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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.
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