Old Q & A on investing in A REIT
Another spring cleaning article. Note that A REIT has ran up alot since that time and has fallen back to a rather fair value.
Q: I read that REITS give out 100% of their earnings as dividends. If that is the case, how do they grow? Without retained earnings, how to buy more properties to manage?
A:
When REIT wants to expand their business, they can either tap on Equity or debt. They can issue more shares, like what A-REIT did. Under the regulations, they can have debt-asset ratio of 35%. A-REIT’s current debt-asset ratio is 25.8%, which means it still has room to raise more debt to fund its expansion without even issuing more shares.
This means that when we invest in REIT, 1 important thing to watch out for is its debt-asset ratio. Once it nears 35%, better hands off from REIT. Beyond this point, if the REIT wants to grow, it has to take back money from investors from new equities. For new investors, this is even worse because they did not even have the chance to enjoy the generous dividends of the past years.
If debt asset ratio is close to 35%, the REIT can choose to raise capital for its expansion. If any acquistion of property is done on a “yield enhancing” basis, then new shareholders will still get a reasonable yield on their capital.
Basically, REIT is for institutions and people who are looking for “yield” and stable returns. It’s not expected to provide high potential capital gains. Thus, importantly is for you to ask yourself what’s your investment objective? What type of investments are suitable for you? Does REIT have a place in your investment portfolio. Different people will have different answers for these questions.
A REIT is not a pure equity offering. When you invest in the REIT, it is like buying property. The REIT increases in value if the underlying property (or its yield) rises.This is notwithstanding the debt picture. Remember that interest rates on debt are not gauranteed to stay low.i.e. you may want to take into account the debt when investing in a REIT. But, really, you are becoming more like a landlord (with a management company that manages everything for you and takes its cut).
REIT prices are supposed to be less volatile than than equity (steady, but not volatile income). The fact that a REIT like ascendas has increased in price from 88 cents (at IPO) to $1.40+ may be a one time exception as the REIT settles into steady state operation and investors settle on a yield that makes sense to them. Assume that I consider 200 basis points above the SGS bond rate to be an minimum yield for a REIT. Assuming a SGS rate of 3.75%, than a yield of 5.75% might be considered a good long term rate.
If I further assume that Ascendas REIT income (my example) will top out at 9.3 cents per share (without raising further equity), than my theoretical intrinsic value for the REIT is about $1.60.
Note that SGS bond rates may change naturally. It is common to assume that an interest rate rise would affect fixed income instruments (of which a REIT can be considered to be a pseudo example) in the sense that alternative investments are possible. In practice, in Singapore, with a limited array of fixed income instruments and a lack of investor knowledge, REITs are a major factor to the income oriented investor.
As a check, here’s another way to calculate it. Assume that the average lease of land (weighted by contribution of property to yield) in the AREIT portfolio is 25 years (I’m sure this can be checked, but I didn’t bother). Assume further that an “optimum yield” given current equity is 9.3 cents (as above), and it increases by an average of 3% per year. A required return of investment is 5.75% as above. Then, using an IRR calculation in your spreadsheet, I arrive at an intrinsic value of $1.63 cents.
A similar calculation where there is zero growth in yield on average, gives $1.22 as the intrinsic value.
This method is probably “better” and allows you to play with growth in yield scenarios.
A home mortgage, while admittedly secured against a “hard” asset, is fundamentally inconvenient for the lender to foreclose on and seize for disposal. It also makes for bad publicity to oust people from their homes, especially the down-and-out hard luck stories. So although the deed or lease is assigned to the bank, the assessment is ultimately predicated upon the aspiring owner’s ability to pay.
In the case of a salaried worker, the quality of the job held (in terms of pay, promotion prospects and resistance to retrenchment) is a key factor. An employer, on the other hand would likely be assessed on the strength of his business, but the control he exerts over the business and its finances would normally tilt the balance in his favour. The self-employed are subject to the most stringent scrutiny of all, on account of the volatility of their earnings.
In the case of A-REIT, its ability to pay is in turn dependent on the creditworthiness of its own tenants. Since there are many tenants, and many of these are large, financially sound concerns, the risk of significant rental arrears is minimal. Correspondingly the risk of A-REIT itself defaulting is low. Together with the low gearing, the margin of safety is good, so the banks lend cheaply.
With homeowners, there is no equivalent diversification - either you have a job or you don’t. Plus, your gearing tends to be higher. The margin of safety is lower, so the rate demanded is higher.
A-REIT’s interest expenses are relatively low because of 2 factors: a) low interest rate and b) low gearing. Notice that REITs in Singapore are restricted to 35% gearing as a matter of prudence to minimise damage from rising interest rates. The average homeowner on the other hand is geared to the tune of 70-80%. So when interest rates rise, the REITs will merely earn a little less, while many people will lose their homes.
If a homeowner decided to gear to only 35% I’m quite sure the bank would happily lend at 2% or less, long-term, for it would take a 65% reduction in property value before there was a risk to the bank’s principal, the inconvenience of foreclosure and disposal notwithstanding. In return for low risk, most banks would willingly take a low return.
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