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Gear up and receive more passive income.

Friday, March 28, 2014

I have mentioned before that I rather not have any debt in my life. This does not mean that I don't understand how debt can be good. It just means that I am more comfortable not having any.

I rather not borrow money to invest in stocks even though it could potentially give me higher returns.

I rather not borrow money to pay for consumption items which definitely is a road to wealth destruction and, in severe cases, obliteration.


However, in an environment of very low interest rates (still), some think I am being silly not to take advantage of the cheap money sloshing around.

For sure, used sensibly, debt can help to enhance gains in investments. Of course, if things should go wrong, the damage would also be magnified. So, as you can imagine, whenever the issue of debt crops up, inevitably, we will have debates.

We might not have debt in our personal lives but we might be invested in business entities which have debt. If we are invested in REITs and a business trust like Croesus Retail Trust, we are invested in entities which have debt.

Simplistically, debt could increase income available for distribution per share provided that the cost that comes from having it is lower than the income received from the additional investment. So, debt could make more money for us. This is probably a financially sensible reason to take on debt.

However, is it financially sensible to introduce debt in our personal balance sheet to invest in REITs and a business trust like Croesus Retail Trust?


A reader, let us call him Mr. Gear, told me that he could borrow cheaply at an interest rate of 2% per annum, invest in a REIT that offers a 7% distribution yield and the spread of 5% is free money. Sounds good, doesn't it? Well, as long as we have the status quo, yes.

So, how long will the status quo last? Does anyone know? I don't.

In the event that risk free rates go up which is more likely to happen than not and Mr. Market demands higher distribution yields from REITs, we could see unit prices declining again.

With a distribution yield of 7%, a 1% increase in risk free rate will mean that unit price will have to decline some 12% to give Mr. Market the 8% distribution yield that he demands. A 2% increase in risk free rate will mean a decline of 22% in unit price in order to give a 9% distribution yield.

So, all else remaining equal, if the risk free rate should go up by 1% within the next 2 years, Mr. Gear could lose almost all the income he would have collected. If the risk free rate should go up by 2% within the next 4 years, Mr. Gear could lose almost all the income he would have collected over the same period. If the risk free rate should go up sooner than expected by 1 or 2%, Mr. Gear could end up losing some money and not just the income collected.

Although I still believe that REITs are relevant for income investors, do we want to gear up our personal balance sheet to invest in REITs for passive income now?

To me, peace of mind is priceless and this is a risk I rather not take.

I would still invest in Croesus Retail Trust, for example, only if I have money to spare. To me, being able to get a non-leveraged property income yield of some 5% for owning malls in Japan is pretty attractive. This is the kind of yield that we would get if Croesus Retail Trust were debt free.


Investing in a Trust that distributes 90% to 100% of its income, we have to be prepared for the possibility of equity fund raising in the form of a rights issue. So, although the estimated distribution yield at 87.5c is about 10%, if we are prudent, we would put aside some of this income.

For someone like Mr. Gear who is thinking of borrowing to invest in REITs, he must be pretty sure that he is able to take on more low interest rate debt to fund his participation in a possible future rights issue.

So, gear up to receive more passive income? Not me.

Related posts:
1. The secret to avoiding financial ruin.
2. Don't think and grow rich.
3. Croesus Retail Trust: Much ado about Yen.

33 comments:

The Sun said...

For Reits and business trusts investors, setting aside a war chest means not only taking advantage of substantial price declines but also the possibility of these entities calling for rights issues. The recent and perhaps rather unexpected rights issue exercise by Aims industrial REIT comes to mind here.

AK71 said...

Hi Sun,

Indeed so. :)

Distributing 90 to 100% of their income means that some form of equity fund raising from time to time is to be expected from REITs.

SOLIDCORE said...

Hi AK,

Gearing up on an individual basis does have its inherent risks and rewards. When risk goes up, rewards go up as well. As you so famously say, it depends on the motivations of the individual.

With my common laymen sense, there are plenty of financial fogs ahead (Tapering continues, rates are to rise, China's problems, etc) and gearing up at this time may also mean gearing up on some serious trouble.

On the other hand, when all the water in the lake has dropped, and when one is scooping up fish from the bottom of the lake, getting some help with the scooping may not be such a bad idea. However, how much fish does one need? It depends on the individual.

AK71 said...

Hi Solicore,

When the water receded the last time, I only used whatever nets I had in hand. I did nott borrow nets from anyone to get more fish. I was afraid that the fish might not have been edible, maybe. ;p

temperament said...

i have been as debt free as possible all my life. For what? For sleeping well at night lol. And i am doing alright too. Not too bad for my standard. In fact exceeds my expectations. Because actually i have no expectations except very paranoid to land in the "poor house".
i think the only reit that has not ask for money from investors till now is "FCT"
Unfortunately i have sold it.
Is there any other REIT that has not ask you for money?

AK71 said...

Hi Temperament,

Hmmmm... So far, I have not been asked by Cache Logistics Trust, Suntec REIT, Sabana REIT and Saizen REIT for money.

EY said...

Hi AK,

I absolutely agree with your views that even when we are debt free, the companies we invest in might not be so. Hence, those who wish to borrow to invest better have their exit plan all mapped out before going in. Knowing when to cut loss will limit the damages and won't land one in serious debt shall things derail.

When we decide to take on debt and knowing we are over extending ourselves a bit, then we must go in with our eyes peeled. Timing will be very important. Know the market cycle and check for signs of weakness. For instance, in the property market, the auction market has started to warm up again. Forced sales has gone up a bit. If a trend is forming, it's time to tread with greater caution.

xliew said...

Hello, can I ask how did he manage to borrow at 2% per year? Or is it a hypothetical scenario?

AK71 said...

Hi Endrene,

Yes, things are looking weaker now. For those whose positions are without a good margin of safety and if they did not prepare a war chest, things could get a bit rough.

Leveraging to invest in leveraged income instruments could land us in a situation like what MIIF or MPSF were in. That was when I learned about the difference between leverage at the fund level and look through leverage. -.-"

AK71 said...

Hi xliew,

Not hypothetical. If we were private banking customers, I think we could get loans which are quite cheap. :)

r said...

Hi AK,
I do like getting passive incomes from Reits and got some Cache and Sabana during end 2012.
However going forward, there's no need to guess whether interest rates will increase and it's every shareholders' concern, prices of SReits will be affected.
In this case, as a person looking for passive income:
1) Is it wise for me to cut off any shareholding in Reits and go into known dividend plays like SPH, STEngg...?
2) If no reason to cut, is it wise to just leave the stock for a period of 10 years and average it out (like we always read up reports - people who hold out stock, example STI. We will beat any form of fluctuation in the market and still give decent returns over the long run.

Regards
Jeremy

mrkoh said...

Hi, could you explain why if interest rate were to go up by 1%, he could lose his income he collected cause of the drop of 12%? I feel that even if interest rate were to increase, it does not necessarily mean that the unit price will drop. He could still earn the spread, although at a lower rate than before. Btw I agree with you that as little leveraging as possible is still the best:)

temperament said...

Hi AK71,
These reits-- Cache Logistics Trust, Suntec REIT, Sabana REIT and Saizen REIT+FCT that do not ask for our money (Right Issue), is it because they use private placements or some other capital structure?

Some of the reits' DPU may be increased but won't it be even better DPU if we were allowed to subscribe to rights issue?

Do we really benefit or lose out?
Puzzles?

AK71 said...

Hi Jeremy,

If we got in with some margin of safety, I feel that most S-REITs are good to hold as a source of passive income. There is no need to rush for the exit, unless our primary motivation for being invested was not for income but for capital gain.

Interest rates will rise in future although we won't know exactly when it will happen. However, we could also see property values improving and rentals rising in the longer run. In fact, if we look back, this has always been the case. Just look at the prices of apartments 10 years ago and now, or 20 years ago and now.

So, for anyone investing for income and is doing so for the long run, holding and adding if unit prices should weaken seems like a good idea. :)

AK71 said...

Hi mrkoh,

I am wondering how could I explain this in another way...

OK, let us assume that you bought into a REIT at $1.00 per unit and it offered a 7% yield or a DPU of 7c. Let us say that the risk free rate increased by 1%. So, REITs (perceived to be riskier by Mr. Market) will have to offer 1% higher in yield to attract investors. Everything else remaining equal, to achieve this, unit price will have to fall proportionally.

So, to give an 8% yield, assuming DPU remains at 7c, unit price would have to fall to about 88c. So, what you gained in income, you might lose in capital. Depending on how quickly and how much the risk free rate increases, you could lose some or all the income received in this manner or even lose some money.

If someone had borrowed money to invest in this manner, I would be worried for him since he would be holding on to a "depreciating asset". I don't think the lenders would look the other way.

AK71 said...

Hi temperament,

If debt level is already pretty optimal, then, if a REIT needs funds, it is either a placement or a rights issue. So, chances are that these REITs had placements.

Saizen REIT had warrants but that was before my time as a unitholder. Sabana REIT has a convertible sukuk (bond) now which is quite clever because the debt will disappear as the bond holders convert them into units but it dilutes current unit holders' interests.

It is more difficult to answer your other question because I believe that there is no generic one size fits all answer.

It really depends on the circumstances surrounding the need for extra funds. However, I have always preferred rights issue because it would allow all unit holders to participate. :)

temperament said...

Hi AK71,
Well put.
i agree all unit holders should be given priority. But then i think Reits will have their own "private" reasons to look elsewhere for capital to expand AUM.-- Not paying debt hoh!

AK71 said...

Hi temperament,

Well, the way the REITs work, having to pay out at least 90% of their income, they don't really have much left unless their income base is very big. This is why bigger REITs have an advantage here. :)

Actually, Saizen REIT's loans which are amortising in nature really sets it apart from the other S-REITs. Its balance sheet will strengthen over time, all else remaining equal. Truly under-appreciated. ;)

temperament said...

Hi AK 71,
Hmmmm... Saizen Reits, quite interesting. i shall start to pay attention to REITS again. Not vested in any now.
Thanks.

SnOOpy168 said...

sounded like my friends who call me siao for early paying my HDB loan. 2.6% or bank loan 1.x% is peanut cost vs the higher returns you can do with your own money. Assuming you can reach 7% (for example) for the duration of the loan 25-30 years.

Erm, true, why pay of a 2.6% loan when that $ can generate 7% ? Nett 4.4% gain. Simple.

For those using CPF to pay their loan, you have 2 interest rate running. the 2.5% p.a. that you will need to pay back CPF when you sell the flat (in the name of recouping interest if you had left the funds in OA untouched) AND that housing loan interest.

I feel that to many CPF $ are not cash on hand, it doesn't really matters does it.....

Debt free - feels good. Passive income with no COF, feels shiok. ^-^

AK71 said...

Hi SnOOpy168,

I know. When I tell people that I paid up my housing loan within 3 years, I got the same tongue lashing from some too. :(

For my soon to be completed hut in the sky, I am thinking of paying up in full once I can do it without incurring any penalties. This time, I won't even have to wait 3 years to do it. I am going to be clever about it and not tell anyone so as to avoid any tongue lashing. ;p

temperament said...

Alamak!
I paid all my purchases with out loan unless force to do so like buying a new car. How? Don't scold me leh!
Thank God, for me can't pay in cash means i can't afford it. Don't buy lol!
You are not paranoid about getting into debt, doesn't mean i am not. To each his own.
Shalom.

AK71 said...

Hi temperament,

My current car, I also bought without having to take a loan. How? How? -.-"

Yes, often, it really depends on what allows us to sleep better at night. :)

Poh Soon said...

I often do my purchase with loan (credit card) as much as possible to earn point (which can use as cash in NTUC), and paid it off in full at end of the month =.=

AK71 said...

Hi Poh Soon,

That doesn't count. That is credit, not a loan, unless you roll over your credit card balance every month. ;p

Chan jian wen said...

Hi AK,

Can I know your rationale for paying off your housing loan so early?

I currently have a 30 year loan charging me an interest of 1.2% and I'm planning to take advantage of this for as long as possible (might do an early repayment if the all-in rate hits 3%).

Understand the rationale for paying your car loan early (as loan amount for car loans are calculated on the initial amount), but don't understand the rationale for pre-paying the house loan in this low interest rate environment.

JW

AK71 said...

Hi JW,

I bought my current car without taking a loan. I think the penalty for early repayment of car loans is quite hefty. Best is not to take a loan to buy a car or try to keep the loan to $20K or $30K and have the loan period for only 3 years.

As for my future home, it is really for a peace of mind. Strictly speaking, a home for self stay is a consumption item and I have never liked the idea of debt driven consumption.

I fully understand your position, of course, and if you could make more money with cheap debt, it is an attractive proposition. The question to ask is whether you would be able to liquidate your investments without suffering any losses when the interest rates rise significantly in future. This, I believe, is a wild card. :)

I have managed to make quite a bit of money from the stock market in the last 3 years, almost enough to pay for my future home in full. So, if I think of my future home as a gift from Mr. Market, it makes it easier to accept the opportunity cost of not embracing cheap debt. ;)

temperament said...

Hi AK71,
i had read a book that stipulated that you know you have really arrived when you only spend your money from the interest on the interest on the interest. He is only spending money on his money that has made money. His capital is growing all the time. WOW!

Does this authur means he is never in debt then onwards?

Ha! Ha!
Have you arrived?
i still struggling very hard to arrive.

AK71 said...

Hi Temperament,

That is a tall order.

Already, it is difficult enough to get to a stage where we are only using the money generated by our money. -.-"

temperament said...

Ya lol!

AK71 said...

Hi AK,
I am wondering what if i buy some strong dividend REITS share with leverage. Do you think the financial charges will eat into the dividend over lets say 1 year period.
*assuming the REITS price that i bought is stable and non volatile, etc
Best regards, M

-------------------------
AK:
Volatility free REITs? Where? Where?

Kevin said...

Hi AK and M,

REITS are like physical real estate. buy and hold for long term to see significant gains. ;)

AK71 said...

Hi Kevin,

If the REIT is well managed, it could happen. :)

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