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REITs: Leasehold properties revisited.

Sunday, November 8, 2015

This is a brief reply to a comment from a reader on a topic which was rather hotly debated before: here.


Hi kh,

Investing in REITs, we have to understand something very basic and that is REITs distribute income. REITs don't distribute earnings. So, they do not account for depreciation or amortisation.

When we look at REITs, we mustn't look at them like how we would look at stocks where we look at earnings per share (which takes into account depreciation and amortisation).

When we buy properties, if they are not freehold, then, there is a lifespan. 

So, if we buy a HDB flat, theoretically, at the end of its 99 years lease, we have to to return it to HDB and the value of the flat becomes zero. So, on average, theoretically, it depreciates by slightly more than 1% per year.

To make investing in a property which has a 99 years lease sensible, theoretically, the yield should be 1% higher than a freehold property. This is to make it equally attractive. 

Whether that happens or not depends on many things and one of the things is that real estate, unlike other assets, are tied to locations.

I am using the word "theoretically" quite a bit in this blog post.





So, we are not wrong to ask wouldn't REITs with only leasehold properties end up with nothing one day if they keep paying out their income fully? Again, theoretically, yes.

However, real estate is unlike other forms of assets like machines, inventories or even cash. In an economy that does well, older properties could be worth much more too. Their values could, in fact, appreciate. 

REITs with leasehold properties could do quite well too by actively managing their portfolios. 

For example, a REIT could sell off older properties when the real estate market is strong and the values of their properties go up. Buy newer properties when the real estate market is weak and properties are cheaper. 

So, to me, the management's competence and motivation are more important considerations.

I think you understand the theory that if a REIT with only leasehold properties pays out 100% of its distributable income, it is not putting aside anything for depreciation. This is the way REITs work. 

REITs are allowed to hold back as much as 10% of their distributable income and I believe that it is a matter of time before S-REITs with mostly or exclusively leasehold properties do this to help address the issue of shorter remaining leases (i.e. depreciation).

In closing, I would say that whether to invest in REITs or not, there are many considerations. It would be a mistake, I believe, to be fixated with the issue of land leases.

Related post:
REITs: Leasehold properties.

10 comments:

Siew Mun said...

Good educational piece on REITS depreciation/ amortization, leasehold and income. More educated, more opportunities for luck to find you. AK do you any good REIT books for me to beef up?

AK71 said...

Hi Siew Mun,

I pay a visit to the public library every 3 or 4 weeks. There, you will find good books on REITs. I won't say which ones are better because I find that I pick up different things from different books. :)

Goh said...

For example, a REIT could sell off older properties when the real estate market is strong and the values of their properties go up. Buy newer properties when the real estate market is weak and properties are cheaper.

The above is rather difficult in practice.
When the real estate market is weak, the REIT tends to suffer from low stock price, which makes issuing rights expensive. Also, gearing ratio is elevated due to lower value of properties, which also makes debt financing more difficult.

Selling properties when the market is strong is more possible, but instead, REITs with influential sponsors tend to do the opposite, that is, they are pressured to buy highly valued properties from the sponsor so that the sponsor can earn a good profit.

AK71 said...

Hi Goh,

This is why the competence and motivation of a REIT's management is so important. Managing a REIT looks easy but it really isn't although some managers have taken easy ways in order to increase fees for themselves.

As you have rightly pointed out, having a sponsor can be a good or bad thing. If the sponsors are not interested in adding value to their REITs but view their REITs simply as ways to recycle capital and get maximum gains, the REITs are unlikely to do their investors justice.

I feel that S-REITs which have been doing very little or no acquisition locally in the last couple of years and at the same time have been quite prudent in reducing their gearing levels are doing the right thing.

Siew Mun said...

Couple of points to look at. 1. Manager buy new property at discount or above valuation. 2 New property NPI can increase our DPU. 3. Purpose fun raising to buy new properties or repay debts. 4. Generate DPU growth through AEI. 5. Hidden withdrawal of rental support from Sponsor. 6. Lastly, use of NPI to amortize debt. AK got a question where do I look in the income statement for debt amortization?

AK71 said...

Hi Siew Mun,

All very good points to bear in mind. There are definitely many things to take into consideration when looking at REITs.

If you want to look at debt amortisation, there is only one REIT in Singapore which has that, Saizen REIT. You won't see this in any other S-REIT. So, you cannot find this in their presentations.

Tiger said...

I think it should be noted that REITS are relatively new. There is precedence yet of a REIT with its property leases approaching zero years. So there is no reference on how the market or management will react.

AK71 said...

Hi Tiger,

Yes, I agree. 10 years old. Not even a teenager. ;p

Time will tell. :)

Siew Mun said...

Perhaps we can use other country's Reits as a reference?

AK71 said...

Hi Siew Mun,

I think that would be very difficult. The mature REIT markets are in the USA, Japan and Australia and they mostly have freehold properties. Also, even though there are leasehold properties in Japan, the rules governing lease extension as well as the costs involved are probably very different from those in Singapore.

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