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How should we approach REITs as investments for income now?

Sunday, September 21, 2014


All good things come to an end and although it is debatable whether the many rounds of quantitative easing (QE) by The Federal Reserve have been good for us, they are definitely coming to an end as the Fed cut their bond buying program to US$15 billion a month and indicated that QE will end in October. That's next month. Money supply will stop growing and interest rates could rise 6 months later.


Of course, for quite a while now, this is something that I have been talking about too and how I have been taking action to have a portfolio of investments that is going to be less easily affected by rising interest rates. How is this being achieved? Simply, it latches upon the idea that companies which have less debt will have a relatively lighter debt burden when interest rates rise, which they will.

Having said this, I am not saying that companies which have more debt will not do well when interest rates rise. Heavily leveraged companies which are growing their earnings rapidly could still overcome their higher cost of debt and deliver good results. These are probably some high growth companies.

However, as I am investing mostly for income and maybe a little bit of growth, I would like to have more predictability and I like companies with less debt which have shown themselves to be consistent payers of meaningful dividends. I like them even more now that interest rates are set to be higher in the near future.


Now, what about REITs?

REITs have conventionally been looked upon as an asset class that is somewhere in between stocks and bonds. The regular income distributions make them bond-like but when we hold REITs, we are investors and not lenders. When we hold bonds, we are actually lenders of money. This is, of course, an interesting bit of trivia for most people and what they are probably more interested in knowing is how rising interest rates would affect their investments.

Well, if interest rates should rise, as investors in REITs, we want to think of the following:

1. Cost of debt.
2. Distributable income.
3. Unit price.

Quite simply, if interest rates go up, the cost of debt goes up. More income will have to go to servicing debt. When this happens, the amount of income available for distribution to unit holders will reduce, everything else remaining equal. If distribution per unit (DPU) should reduce, then, unit price would fall accordingly as Mr. Market demands a distribution yield that makes sense to him.


So, does this mean that as interest rates rise, REITs become pariahs and we should avoid them at all costs? I am inclined to believe that if we are income investors, REITs remain relevant assets to own. However, we will have to pay more attention to the issue of debt. Specifically, we want to be mindful of the following:

1. Percentage of debt with fixed interest rates.
2. Debt maturity profile.
3. Average cost of debt.

In an environment of rising interest rates, home owners who have loans with fixed interest rates will worry less about the possibility of a higher cost of debt. For REITs, similarly, if a bigger percentage of their debt are of the fixed interest rate type, then, they have less to worry.

Eventually, all REITs will have to refinance but those which have most of their debt due for refinancing in the next 12 to 18 months will see their cost of debt increasing ahead of the pack. Of course, this will put downward pressure on their available income for distribution, all else remaining equal.

Finally, REITs with very low average cost of debt now would probably see a big percentage jump in their cost of debt when they refinance eventually. So, investors in such REITs must be mindful of this as the REITs' interest cover ratio (i.e. the ability of a REIT to pay interest on its debt) could take a relatively big hit.


Basically, a higher interest rate will result in weaker cash flow and balance sheet, all else remaining equal.

However, remember that REITs are not bonds. REITs could improve the amount of income available for distribution by getting cheaper loans which are less likely in future but they also have the ability to improve income by raising asking rents.

The question is whether the health of the economy and the sector which the REITs are found in will support higher rental rates or not although it is believed that in an inflationary environment (which is why interest rates should increase), asking rents should rise too.

So, there you have it. How should we approach REITs as investments for income in an environment of rising interest rates? We should be thinking about debt.

Related posts:
1. ST Engineering: Wealth accumulation.
2. NeraTel: What is a sustainable dividend?
3. SATS: A nibble.
4. SPH: Mystery of extra money.
5. Building an income portfolio is like building a house.
6. Gear up and receive more passive income.
7. Bonds, REITs and the instant gratification of yield.

30 comments:

Les Lim said...

Hi AK,
I was rading the Financial Times over the weekend and the article of rising interest rates in the next 24 months caught my eye. The writer expects Fed to start increasing interest rates by 25 basis points every quarter ,starting mid 2015 . By end 2016, interst rates are expected to be around 3%. This will have profund effect on stocks, especially reits. Given that interest rates are expected to rise and adversely affect share price, won't it be prudent to take money off the table and sit out the storm. What do you think?

Sillyinvestor said...

Hi AK,

Somehow I expect you to write something about interest rate and reits soon.

Allow me my 2 cents worth.

I think it is important when investing in reits, to

1) Think long term, and the long term yield that you are comfortable with.

e.g. You think you are comfortable with a 7% yield for a particular class of reit, the business is still robust, you still get 7% plus minus with the interest increases, but the market when into a frenzy, and now demanded 8-9% yield, your income seems to become capital returns, do you lose sleep? Worry about how low can it get? Thinking about sell and buy back cheaper? Whether to average down?

If you think long term, at least more than 3 years, you can sleep through the volality. The longer your horizon, the sounder you sleep. If you are confident of a 7% for the next 5 years, I think market need to make the price fall for 35% and let it stay that way for 5 years before you lose money. Now if you reit can earn 7% for 5 years and above, how long can it stay 35% underwater and yield almost 10%? Can sleep better now?

Do not go for short puff, you must be confident of the long term yield.

2) How to have that confidence for long term?

a) Track records of stable or increasing DPU

b) Track record of fund raising and yield accretive acquisitions (Not to pump up their own management fees!!)

c) Track record of debt managements, ratio include those AK has said.

I think there are several within the s-reit universal.

Sometime it is better to take a lower yield, for long term stability than a higher yield for long term pains.

The reit I think give me lower yield for long term stability is ascendas.

As for pains, it is sabana...

Thank you for your airtime.. AK

AK71 said...

Hi Les,

I do not think a gradual increase in interest rates would be classified as a storm. In fact, I think that an increase in interest rate in this manner shows that economic recovery in the USA is gaining traction.

I would consider sudden and big spikes in interest rates to be storms. It would be extremely difficult for businesses to adjust to such interest rate movements and Mr. Market knows it.

If you were to read related post number 7 here, you will see why I think REITs would respond better than bonds in a controlled environment of rising interest rates.

Given these considerations, to be accumulating cash is a prudent thing to do but to be 100% in cash is probably doing a Chicken Little. ;)

AK71 said...

Hi Mike,

Yes, a good track record is definitely a plus although it does not guarantee future performance. ;p

I like to take what is available now because I do not know what the future is like. I do not know if the management would stay the same.

Knowing that I don't really know, at prices I deem fair, I would initiate smallish long positions. At prices which are lower, I would buy much more.

What is considered a fair price? Well, for different people, this means different things. It depends on the way we do valuations and it depends on our motivations too. :)

Having said this, I believe that the best way to have peace of mind is to get in at prices that a mediocre sale will give good results. We need a war chest for that. :)

temperament said...

REITs need to be kept alive by assets releasing,(except FH,how many are there?) debt servicing,
quality of portfolio, capability/ability of management, Agency rating (the higher the rating (AAA,BBB)the higher the gearing allowed and the better rate offer by creditors)

Some one think REIT is just like a milk cow on the farm. In other words, Reit is just a passed-through investment, hopefully
can catch a little growth on the way out and then maybe in again.
Not vested in any now.
Cash rotting somewhere lol.

AK71 said...

Hi temperament,

I don't think the quality of a REIT's credit rating affects the level of gearing that is allowed. As long as a REIT obtains a credit rating, it is allowed a gearing level of up to 60%. Unrated REITs are allowed a gearing level of up to 35%.

However, a better credit rating could possibly result in a lower cost of debt. :)

E H said...

Some options to mull over:

1) If you are in the money and concerned about possible volatility, sell enough to take back your capital.

2) If you are in the money and don't give a damn about volatility, don't do anything.

3) If you are not in the money and concerned, buy some long dated put options to hedge.

4) If you are not in the money and don't give a damn, do nothing.

5) In all options, you can consider buying more when blood's on the street. That is if you have enough cash in hand.

:)

AK71 said...

Hi E H,

I like option 5. LOL. ;p

Thanks for weighing in on this. :)

temperament said...

I think I will like option 2 after option 5. Still waiting.

Casey said...

Hi Ak,

Hope that you allow me to express my opinions here.

Frankly, i do think that it is time for me to leave the REITS which once dominated my investment portfolio, I have reduced my exposure in REITS by 50% and now it forms only around 30% of my total investment. It is still good investment class asset for steady yield but with nothing much to talk about.

I am still keeping MCT, Saizen, MGCCT in significant position, vivocity and festival Walk are kind of evergreen sought-after assets, Japanese residential property is a wildcard. I do not like Sabana since day one, I have similar doubts on SB... and CRT, as I could not understand its logic, and only time will tell if it is a valid doubt.

To me, while keeping and 'forgetting' about good quality REITS, the next focus shall be waiting for the chance to buy blue chips with strong cash position, under value and poise for growth.

What is your view? Waiting for the crash? Any target? Thanks.

Casey

AK71 said...

Hi Casey,

I do not know if a crash is coming although with interest rates poised to rise, I believe that in a world drunk on cheap debt, something will have to go.

I also know that in an environment of rising interest rates, cash as an asset will no longer be looked down upon. Interest income would once again be meaningful for anyone and not just the income investor.

I am maintaining the 70% exposure I have to the stock market and collecting dividends which helps to shore up my cash position. So, my exposure to to the stock market will reduce slowly without any divestment.

E H said...

Hi Casey

Which blue chips are you looking at?

Capricon said...

Hi Casey,
Do you mind sharing your opinions on SB (I suppose it is soilbuild) and CRT ? What doubts you have and what logic that is concern to you ?

Always good have to have different views for our own thoughts.

Thanks

pf said...

I'm currently thinking what i shld do with my property counters in my portfolio.

AK71 said...

Hi pf,

Once you have decided, please share your decision with us and the reasons behind it. Kamsiah you. ;)

Casey said...

Hi

Like what AK said, I am just talking to myself, and have nothing to advise or share.

SBR- my doubts:
1. The exposure to Business Park is very significant in terns of asset size, much more significant than most of others;
2. The occupancy for these Business Parks is high, much higher than the rest.
3. The yield on asset for these Business Park is high too, better than most of the rest, despite master lease in the picture.
4. It seems a bit too good to me.

CRT- my doubts:
-the yield on asset is very high. What is the yield on asset for most of the suburban retail unit in Kanto area? How about Starhill's asset in the Roponggi Area?
-the mall in suburban is nothing near Singapore neighbourhood' malls, in terms of the crowd.
-what is the competitive advantage of these retails space? Outstanding or just average?
- so why is the yield so high?

I asked similar questions in AK blog last time on the SAbana. It is just my doubt, I might overlook details and my decision is just for myself.

Casey.

Casey said...

Hi AK,
Hi EH,

I am accumulating cash too, at this time, I am keeping an eye on the Sembcorp Ind., Sembcorp Marine, OCBC, Keppelland for 2014. Capitaland and Wilmar for 2015, just waiting to accumulate more at the lower prices. How about yours?

Thanks.

Casey.

AK71 said...

Hi Casey,

Thanks for sharing your thoughts. :)

All I can say is that I did not see any signs of financial engineering in Soilbuild REIT and Croesus Retail Trust. Sabana REIT had a bit of financial engineering which I overlooked.

However, in both Sabana REIT and Croesus Retail Trust, I think I got in with a bit of margin of safety. This is so that in my partial divestment of Sabana REIT I was still able to book capital gains on top of the income distributions received in the last few years.

I try to remember what Buffett said about getting in at good prices so that even a mediocre sale will give good results.

However, with Soilbuild REIT, I believe I got in at only a fair price recently and, so, it was only a nibble and not a large position. A good price would have been at a more significant discount to NAV and a higher distribution yield exceeding 8%. A very good price would be at a distribution yield closer to 10%, all else remaining equal.

Right now, I am just shoring up my cash position and I am sure that when the next downturn comes, there will be plenty of stuff to buy. In terms of income producing stocks, I like ST Engineering and SPH, for examples. For cyclicals, Wilmar is the one I would like to get more of.

All investments are good at the right prices. So, I will keep my war chest filled and close at hand. ;)

AK71 said...

MAS proposed increasing the leverage, or borrowing, limit imposed on unrated REITs to 45 per cent of total assets from the current 35 per cent. For REITs with credit rating, the present 60 per cent cap on leverage will be removed.

Meanwhile, the development limit for a REIT will be raised to 25 per cent of its deposited property, up from 10 per cent. These proposed changes will provide the REIT with greater operational flexibility to rejuvenate the REIT's maturing portfolio of assets, MAS said.

In terms of disclosure requirements, MAS proposed REITs be made to provide information such as the amount of income support payments received as well as the remuneration policy for directors and executive officers.

Those wishing to comment on MAS's consultation paper on REITs should do so by Nov 10.


Source:
http://www.channelnewsasia.com/news/business/singapore/emb-5pm-mas-proposes/1405832.html

AK71 said...

Ratings agency Moody's Investors Service on Monday (Oct 13) said regulatory proposals to tighten Singapore's Real Estate Investment Trusts (S-REITs) are "credit positive". The US-based firm added that the regulatory proposals by the Monetary Authority of Singapore (MAS) would foster financial discipline, enhance corporate governance and strengthen investor confidence.

The proposed changes include adjustment to borrowing limits. Under the current rules, rated S-REITs can borrow up to 60 per cent of their total assets, while unrated S-REITs can leverage up to 35 per cent. MAS is now proposing a single-tier leverage limit of 45 per cent across the industry, regardless of whether the REIT has been rated.

In a statement, Moody's assistant vice president and analyst, Ms Jacintha Poh, said: "Notably, the proposal to lower the borrowing limits for Moody's-rated S-REITs would ensure that they maintain a prudent approach when funding expansion plans and reduce potential losses to creditors".

Other proposals which Moody's said are credit positives include strengthening corporate governance and enhancing disclosures on income support arrangements, total operating expenses, length of new leases and debt maturity profiles.

The ratings agency said these will improve transparency and make these property investment vehicles more attractive to investors.


Source:
http://www.channelnewsasia.com/news/business/singapore/regulatory-proposals-to/1413256.html

AK71 said...

The Monetary Authority of Singapore (MAS) has refined its proposals to strengthen the real estate investment trust (REIT) market, following feedback from industry participants.

The changes, which will be phased in to facilitate smooth implementation by the industry, include capping borrowings to 45 per cent of the REITs' total assets, MAS said on Thursday (Jul 2). Currently, the cap on borrowing is 35 per cent of total assets for REITs that are not rated, and 60 per cent for REITs with credit ratings.

Another proposal will make it easier for REITs to rejuvenate their portfolios, by raising the development limit from 10 per cent to 25 per cent.

Analysts said that the increase in development limit will enable REIT managers to improve the quality and yield of their assets. They also said the tighter borrowing limits could encourage some REITs to be more prudent.


Source:
http://www.channelnewsasia.com/news/business/singapore/mas-refines-proposals-to/1956200.html

irene said...

In view of rising interest rate, and not having any REITs in portfolio, would you suggest buying REITs now for dividend ?

AK71 said...

Hi Irene,

I have always maintained that REITs are relevant to the income investors. :)

A low interest rate environment is good not only for REITs but for all businesses that rely on leverage to a certain degree. However, interest rates will normalise. So, expect some speed bumps ahead for such businesses and REITs.

I won't suggest anything but I will say that REITs are not bonds. If interest rates were to rise, bond prices would fall. There is no two ways about it. That is how bonds work.

Interest rates usually rise because the economy has turned inflationary. In an inflationary environment, we would expect rentals to go up and REITs are beneficiaries. REITs are businesses. Bonds are not.

I try to be pragmatic as an investor. I try not to be overly optimistic or pessimistic.

AK71 said...

Among Singapore's Reits, the respective sub-sectors also have their own headwinds to contend with.

The office sub-sector faces a massive four million square feet of supply until end-2016, and while there appears to still be some time, this has put the bargaining power back into tenants' hands.

According to Knight Frank, office spot rents grew at a slower pace of just 0.2 per cent in Grade A+ buildings in Raffles Place and Marina Bay quarter on quarter in Q1. Office Reits have traded down about 7 per cent year to date, making them the biggest laggards compared to other sub-sectors.

The industrial property sector faces a similar oversupply situation, as well as a slew of restrictions - on strata sub-division and space occupied by anchor tenants, seller stamp duties, shorter land tenure, longer minimum occupation periods before asset sales - all of which are measures by the government to cool industrial property prices and rents.

Retail is on a structural downtrend, plagued by labour costs and online competition, while hospitality is faced with falling tourist arrivals - a 5.4 per cent drop in the first four months of this year - and weak regional currencies which make Singapore an expensive destination.

Maybank has an "underweight" recommendation on Reits, with "sell" calls on CapitaLand Mall Trust (CMT) and Ascendas Reit. UOB Kay Hian has a "sell" on CMT too, citing retail weakness, while RHB recommends "buy" for its economies of scale and low gearing. OCBC Investment Research and RHB are neutral on Reits, citing rate fears. Different houses are more pessimistic on different sub-sectors with no clear consensus.


Source:
http://www.businesstimes.com.sg/stocks/unclear-timing-of-rate-hike-causing-reit-jitters

slacker said...

Hello AK, with so many different type of reits to choose from. How do u/we choose what kind of reits to buy? When I searched sgx, it's in a sea of red now. I was looking at keppel reit, and the quarterly result is weak, compare to other quater. it has drop more 15% ytd. In this case is it a good to buy in now?

AK71 said...

Hi slacker,

I don't tell people what is good to buy or when is it good to buy. Very dangerous for me. ;p

I have shared in many different blog posts on how I choose which REITs to buy. So, you might want to do a search yourself. ;)

Keppel REIT? I warned about the financial engineering involved to prop up the DPU at one point. I also believe that office space in the CBD will see an oversupply and lacklustre demand situation. So, things could get challenging. -.-"

Solace said...

Not only is Keppel Reit trading below its NAV, capitalCommerical Trust is also trading below its NAV. One of the reason why they might be trading below NAV is due to the negative outlook of office space.

We have to be careful when it comes to NAV of Reits. Annual re-evaluation is used to determine NAV. one method use involve the use of rental income divided by the capitalization rate. With more office space and a future higher rate hike. Cap rate might head up. with a higher cap rate, valuations of the office buildings will go down.

it might result in a lower NAV in the future. Put in a bit of safety margins when we see Reits trading under its NAV.

I have never seen Suntec Reits (Another Office Reit) trading above its NAV by the way.

AK71 said...

Hi Solace,

A very thoughtful comment, as always, from you. Thanks. ;)

Yes, property developers and REITs could take impairment charges and their NAV would then take a hit, all else remaining equal.

Using NAV, DPU and gearing is a quick and dirty way of looking at REITs but they are just scratching the surface. There is a lot more to analysing REITs.

I would suggest newly minted investors to read up more and, maybe, sign up for a value for money course like "Dividend Machines" to shorten their learning curve in future.

Ricky said...

Looking back at these comments, it's interesting how things have played out. From 25 bps every quarter to just once last year and none so far this year. AK, wish to ask if you have any comments on MLT and CMT?

AK71 said...

Hi Ricky,

I have blogged about CMT before. Not sure about MLT.

You might want to use the "Search" function at the top right corner of my blog. If I have blogged about something, you will find it. ;)

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