reit dreams pages · 2017-10-07 · learn how to select the most reliable reits 2 ... reits invest...

Fortunes have been made from property. Fortunes have also been lost on property. Have you ever wondered why?

How is it possible that bricks and mortar or a parcel of land can have such

a profound effect on wealth?

The simple answer is that land is a finite resource. In theory, property

prices should rise over time, as rising economic activity and population

growth drives demand for the available space.

Property prices tend to rise over time. That is primarily why many people

are attracted to it as an investment.

1

MOTLEY FOOL STOCK ADVISOR GOLD MAY 2017

In-built growth mechanism

Identify REITs that can consistently

deliver

Build your portfolio

Aim to include some REITs for

balance

Income for life Spend or reinvest

your quarterly REIT distributions

EFFORTLESS GROWTH

Invest well and watch your REITs grow

1DO-IT-YOURSELF

Learn how to select the most reliable REITs

2LOW MAINTENANCE

No need to constantly buy and sell your REITs

3

How To Turn Your REIT Dreams Into Hard Cash

Written by David Kuo

One way bet Property can have terrible periods, as

well as stretches of quite spectacular

ones. It cannot - as much as we would

l i k e - e s c a p e t h e e c o n o m i c

fundamentals of supply and demand.

When demand for property exceeds

supply, prices could rise. But when the

opposite happens, prices could just as

easily fall.

Consequently, the cyclical nature of

property can both create and destroy

wealth. But that’s not the entire story. No

it’s not….

“…the cyclical nature

of property can both create and destroy

wealth.”

Property can also be a very expensive

asset to buy. Don’t we know it?

That invariably means that a visit to a

friendly bank manager is somehow

involved along the way.

That can add extra layers of risk to

property ownership. These could

include the outlook for interest rates,

the prevailing state of the economy,

geopolitical considerations, changes to

demographics and the availability of

credit. They all have a lot to answer for.

So who, in their right mind, would ever

want to get involved in the property

market, if it can be so inherently risky?

Many do, is the simple answer.

2


H e r e , t h e r e a nd everywhere Take a look at the number of property

developers, landlords, house builders

and construction companies that

populate not only the Singapore stock

market but many overseas markets too.

Our Singapore market for instance,

especially our mid-caps, would look and

feel quite different, if not for the many

Real Estate Investment Trusts or S-REITs

that lend their weight to the index.

REITs, which vary considerably in size,

can be interesting investments. Some

people might even try to tell us that

they are so unique that they should be

treated as a separate asset class.

But let’s put that bit of misinformation to

rest straight away. They are not.

There are only four asset classes. In other words, there are only four types of investments we can hold that will provide us with income. For that reason, gold is not an asset class, despite what some might say.

Soft and hard commodities, which

include iron ore, palm oil, cotton and

belly pork, are also not asset classes.

Hedge funds are not a separate asset

class either, though some might try to

convince us that somehow they are.

Same goes for private equity funds.

They, too, are not a separate asset class.

There are only four types of investments that generate income:

1. Cash 2. Bonds 3. Property 4. Shares

Classy assets Cash, bonds, property and shares are

the only four asset classes. To qualify

they must generate income.

Cash pays interest; bonds deliver

coupons; shares distribute dividends,

while properties yield rent.

REITs invest in income-generating

properties. They might invest in

shopping malls, commercial buildings,

accommodation and industrial parks,

which are rented out. Some even invest

in telecommunication towers.

These assets generate income which

can reward investors with distributions.

These payouts are a share of the

income that REITs derive from their

property. Distributions are, to all intents

and purposes, dividends, which mean

that REITs are, essentially, income-

generating shares.

3


Confusion reigns The potential for confusion lies in the

rules that govern the way that REITs

operate.

Unlike shares, REITs do not have

discretion, when it comes to paying

dividends. They are required to pay out

at least 90% of their profits as dividends

to investors, whether they like to or not.

There are no ifs. There are no buts.

By paying out almost all of their profits

to shareholders, REITs are, in turn,

afforded a favourable tax status. They

are virtually exempt from paying any

corporation tax.

That was one of the main reasons why

they came into existence, in the first

place.

“REITs are required to pay out at least 90% of their profits as dividends to investors, whether they like to or not.”

A potted history REITs were first introduced in the US

around 50 years ago to encourage

investors to pool their money in the

property market. The idea caught on in

other countries later on.

Thing is, developing property on a

massive scale can be costly… very

costly. But if property investors were

taxed once at the corporate level and

again at the personal level, who would

want to do it?

The answer is not that many. But a

favourable tax treatment might.

So REITs, with their favourable tax status,

provided developers with the capital

they need to build more. Meanwhile,

towns and cities benefitted from much-

need construction.

A REIT would only receive preferential

tax treatment, if it paid out nearly all its

income as distributions to investors.

4


So, the attraction of REITs lies in their

ability to generate long-term rental

income for shareholders, who are also

known as unit holders.

Investors buy REITs for both the

r e c u r r i n g i n c o m e a n d p r i c e

appreciation, should the properties

held by REITs rise in value over time.

Show me the cash The income-producing characteristics

of REITs can create some curious but

interesting results.

Since payouts might be thought of as

being somewhat predictable, REITs are

often seen as proxies for bonds. They,

like bonds, could be capable of

delivering dependable income for

investors, over the long term.

But just as bond prices might move in

the opposite direction to interest-rate

movements, the prices of REITs have a

tendency to do the same.

When interest rates rise, investors would

probably want to pay less for each unit

of a REIT to generate a comparable

return from, say, a risk-free investment,

such as a government bond.

Similarly, when interest rates fall,

investors might be prepared to stump

up more to capture every dollar of a

REIT’s distribution.

There is another reason why REIT prices

might move in the opposite direction to

interest rates movements.

“Investors buy REITs

for the recurring

income and price

appreciation.”

That is because REITs tend to borrow

money to buy property. So, higher

interest rates could, say, result in heftier

interest payments, which, in turn, could

sap distributions available to investors.

The prospect of lower distributions in

the face of rising interest rates could,

therefore, depress the share price of

REITs.

5


Here’s the rub Rising interest rates - rather than hurting

REITs – could even benefit them.

Interest rates generally rise because the

rate of inflation could be on the

increase. In order for central banks to

keep a lid on inflation, they need to

ensure that their interest rates are

sufficient to bear down on rising

consumer prices.

But in an inflationary environment, REITs

could justifiably charge higher rents,

which could result in more rental

income and, in turn, higher distributions

to shareholders.

Put another way, a REIT’s performance is

in f luenced by preva i l ing credi t

conditions and the economy. We should

try to keep that in mind when we are

thinking about investing in REITs.

In theory, if either the economy is doing

well or credit is readily available, then

REITs should be capable of doing well

too. That should ensure regular

distributions to investors.

As income from REITs is often the

primary objective for many investors, it

is perhaps understandable why they

might pay so much attention to their

yields. That is just one way to assess a

REIT. But it is not a reliable way of

looking at REITs.

Nevertheless, it can be a good starting

point.

The pecking order Current ly the average y ie ld on

Singapore REITs is around 7%. That is

almost twice the yield for the Singapore

market.

In every instance, the yield on S-REITs is

higher than the market average. That

could imply that almost every one could

be a good prospect.

But it is important to dig a little deeper,

to avoid jumping to the wrong

conclusions, or worse still, jumping into

the wrong investment.

The average yield on

S-REITs is 7%.

6


It is important to consider that a high

yield might not automatically equate to

a good investment.

The yield is made up of two separate

components – the dividend, which is the

numerator, and the share price, which is

the denominator. A high yield could,

therefore, be the result of a dividend

that is too optimistic or a share price

that is too pessimistic.

We need to figure out why….

Cash is King Distributions by a REIT have to be paid

from income. So it is crucial that

a n y t h i n g t h a t i s p a i d o u t t o

shareholders is adequately covered by

profits.

The higher the coverage, the better and

safer it could be. It means that the REIT

does not have to work too hard to meet

its obligations.

Dividend coverage varies amongst the

30 S-REITs. The median coverage is

around 1.05. In other words, for every

dollar paid out as dividends, there is

$1.05 of profit behind them. But there

are differences between the best and

the worst.

7


The dividend coverage is noticeably

lower than for shares, in general.

Typically, dividend coverage of around

two times profit for most shares is

desirable. It allows the company to

retain some of the profits to grow the

business.

But REITs are different.

They are required to pay out most of

their income as dividends to qualify for

the favourable tax treatment. Them’s the

rules. So that’s why the dividend

coverage is lower.

However, profits are not a reliable way

to look at REITs. No they are not. There

are much better ways to gauge the

health of REITs and their payouts.

But first, a look at one of the major

expenses for REITs – interest payments.

Interesting times REITs typically borrow heavily to fund

their purchases. So, it is important to

ensure that not only are dividends

adequately covered but that interest

payments can be easily met too.

In the case of S-REITs, on average the

profits are more than three times higher

than interest payments. The median

interest cover of 3.8 times suggests that

S-REITs are in reasonably good health.

In fact Singapore REITs could probably

afford to borrow more. Some can. But

some are unable to do so.

8


Changing gears The reason why some can’t is not too

hard to understand. There are stringent

regulations in Singapore that restrict

how much REITs are allowed to borrow.

The ceiling for the amount of debt

taken on by REITs has been capped by

the Monetary Authority of Singapore at

45% of Total Assets. In other words, the

gearing must be below 45%.

Currently, the median gearing is a

modest 34%, which might suggest that,

on average, S-REITs could have room to

borrow more, if they wanted to.

However, averages can be deceptive.

Some REITs have borrowed less than

30% of their Total Assets. But some are

already closing in on the limit of the

debt ceiling.

So what’s better – to have too much

debt or not enough borrowings?

Is lesser better? There are a couple of implications to

the assumption of debt. And it may not

always be the case that a lower level of

borrowings is necessarily better.

Debt, i f used judiciously, could

significantly improve shareholder

returns because the business is using

other people's money.

But too much debt could also be

detrimental. Oh yes it can.

It can restrict the amount of money that

a company could borrow at a later date

to pay for new acquisitions. When that

happens, the REIT might pass around

the begging bowl for more cash.

Debts also need to be either repaid or

refinanced when the loans mature.

There are no guarantees that either of

those two things could happen, when

the lender comes a knocking. Again, the

indebted REIT might have to tap

shareholders for cash.

9


Leverage Ratio The Leverage Ratio could provide some

help in determining a REIT’s exposure

to debt. It measures the total amount of

liabilities compared to total assets.

The average Leverage Ratio for the

Singapore market is around 1.7. It’s

similar for REITs. Their median Leverage

Ratio is around 1.6.

A high Leverage Ratio can improve the

Return on Equity. It can have a powerful

multiplier effect on the profits that a

REIT generates for shareholders. So it

can be tempting to lean towards REITs

that have substantial leverage.

But it’s not easy to tell when a REIT has

borrowed too much. It can creep up on

you just like when we have been

overeating, and one day we can no

longer fit into our clothes.

Fix it Another useful measure is to compare a

REIT’s long-term borrowings to its short-

term debts.

When interest rates are falling, REITs

that predominantly use short-term loans

can benefit. It means that they could

refinance loans at more favourable rates

when the debts mature.

But if interest rates should rise quickly,

they could be disproportionately hurt.

On the other hand, REITs that have

taken on longer-term loans could be

insulated from interest-rate rises, until

they need to refinance at a later date.

Less than 2% of S-REIT debts are short-

term loans. This might suggest that on

average Singapore REITs could be

adequately shielded from short-term

interest rate hikes.

10


By the book We should never lose sight that REITs

are property assets. So it is important to

think of them as such. We should weigh

up carefully how much we are paying

for every dollar of Net Asset.

In the same way that you would

probably balk at overpaying for a house

or a condo, the same goes for buying a

REIT. They are, after all, just a collection

of income-generating bricks and

mortar.

One way to assess REITs is to look at

their book values. Since the properties

held by REITs are appraised regularly,

the book value should provide a

reasonable gauge.

Currently, Singapore REITs are, on

average, trading at a small discount to

their book values, though some are

trading at quite a hefty premium.

There could be valid reasons why the

market might be pessimistic. An

economic slowdown could make some

properties less valuable.

“One way to assess

REITs is to look at

their book values.”

Remember the market is always looking

forward to what it thinks might happen.

There might also be perfectly good

reasons why the market could be

prepared to pay a premium for some

REITs. Prize assets in prime locations are

highly valued. They might also rise in

value, faster than other properties.

The best time to buy a REIT is when the

market is under-appreciating the value

of its assets. In other words, the best

opportunities could be when a REIT is

either not trading at a massive premium

or at a discount to its Net Asset Value.

That could happen for all sorts of

reasons. Irrational market behaviour is

not uncommon.

11


Show me the money Another way to view REITs could be to

consider how much we are paying for

every dollar of cash that they generate.

Cash is not the same as profits.

So, a better way to value REITs might be

to look at their Funds from Operation

(FFO), rather than profits. In some

countries, FFOs are reported as a

matter of course in a REIT’s accounts.

But not in Singapore, yet.

That said, it is not too difficult to work

out the numbers for ourselves.

Currently, the median Price-to-FFO for

S-REITs is a not-too-demanding 14. It

means that investors are paying around

$14 for every dollar of cash generated.

Cash is probably more useful than

profits, which tend to be complicated

by accounting rules that require REITs to

d e p re c i a t e a n d a m o r t i s e t h e i r

properties. REITs also have to account

for non-recurring items such as the

disposal or purchase of properties.

Property values tend to rise over time

rather than depreciate. But general

accounting rules require properties to

be depreciated over their lifetime. The

upshot is that the reported profit

number could underestimate the cash

generated by the asset.

Additionally, REITs tend to hang on to

their properties for ages. In fact, we

should be a little concerned if a REIT

buys and sells buildings too frequently.

So the purchase or sale of a building is

not something that they do regularly.

But by general accounting rules, the

gains or losses from the disposal of

buildings have to be accounted for in

the profit figure. That’s the way the

cookie crumbles.

Consider how much you are paying for every dollar of cash

that the REIT

generates.

12


Capitalisation rate A common problem with comparing

different REITs is that it can be a bit like

comparing almonds with pistachios.

That’s just nuts.

Is it really possible to compare, say, a

REIT with prime properties in the

Central Business District with another

REIT that owns a portfolio of suburban

malls? Which is better?

It’s not easy. But capitalisation is a way

of solving the problem. It looks at the

rate of return that a property owner

expects to achieve from its assets. It is a

measure of the annual income that a

REIT generates from its properties.

At present, the median capitalisation

rate for S-REITs is around a 6%. It means

that they are able to generate roughly

$6 from every $100 of property assets.

It implies that S-REITs are relatively low

risk because they are generating steady

income from reasonably valued assets.

But hang on. Isn’t a higher capitalisation

rate better? Wouldn’t it be great to

squeeze tenants until the pips squeak?

That might seem like a good idea. But it

could also mean that the REIT could be

charging too much rent, which, in turn,

could mean that the high income might

be unsustainable over the long haul.

It could also mean that the landlord

might have targetted riskier tenants.

Alternatively, it might mean that the

tenants are on short-term leases.

Unfortunately, there is no right or wrong

capitalisation rate. But perhaps those

clustered around the market median

could be seen as being more stable for

the long-term investor.

13


Putting it altogether We have looked at different ways of

valuing REITs. But what - if any - is the

best method to look at these income-

generating assets?

Should it be the distribution yield or

price-to-book, both of which are

popular amongst investors? The answer

is that everything should play a part

when evaluating REITs. There are no

short cuts.

If we put ourselves into the shoes of a

property manager, it is probably the

cap i ta l i sat ion rate that w i l l be

paramount. So, perhaps we should be

paying more attention to that.

The capitalisation rate could play a role

in the types of properties that a REIT

might want to buy. It could determine

when a REIT might decide to sell an

asset. And it could even establish the

maximum interest rate that a REIT can

afford to borrow money at.

S o f r o m a n i n c o m e i n v e s t o r ’s

perspective, we should perhaps start by

looking at REITs whose capitalisation

rates are bunched around the median,

with, say, a minimum rate of 5% and a

maximum of no more than 9%.

That should prov ide us w i th a

considerably smaller crop of REITs to

investigate further.

What to look for: * Yields between 5 - 9% * Profits twice that of interest payments

* Distribution growth of more than 4%

* Price to book around the market average

Filter tips From the smaller batch of REITs, we

could start eliminating those with

distribution yields below 5% and those

with yields above 9%.

Wash, rinse and repeat for REITs with

interest cover of more than two, and

those with price-to-book values that are

clustered either side of the median.

By eliminating the outliers we can start

to identify the best performing REITs.

Currently, the list includes CapitaLand

Commercial Trust, Starhill Global,

Frasers Commercial Trust, Suntec REIT,

Frasers Centrepoint Trust, Ascott REIT,

CapitaLand Retail China, CapitaLand

Mall Trust, Mapletree Commercial Trust

and Keppel REIT.

That’s still a big bucket of REITs.

14


But we are not quite done yet. We

should be looking for REITs that have

demonstrated a good track record of

growing their payouts too.

That cou ld be a s ign o f good

management. So, as a final test we

could set a criterion of, say, four

consecutive years of rising dividends. In

fact, we can be as ruthless as we like.

We could set a minimum compound

growth rate of 4%. That’s enough to

keep up with inflation. With that, we are

left with Suntec REIT, Starhill Global,

CapitaLand Retail China, CapitaLand

Mall Trust, Frasers Centrepoint Trust,

Ascott REIT and Keppel REIT.

But we are still not quite done, yet.

The fun begins The next stage is the really fun part of

researching REITs. This is where - with a

much smaller crop of REITs – our job of

finding the right investments should

now be considerably easier.

“My stock picking method, which involves elements of art and science plus legwork, hasn’t changed in 20 years.”

Peter Lynch

The same goes for investing in REITs.

So it’s time to slip on our walking shoes

and visit the properties. That means

taking a look at the buildings. If they are

commercial offices, then ask yourself if

they are the kind of places that you

would like to work in. Do they have

adequate amenities, good facilities and

convenient transportation close by?

If it is a shopping mall, then turn up at

different times of the day to check

shopper traffic and footfalls. Are

shoppers laden with carrier bags or are

they just walking around empty

handed? Pop into the shops to see just

how busy they are. Check out the

restaurants? What is the mix of eating

outlets to retail stores in the mall?

15


The final chapter When we invest, we should set out to buy

wonderful companies at fair prices.

Evaluating companies through a bottom-up

approach might seem old fashioned. But it

forces us to look at business fundamentals

before we start looking at prices.

Fundamentals can tell us whether they are

wonderful businesses. The latter will tell us

if it is possible to buy those wonderful

businesses at a fair price.

All too often investors focus on the price

b e f o re t h e f u n d a m e n t a l s . Th at i s

tantamount to putting on our shoes before

we have put on our socks. We would never

dream of doing that.

Yet many investors will look at yields and

price-to-book before they have even

looked at the company’s balance sheet.

It is little wonder that they panic at the first

sign of market turmoil.

“We don’t get paid for activity, just for being right.”

Warren Buffett

If we analyse a company properly, and buy

with a decent margin of safety, we have a

greater chance of being right.

David Kuo owns shares in Mapletree Commercial Trust, Parkway Life REIT, Keppel REIT, Starhill Global, CapitaLand Retail China and CapitaLand Mall Trust.

All information is provided exclusively by The Motley Fool Singapore Pte Ltd, a licensed investment advisory research provider (MAS Licence No. FA100056-1). Any information, commentary, recommendations or statements of opinion provided here are for general information purposes only. It is not intended to be personalised investment advice or a solicitation for the purchase or sale of securities. Before purchasing any discussed securities, please be sure actions are in line with your investment objectives, financial situation and particular needs. International investors may be subject to additional risks arising from currency fluctuations and/ or local taxes or restrictions. The information contained in this publication are obtained from, or based upon publicly available sources that we believe to be reliable, but we make no warranty as to their accuracy or usefulness of the information provided, and accept no liability for losses incurred by readers using our research. Recommendations and opinions are subject to change without notice. Please remember that investments can go up and down, including the possibility a stock could lose all of its value. Past performance is not indicative of future results.

Copyright © 2017 The Motley Fool Singapore Pte. Ltd., All rights reserved. No part of this publication may be reproduced, stored, transmitted in any form of by any means without The Motley Fool’s prior written consent.

Contact Member Support at: [email protected]

16


mailto:[email protected]

APPENDIX List of Singapore REITS (as of April 2017)

17


Company Name Ticker Market Cap (S$m)

AIMS AMP Capital Industrial REIT SGX:O5RU 846

Ascendas Hospitality Trust SGX:Q1P 843

Ascendas Real Estate Investment Trust SGX:A17U 7278

Ascott Residence Trust SGX:A68U 1802

BHG Retail REIT SGX:BMGU 338

Cache Logistics Trust SGX:K2LU 729

Cambridge Industrial Trust SGX:J91U 730

CapitaLand Commercial Trust SGX:C61U 4555

CapitaLand Mall Trust SGX:C38U 6842

CapitaLand Retail China Trust SGX:AU8U 1237

CDL Hospitality Trusts SGX:J85 1385

EC World REIT SGX:BWCU 576

Far East Hospitality Trust SGX: Q5T 1065

First Real Estate Investment Trust SGX:AW9U 996

Fortune Real Estate Investment Trust SGX:F25U 2943

Frasers Centrepoint Trust SGX:J69U 1828

Frasers Commercial Trust SGX:ND8U 1007

Frasers Hospitality Trust SGX: ACV 1249

Frasers Logistics and Industrial Trust SGX:BUOU 1365

IREIT Global SGX: UD1U 445

Keppel DC REIT SGX: AJBU 1319

Keppel REIT SGX:K71U 3402

Lippo Malls Indonesia Retail Trust SGX:D5IU 1094

APPENDIX List of Singapore REITS (continued)

18


Company Name Ticker Market Cap (S$m)

Manulife US REIT SGX:BTOU 743

Mapletree Commercial Trust SGX:N2IU 4292

Mapletree Greater China Commercial Trust SGX: RW0U 2725

Mapletree Industrial Trust SGX:ME8U 3028

Mapletree Logistics Trust SGX:M44U 2675

OUE Commercial Real Estate Investment Trust SGX: TS0U 892

OUE Hospitality Trust SGX: SK7 1224

Parkway Life Real Estate Investment Trust SGX:C2PU 1470

Sabana Shari'ah Compliant Industrial REIT SGX:M1GU 480

Saizen Real Estate Investment Trust SGX:T8JU 8

Soilbuild Business Space REIT SGX: SV3U 664

SPH REIT SGX:SK6U 2464

Starhill Global Real Estate Investment Trust SGX:P40U 1603

Suntec Real Estate Investment Trust SGX:T82U 4471

Viva Industrial Trust SGX: T8B 724

reit dreams pages · 2017-10-07 · learn how to select the most reliable reits 2 ... reits invest...

Documents