A Smart Guide to Investing: An Introduction to REITs Part 3

2021-04-24     thesmartinvestor
A Smart Guide to Investing: An Introduction to REITs Part 3

Hello Smart Investor!

Welcome to our final part of a three-part series on investing in REITs.

As a quick recap …

Part 1 provided an introduction to REITs and why you should invest in them.

Part 2 talks about the different types of REITs available for investment and common REIT terms used.

In this final installment, we look at the various methods REITs use to grow their distribution per unit (DPU) and assets.

We also delve into the risks associated with investing in REITs, and how these can be mitigated.

Ways that REITs grow their DPU

A growing DPU is probably the most important aspect of investing in a REIT.

REITs that can increase their payouts over time can help to increase your flow of passive income. The increase in DPU typically leads to a higher unit price as well.

As such, unitholders end up enjoying the best of both worlds — capital gains from a rising share price and a steady increase in the distributions they receive.

There are three main methods that REITs use to increase their DPU — positive rental reversion, asset enhancement initiatives (“AEI”) and acquisitions.

Let’s take a closer look at each of these methods.

Positive rental reversion

As explained in Part 2, rental reversion represents the change in overall rental rates for the REIT’s property portfolio.

A REIT that enjoys positive rental reversion signifies its ability to charge a higher rental rate over time, thereby bringing in more revenue.

From there, the rental dollars will flow down to net property income (NPI) and increase distributable income, all things being equal.

Assuming net lettable area remains constant, a higher overall rental rate increases the amount of rental income collected by the REIT.

An example is Ascendas REIT (SGX: A17U), where it reported a positive rental reversion of 3.8% for the fiscal year 2020 for leases renewed that year.

Asset enhancement initiatives (AEI)

AEI are projects undertaken by the REIT manager to spruce up existing properties within the portfolio.

These projects are aimed at refreshing or rejuvenating the asset to make it more attractive to potential clients, or to add an area that can be rented out to tenants.

Examples may include the revamp of the façade of a shopping mall to make it more appealing for shoppers, or the addition of a canteen within an industrial building so that tenants’ employees can have their meals there.

Keppel DC REIT (SGX: AJBU) carried out AEI on several of its data centres for the first quarter of 2021.

It added an additional data hall for its Keppel DC Dublin 2 asset that has been taken up by its existing client, thereby renting out additional floor area and upping its gross rental income for this asset.

Acquisitions

Acquisitions are by far the most common method used by REITs for growing their DPU.

For rental reversions and AEI, these two methods are described as “organic growth”, meaning the REIT is increasing its DPU internally, without increasing the number of assets it owns.

Acquisitions are a way for REITs to grow “inorganically” by increasing both the REIT’s asset base and, hopefully, DPU.

A REIT may either borrow fully to acquire, rely on a mix of debt and equity fund-raising, or choose to rely entirely on raising money through equity to fund the acquisition(s).

If debt is utilised, investors need to monitor how the REIT’s gearing ratio will be impacted.

Mapletree Logistics Trust (SGX: M44U), or MLT, has been acquiring properties aggressively over the past year to grow both its portfolio and DPU.

In October 2020, MLT spent nearly S$1.5 billion to acquire nine logistics properties in China, Malaysia and Vietnam, as well as a 50% interest in 15 logistics properties in China.

Watch out for these risks

It’s not always rosy for REITs.

Like all investments, investing in REITs comes with risks.

Investors need to be mindful of these risks and assess if they relate to the REIT that they wish to invest in.

Unable to refinance debt

During the global financial crisis in 2008-2009, a few REITs that had high gearing had problems refinancing their loans as credit markets froze.

Some had to resort to dilutive rights issues at significant discounts to market prices to shore up their balance sheet.

An example is CapitaMall Trust back in February 2009.

The REIT’s gearing was 43.2% back then, close to the regulatory ceiling of 45% as mandated by the Monetary Authority of Singapore.

The REIT manager then undertook a dilutive 9-for-10 rights issue at S$0.82, a 43.4% discount to its then-closing price of S$1.45, to raise around S$1.23 billion.

Because of the increase in the number of issued units, DPU for the REIT fell by 38.1% year on year from S$0.1429 in 2008 to S$0.0885 in 2009.

The risk relating to property type

Certain REITs may be more vulnerable than others during a crisis.

For instance, the COVID-19 pandemic has hit hospitality REITs hard as air travel is curtailed and borders remain closed as of this writing.

As hospitality REITs rely heavily on tourism, unitholders need to be aware that any prolonged stoppage in leisure travel will have detrimental effects on revenue, and hence DPU.

Unattractive properties

Some properties may face low demand due to their inaccessible locations or may have features that clients eschew.

REITs that own such unattractive properties may face an uphill task in trying to retain and attract quality tenants.

As a result, vacancy rates may be persistently high in what should be a red flag for investors.

Weak sponsor

A sponsor’s role is to provide financial support for the REIT(s) and also a pipeline of properties that can be injected into the REIT in future.

Strong sponsors can provide a steady stream of eligible properties for the REIT to acquire, thus ensuring it can consistently grow its assets and DPU.

A weak sponsor, on the other hand, may not possess the means to inject assets into the REIT as its properties may be sub-par.

Strong sponsors can also borrow at lower interest rates due to their reputation and financial standing.

Weaker sponsors have no such advantages.

Get Smart: You’re ready to invest in REITs!

We hope that this three-part guide has helped better your understanding of the REITs sector.

REITs are a great asset class to explore for long-term capital appreciation and a steady stream of passive income.

By reading through all three parts, you should now be equipped with the basic knowledge to invest in REITs.

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Disclaimer: Royston Yang owns shares in Keppel DC REIT.

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