I have had quite a few exchanges with readers regarding REITs and their properties' land leases, if any. Readers who follow the comments section of my blog would be aware of this.
After a while, I realise we could just be running through the same points again and again. So, I am putting up my thoughts in a proper blog post written as a reply to a comment by a reader, Marti:
Hi Marti,
Yes, land leases should not be looked at in isolation. Like you said, if shorter leases are coupled with very high yields, they could still make great investments.
So, properties with shorter land leases if for any reason should be in great demand could command higher rents while freehold properties if for any reason should be lacking in demand could have lower returns. So, investing in the former might make sense as there is also time value of money to consider especially if the difference in yields is stark. We get back more money in a shorter period of time instead of a dragging out of much smaller payouts (although we could receive them forever).
So, if a property has say 15 years left to its lease but is able to generate a 20% return per annum, it would still make a fairly good investment. In situations where people feel that it makes more sense to rent than to own properties, this could come to pass.
I don't think an argument that REITs with properties with shorter land leases should offer higher yields to make investment sense is a persuasive one unless we assume that the managers do nothing to their portfolio of properties under management from IPO to the time their properties' land leases run out. How likely is that?
REIT managers will very likely divest older, less productive properties and acquire newer, more productive properties. They will very likely, conditions permitting, undertake development of properties and have AEI. Asset renewal keeps overall age of leasehold properties younger while development properties and AEI improve distributable income, all else remaining constant.
The issue of whether REITs have leasehold or freehold properties and their implications is not unimportant but I feel that it could have been given too much prominence in some quarters and by some people at the expense of a more holistic approach in the analysis of REITs.
We want to keep things simple but not simplistic.