A Real Estate Investment Trust (“REIT“) is a company that owns, and in most cases operates, income-producing real estate. REITs own many types of commercial real estate, ranging from office and apartment buildings to warehouses, hospitals, shopping centers, hotels and commercial forests.
There are many aspiring landlords who prefer to own properties instead of companies. However, not all landlords are able to pay the price tag for large, diversified properties, much less know how to manage them.
This is where REITs come into play. The managers will collect money from a large number of unitholders (investors) and use the pooled money to buy the income producing properties. Unitholders will then be able to own a portion of these properties and, at a fee, have the manager to manage the properties for them.
Keeping this in mind however, as we are not the ones on the ground managing the asset, we may not be informed on how well our properties are being managed. We need to be able to identify which REIT is well managed and which are not.
There are some Metrics I use to determine if the property is managed well.
Key Metrics:
- Distribution Per Unit
- Occupancy Ratio
- Gearing Ratio
- Interest Coverage Ratio
- Debt Maturity Profile
- Price-to-Book Ratio
Below is a detailed write up for each of the metrics used.
Key Metrics
Distribution Per Unit
Criteria for Distribution Per Unit (“DPU”) must show that it is Improving Year-on-Year.
Distribution per unit (“DPU”) refers to the amount of dividends a REIT investor receives for every unit he has in the REIT. DPU = Distributable Income/Total Number of Units Outstanding.
An improving DPU indicates that management is active in improving the value of the properties. This can be done by various ways such as increasing income or managing overheads such as financing costs by refinancing at lower interest rates.
I do not have a fixed guideline for how much improvement is required given that it is dependent on the different types of industries. This should be individually assessed to our comfort level.
For illustrative purposes, a Data Centre REIT should be expected to do well in the current technology heavy environment and the need for information storage. On the other hand, Retail REITs will fare less better as consumers are shifting towards online platforms to purchase their necessities, and the current situation with Covid-19 is posing a problem for all brick-and-mortar stores.
Occupancy Ratio
A good occupancy ratio would be more than 95%.
Occupancy refers to how much the assets of the REIT are being utilized. Under utilization of the occupancy may indicate the following issues:
- The asset is potentially not in a favorable environment, thus there are no interested tenants.
- The REIT is not active in seeking out and improving the asset utilisation.
In both cases, it is unfavorable to the unitholder as it immediately indicates that there may be paying a premium for a REIT that is unable to maximize their potential. A potential issue could be the property is located in an unfavorable location, like a warehouse that is located far away from any cargo transit areas.
A leeway of 5% is given as there may be instances where tenants change. This requires time to make the necessary renovations and adjustments. Nonetheless it will be preferred if this does not happen frequently and the REIT is able to retain their customers for longer periods of time.
Gearing Ratio
A healthy gearing ratio would be approximately below 40%.
Gearing ratio is a measurement of the entity’s financial leverage, which is the ratio of a REIT’s debt to its total deposited property value. It is calculated by dividing the total loans and borrowings over total property value.
On 16 April 2020, the Monetary Authority of Singapore (“MAS”) has raised the leverage limit for S-REITs from 45% to 50%. This is a form of indirect Covid-19 support and allows the REITs to have more room to maneuver these uncertain times.
Nonetheless, as an investor I will prefer to have headroom before the gearing ratio hits 50%. A high gearing ratio runs the risk that covenants can be easily breached and force the loan to be repayable. This may result in potential rights issues or a fire-sale of assets at a cheaper price to repay the loan. Both of which unfavorable to a unitholder.
With a healthy gearing ratio of below 40%, it allows the REIT breathing space and also the capacity to take on yield accretive opportunities should they arise.
Interest Coverage Ratio
A good interest coverage ratio to me would be approximately above 5 times.
The interest coverage ratio is a debt ratio and profitability ratio used to determine how easily a company can pay interest on its outstanding debt, allowing an insight of its financial health. The interest coverage ratio may be calculated by dividing a company’s earnings before interest and taxes (“EBIT”) during a given period by the company’s interest payments due within the same period.
With an interest coverage ratio of 5 times, this indicates that in order to miss the interest repayment and risk a potential recall of the loans, the REIT would have to experience an 80% decline in EBIT. This is unlikely to happen and allows for the REIT to continue as a going concern for the foreseeable future.
Debt Maturity Profile
A healthy debt maturity profile would be more than 2 years.
Debt maturity profile refers to the number of years before its debts are due to be repaid. It is a good measure of the time allocated for the REIT to refinance their debts.
2 years would also give the REIT a 1 year headroom to seek refinancing opportunities before it is forced to classify the debt as “Current” on the statement of financial position. In the event that it is classified as “Current”, it may flag a going concern issue of the REIT which in turn limits the opportunities it can capitalize on.
Price-to-Book Ratio
A healthy Price-to-Book (“P/B’) Ratio is less than 1.5 times.
P/B ratio is calculated by dividing a company’s stock price by its book value per share, which is defined as its total assets minus any liabilities.
When purchasing a REIT, it is worth noting that the properties are already constantly fair valued. The book value generally are already reflective of potential future income. Thus, it is difficult to justify potential earnings to pay a premium in share price for these properties.
Paying a premium of 1.5 times its book value in my opinion however is justifiable. There are REITs that have been able to grow their book value easily by this amount in the long term. Sometimes it is worth to pay a premium for a peace of mind.
Other Metrics
The Manager
This metric is not quantifiable and in my terms is an Intangible Asset.
There are managers who have been in this industry for a longer period of time and are known to have done well in managing properties. Some popular ones include:
- Mapletree Investments
- CapitaLand
- Frasers Property
For these managers, it was noted that the REITs under them tend to be priced a premium, resulting in lower dividend yields and at a higher price to book ratios. In some instances it may justifiable as assets under these managers are usually well managed and for the premium price, it grants the unitholders a peace of mind.
Dividend Yield
Dividend yield is also a key metric for many unitholders. However in my opinion, it is one that is highly subjective and depending on situation, may not be the most reliable indicator.
The issue is that by ascribing a dividend yield value for the respective REITs, does not necessarily represent it is a good buy.
A value of 10% for risky REITs does not mean that all REITs as long as they pay 10% yield are worth an investment. For instance, Eagle Hospitality Trust before suspension was trading at a dividend yield of 25%. However, it was full of issues with management misrepresentation and finally was suspended as a going concern. Losing all of the unitholders capital.
Net Property Income
Net property income (“NPI”) refers to the gross revenue less any property expenses. This is a good indicator to take note of to understand if the properties under the portfolios themselves are profitable and similar to DPU, must demonstrate that it is Improving Year-on-Year.
However, this is not a good indicator on its own and must be read with other indicators (such as DPU).
A NPI can be artificially inflated by taking on heavy unfavorable debts to purchase properties that while are able to provide an improvement in NPI, will have an adverse impact on the DPU (due to higher financing costs).
An NPI also does not provide insight to the tenant financial health. Gross revenue is recognized based on the contractual terms with the tenants. However, it does not consider whether the revenue recognized is collectible, which is accounted for under working capital changes for DPU.
If the REIT is mismanaged in such ways, it will potentially lead to lose of capital as well for the unitholders if the REIT is to face a going concern issue.
Rental Reversion
Rental reversion is a metric captured by some REITs to show whether new leases signed have higher or lower rental rates than before. In my opinion it is Not Necessary.
A positive rental reversion is good for unitholders as it will ultimately help to generate more DPU. However, from a tenant perspective, it will mean higher rental expenses, which may affect their bottom line. It is important to understand that increasing rental rates needs to depend on the macro environment. For example, during an economic downturn it is not wise to increase rental.
While I hope that the increase in rental is at least able to beat inflation, if the rental expense gets too high, tenants may choose to vacate instead, resulting in potential fall in committed occupancy and under utilization of the asset.
I am of the opinion that as a landlord, the tenant must be happy to be leasing from you. Building a good relationship is more important than maximizing our profits at their expense.
Growth Prospects
Growth prospects refers to any potential for the REIT to be able to grow and strengthen their financial position. While this is a good indicator to have, it is Not Necessary.
Growth prospects are subjective. A REIT may be chasing potential growth opportunities that are not necessary accretive to the unit holders. Some instances may include raising more rights or taking on debt with significantly higher interest rates.
In my opinion, as long as the REIT is able to maintain a healthy and sustainable DPU and financial position, unitholders can take distributions received and reinvest in other opportunities that are more accretive.
Summary
There is no such thing as a “Sure Win” formula. Nonetheless when investing, it is important for us to set key criteria to look out for before making educated guesses. The above are general guidelines I use and is always tailored as the situation require.
Happy investing!
