the gold bar, the cheaper it is in terms of per ounce, but also less liquid. Gold is much more liquid in forms of widely recognised coins like the Canadian Mapleleaf coin (see picture above)

A fellow forumer, who is incidentally my brother, has written excellent articles on gold investing. (Read How to Invest in Gold, History and going forward, Investing in Gold)

For further information and open forums on investments in gold, you can go to http://www.goldclubasia.com/

Other interesting points about gold:
Market movements have shown that crude oil prices and gold are in many ways correlated. It has been widely recognised that oil and gold have one of the strongest historical commodities relationship. It is even more interesting to note that back in 1975, oil was pegged at USD75 per barrel, as compared today's prices of USD113 per barrel. Now, compare that against the gold exchange rates: in 1975, USD40 per ounce of gold. Today, it is USD823 per ounce of gold.

I shall leave you at this thought. For further reading, see here.

Institutional Funds

The institutional fund manager's job is getting immensely difficult these days. With the recent malaise plaguing the financial industry, the fund managers will have an even harder time in future to strive to outperform the benchmark, earn their keep, keep their bosses and financial risk analysts satisfied.

Disclaimer: The below are not directed at any specific funds or agencies; it is merely an expression of the author's opinion on the efficacy of institutional fund management. YMMV.

Institutional fund managers face immense challenges.

Firstly, their portfolio performance is rigourously benchmarked using various indicators across the entire board of fund managers very regularly, like every 3 months. Secondly, they have to maintain a mandatory percentage of cash float for people who may be redeeming their funds. Thirdly, not forgetting, fund managers are increasingly bugged with justifying to a team of risk managers on why certain decisions they make have mitigated financial risks to the benefit of fund holders. Fourthly, they are to invest within the strict bounds of an investment policy that defines what is deemed as a "stable" or "balanced" or "dynamic" portfolio; there are no ways that they can deviate from this policy.

Feels like these measures of investment policy statement, risk managers, quarterly performance ranking, are good for the fund investors eh? Take a closer look and reality reveals otherwise.

A Performance Ranking Induced Myopia in Investment Horizon

The great implication of quarterly performance ranking is that fund managers are forced by circumstances to adopt a very short-term myopic perspective towards managing investments. Structure drives behaviour, the more regular their performance ranking, the more myopic they become. To maintain that mandatory cash float, fund managers will usually look through their list of investments: those investments that are good and have yielded solid gains are the first to be sold, while the losers are retained inside the portfolio. And they have to be careful that there is not too much excess float going around, because they have to invest the excess to obtain good gains.

Influence of Forces and Demand and Supply on Fund Performance

There will also be times when they have made good investments in excellent businesses, but the gains can only realised by the market after an extended period say 12 months, but because they are forced to maintain the float, they often have to sell out prematuredly probably at a loss or break even point. This is a classic case in point that fund performances are in many ways heavily influenced by consumer demand and supply of the fund float. So, sometimes if the funds you bought have performed badly, do not always thumb it on the fund manager, sometimes it is an outcome that is driven by consumer demand.

Portfolio Churning

Normally, what fund managers are 'coerced' into doing is call 'portfolio churning' - they will sell out on good investments to maintain the float, buy back into them when there's excess, keep the lousy ones in the hope of recovery in a bull market, and along the way, incur greater transaction costs that ultimately end up as management fees. Look out for the end-of-year volume on the Singapore Stock Exchange, you will notice unusually high volume of trades, this is because fund managers are near their year end reporting times, and you have large fund investors hopping around.

The Nameless & Faceless Fund Manager

Now, to complicate matters further, fund managers do not always remain in that fund always. Their appointment constantly change. Your returns are in many ways like unpredictable seasons and monsoons, all hinging on the skill of one person, unknown to you, hidden behind the name of a fund. If you get Peter Lynch or John Neff, good for you; but if you get an amateur finance manager, good luck to you then.

If you look across all the funds, there are some of the funds that seem to track the indexes (e.g. Dow, STI, Hang Seng, Kospi, S&P, JCI) pretty closely, well that's because the funds just buy index stocks. Then there are some that outperform the market slight, some that do extremely well, but most of them languish in mediocre gains.

So, is investing in institutional funds, entrusting your money to a group of professional money managers the way to go? I think as a DIY investor, I can probably do as well, if not better than them.

As usual, YMMV.