The Beginner’s Guide to Understanding REITs
by: Tam Ging Wien
author of REITs to Riches: Everything You Need to Know About Investing Profitably in REITs
The article was first published on ProButterfly.com on 25-Sep-2017.
We decided contribute to the InvestingNote community with an educational piece to demystify REITs and help get beginners up to speed on REIT analysis and investing.
What is a REIT?
A REIT is short form for Real Estate Investment Trust. REITs are a type of professionally managed collective investment scheme with its primary business being the acquiring, owning and financing of income generating real estate. REITs have the benefit of providing investors with a regular income stream and prospects of long term capital appreciation.
REITs provide investors an affordable means to invest in a diverse range of real estate assets. REITs tend to have a specific portfolio focus. Typical REITs are classified into the following categories:
- Residential (e.g. Condominiums, Housing, Apartments)
- Retail (e.g. Retail spaces, Shopping malls, Shops and Shophouses)
- Offices (e.g. Office buildings)
- Industrial (e.g. Factories, Warehouses, Industrial parks)
- Healthcare (e.g. Hospitals, Nursing homes)
- Hospitality (e.g. Hotels, Service Apartments)
- Some creative REITs may even have investments in Car Parks,
- Billboards, Storage Spaces, Mines and Plantations just to name a few examples.
Some REITs specialize in portfolios in one region or country, while others hold a portfolio of properties in multiple countries.
Shareholders of REITs are also protected as regulations require that the REIT’s properties are held by an independent trustee. REITs have appointed managers to manage the REIT and act in the best interest of the shareholders. REIT Managers set the strategic direction, manage their assets and liabilities, and give recommendations to the trustee on the acquisition, divestment or enhancement of assets in accordance with the REIT’s stated investment mandate.
Typical structure of a REIT
Below is a diagram illustrating the typical structure of a REIT:
Some REITs have sponsors (typically but not necessarily property developers) which provide backing to the REIT by injecting their own properties into the REIT during listing. These sponsors continue to support the growth of the REITs by providing the REIT rights to acquire the sponsor’s future pipeline of properties. These sponsors may sometimes themselves be a major shareholder of the REIT they sponsor.
In Singapore, REITs are required to distribute least 90% of their net income after tax to shareholders in order to quality for tax exemptions. Shareholders enjoy these tax-exempted distributions in regular intervals (e.g. quarterly or half-yearly) throughout the year in the form of dividends.
The first Singapore REIT was launched and listed on the SGX in July 2002.
Tax Transparency Treatment
REITs provide investors with a means of investing in real estate without having to directly hold illiquid property assets. In Singapore and generally around Asia, rental (and related) income earned by REITs are not taxed if the REIT distributes at least 90% of its taxable income to unitholders (amongst other conditions). Tax is instead levied on unitholders, except where exemptions apply. This practice, known as tax transparency, results in similar, if not lower, tax results for REIT investors relative to what would have been levied on equivalent direct property investments.
An Exchange Traded Fund or ETF is similar to Unit Trusts except that they are listed and tradable on a stock exchange.
A REIT ETF is a special class of ETFs that is made up of only REITs. On 20-Sep-2016, Philips Capital management launched Asia Pacific’s first REIT ETF to be listed on SGX – Phillip SGX APAC Dividend Leaders REIT ETF. The new REIT ETF track the recently-launched SGX APAC Ex-Japan Dividend Leaders REIT index and comprises the top 30 REITs listed across the Asia Pacific exchange, excluding Japan.
REIT ETFs are another alternative way for investors to gain exposure to a diversified portfolio of REITs.
Specifically for the Phillip SGX APAC Dividend Leaders REIT ETF, 70% of the portfolio are foreign REITs listed in Australia and Hong Kong. This means that an investor could easily gain exposure of REITs listed outside of Singapore. When investing in foreign listed REITs, an investor should be mindful that they are also exposed to foreign exchange risk which could impact the distribution yield.
Investors should also be mindful that REIT ETFs are subjected to a hefty withholding tax of 17% and therefore affecting the yield. According to the factsheet for Phillip SGX APAC Dividend Leaders REIT ETF, as of 31-Oct-2016, the annualized yield before withholding tax is 5.1% while the net dividend yield after taking into consideration the withholding next is 4.6%.
Benefits and risks of investing in REITs
Investing in REITs provide various benefits as well as risks when compared to investing in the underlying property or real-estate. Below is a table summarizing these points:
A comparison table of Benefits between Direct Property Investments and REITs
A comparison table of Risk between Direct Property Investments and REITs
Direct property investment is capital intensive. Large amounts of cash are required for down payments and transaction costs (eg stamp duties, legal fees, property tax…etc). Purchasing of property for most would also require a bank loan of easily 70% to 90% of the property prices.
On the other hand, investing in the right REITs can be quite affordable. Yields are also much higher yield, enabling investors to grow their capital in a shorter period of time.
As of time of writing, Singapore is the largest REIT market in Asia (ex-Japan).
Financial Assessment of REITs
Distribution per Unit (DPU)
The distribution of the REIT’s income is determined by the manager. It can be calculated as a percentage of the net income. A REIT could decide to pay out all of its net income or choose to distribute only 90% and retain the remaining 10% for future growth.
Due to the fact that REITs derive their distributable income predominantly from their cash and not profits, it is therefore possible for a REIT to exhibit a negative return (i.e. loss) due to non-cash components (e.g. high depreciation, negative asset revaluation, fair value losses due to hedging) and yet still be able to have a positive distributable income. We have covered this scenario in our previous article entitled How can NetLink Trust Pay Out 4.4c DPU When EPS is Only 1.14c.
The DPU is the amount of dividend paid from the distributable income to the unitholders for every unit or share that they own in the REIT for a specific accounting period.
The DPU is used to calculate the distribution yield.
Net Asset Value per Unit (NAVPU)
The Net Asset Value (NAV) is the difference between the total assets and the total liabilities.
To reiterate the concept of the Balance Sheet, the Total Assets are always equal to the Total Liabilities and the Total Equities. Therefore, NAV is also equal to the Total Equity.
The NAV therefore provides the investor with the amount of cash value of a particular business if all its assets are sold at the price listed on the balance sheet and is used to pay off all its liabilities. A high NAV implies that a business is asset rich; a low NAV implies that the business is asset poor with high debts and or low/equity.
The NAVPU is the net asset value for every unit or share for a specific accounting period.
The NAVPU is used to calculate the Price-to-Book Ratio (PB Ratio).
Price-to-Book Ratio (PB Ratio)
Due to the nature of REIT being asset heavy, they can be compared to their peers in the same asset class. In general, the share prices of such asset heavy businesses should vary within a range of their NAVPU.
Therefore, using a ratio would provide investors an easy way to compare and value a REIT.
The Price-to-Book Ratio (PB Ratio) is calculated as the ratio of the unit price against the NAVPU.
As PB Ratio is a function of the NAVPU and the unit price, short term fluctuations in the share price could influence the PB Ratio of the REIT. If the PB Ratio of a REIT dips significantly, it could be a good entry price for investment.
The PB Ratio provides a good gauge of a REIT’s valuations.
A PB Ratio below one implies that the REIT is undervalued. The conventional wisdom goes that if a business is trading at a PB Ratio significantly below one, the business is better off selling all its assets and paying all its liabilities, and returns the difference to the unitholders instead of continuing operations, i.e. the business is worth more dead than alive!
If used correctly, PB Ratios can be a reliable method of valuing a REIT.
Gearing Ratio (Gearing)
Gearing of S-REITs are capped at 45% effective from 2016 onwards.
Gearing ratio is defined as the total debt over the total property asset value of the REIT.
A gearing ratio close to the 45% ceiling would imply the REIT has little debt headroom and limited options to increase its borrowing to fund future growth. A REIT with a large debt headroom would have more flexibility in managing its funding during acquisitions.
REITs that are close to the gearing limit carry more risk than REITs with a larger debt headroom. As REIT regulations require that REITs revalue their properties on an annual basis, it is possible that property revaluations during an economic downturn or unexpected event may result in lower asset values. If the asset value declines, the gearing increases correspondingly and may result in an adverse situation where the REIT has exceeded the gearing limit. This would result in the REIT being forced to pay down its debts or sell the property at depressed values just to meet regulatory requirements.
Annualized Distribution Yield (DPU Yield)
The annualized DPU refers to the total DPU for the entire financial year of the REIT. The annualized DPU is simply the sum of all the DPU declared in the financial year.
The DPU Yield or yield for short is the ratio of annualized DPU against the share price. Another way to view the DPU Yield from an investor’s perspective is how long it would take an investor to breakeven on the price paid for a unit in cash. For example, if an investor had purchased a REIT yielding 8%, it indicates that the cost of the units paid will be completely recovered in 12.5 years.
Potential investors can use the DPU Yield to compare various REITs, especially those within the same property class, to evaluate an investment.
Investors should compare the DPU Yield against known risk-free rates to calculate the REIT spread. The yield spread will provide a measured gauge of the risk premium when investing in the REIT.
DPU Yield should only be used as one of the criteria when investing in REITs. It should not be the sole criterion of an investment decision as a high DPU Yield does not necessarily translate to a good investment.
A Really Simple Method to Assess REITs for Investing
When investing in REITs, we want to ensure that we invest at the right price such that we are able to maximize the parameters below:-
- DPU Yield above 6.5%
- PB Ratio below 1.0
- Gearing below 35%
I hope the InvestingNote community have enjoyed this educational piece.
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