REITs: Leasehold properties revisited.

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.

NeraTel: Aggressive selling as 3Q disappoints.

Attention grabbing headline in the news for NeraTel:

"...earnings of $2 million for 3QFY2015, down 43.3% from earnings of $3.5 million in 3QFY2014."

This news led to some rather aggressive selling of the stock and I wondered if it was justifiable?

I made the observation before that NeraTel's revenue recognition can be lumpy because it is a project based business. It would be a mistake to place too much emphasis on any one quarter's results.

Could we see 4QFY2015 doing better which might give the full year results a boost? Of course, I don't know but looking at the first nine months' results, year on year, things don't look so bad.

The numbers are not pretty, for sure, but they don't look as bad as the headlines in the news which is about 3QFY15.

Quite obviously, revenue is down and expenses are up. 

A very competitive environment is old news, of course. In such an environment, remarkably, more or less, NeraTel has been able to maintain their gross profit margin. This is encouraging.

The question is whether am I going to stay invested?

I first invested in NeraTel at 40.5c a share and later added to my long position significantly in the middle of 2013 at prices from 60c to 63c a share. Given my rather large investment, the question of whether to stay invested or to partially divest is not one to be taken lightly.

As I invest primarily for income, I am mainly concerned whether NeraTel is still able to pay a meaningful dividend. I am also concerned if the balance sheet is still strong, naturally.

NeraTel is still a profitable business although it is not doing as well as before. 

To be honest, I would be pleasantly surprised if NeraTel is able to report a full year EPS of 4c which would mean having to report an EPS of 1.51c in 4Q2015, equivalent to 60% of earnings achieved in the first 9 months of 2015.

However, it would be equally surprising to me if NeraTel is unable to achieve at least a full year EPS of 3c which would suggest 4Q2015 coming in worse than 3Q2015.

Barring a bombshell of a 4Q, assuming that NeraTel should pay out most of its earnings as dividends, I believe a 3c dividend per share (DPS) is reasonable.

NeraTel's balance sheet is still strong. Operating cash flow has also remained positive.

I see challenging conditions for NeraTel but I do not see NeraTel going the way of the Dodo in the near future.

So, I will stay invested but, at this juncture, I won't add to my investment although I believe that NeraTel should be comfortable paying an annual dividend of 3c a share. 

I want to remember that given the stiff competition that NeraTel faces, earnings could continue to come under pressure.

If a DPS of 3c is a more realistic expectation based on a 100% payout of earnings, then, I would need a higher dividend yield for me to add to my investment.

Related posts:
1. NeraTel: 1QFY15.
2. NeraTel: 2QFY15.