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One Important Risk You Might Have Overlooked with REITs

Ser Jing - Why You Might Be Getting Poor Investment Returns and How You Can Improve (pic) Last week’s initial public offerings of SPH REIT (SGX: SK6U) and OUE Hospitality Trust (SGX: SK7) were very well received.

SPH REIT, which currently comprises of two retail malls, was spun off from newspaper publisher Singapore Press Holdings (SGX: T39) and saw 122m units changing hands on its first day of trading. The amount of units being bought and sold represented almost 5% of the REIT’s total units.

OUE H-Trust, which owns a luxury hotel and upscale shopping mall, was split from real estate group Overseas Union Enterprises (SGX: LJ3) and had 80.5m units (roughly 6% of the REIT’s overall ownership) being traded on its debut.

Part of SPH REIT and OUE H-Trust’s appeal likely comes from its strong projected distribution yields. For financial year 2013, based on their respective offering prices, SPH REIT had projected an annualised yield of 5.58%, while OUE H-Trust’s forecasted yield clocked in at 7.36%. Those yields are much higher than the Straits Times Index’s (SGX: ^STI) trailing dividend yield of around 2.8%.

But, if you’re an investor focused on yield, there might be one important risk you’ve missed out on the IPO prospectuses for those two REITs – the risk of not being able to meet their future obligations in terms of doling out cash to both unit-holders and debt holders.

From SPH REIT’s prospectus (emphases are mine):

SPH REIT will distribute 100.0% of its Specified Taxable Income for the Forecast Period 2H FY2013 and Projection Year FY2014 and at least 90.0% of its Specified Taxable Income thereafter.

As a result of this distribution policy, [it] may not be able to meet all of its obligations to repay any future borrowings through its cash flow from operations. [It] maybe required to repay maturing debt with funds from additional debt or equity financing or both. There is no assurance that such financing will be available on acceptable terms or at all.”

That sounds a tad worrying, doesn’t it? Turns out, OUE H-Trust contains a very similar paragraph under the ‘Risk Factors’ heading (emphases are mine):

“[OUE H-Trust] intends to distribute 100.0% of its Taxable Income for Forecast Period 2013 and Projection Year 2014.

Thereafter, [it] will distribute at least 90.0% of its Taxable Income, with the actual level of distribution to be determined at the REIT Manager Board’s discretion… As a result of [its] distribution policies, if the cash flows from [the REIT’s] operations are insufficient, [it] may have to obtain additional debt or equity financing or both to meet [its] distribution obligations. There can be no assurance that such financing will be available on acceptable terms or at all.”

To put things simply, REITs are required to pay out a huge chunk of its cash flows from its operations (which stem from its normal business activity of sprucing up and collecting rents from the properties it owns) to unit-holders in the form of distributions. On top of that, REITs also have the obligation to pay interest on the loans they carry, as well as repay any loans that come due.

In the event that cash flow from operations fall short, the REIT has to take on new debt to repay old ones or it can raise cash by issuing new units and use the proceeds to repay loans. In the possible-process of taking on new debt, it then faces the risk of onerous interest rates or debt-covenants that might severely hamper the REIT’s operations.

Unlike normal businesses, which have the flexibility of capital allocation in determining the full extent of the dividends they’re willing to pay shareholders, REITs enjoy no such flexibility.

Where normal businesses can conserve cash in preparation for future debt-obligations or crucial upgrading/maintenance of business facilities, REITs have no such luxury.

We can take a look at OUE H-Trust’s unaudited pro-forma (meaning the numbers are displayed as if  the REIT was already an established-entity) financials, laid out in its prospectus, as an example to see how all that plays out.

We can use financial year 2012’s numbers as a ball-park figure for future estimates. For FY 2012, the trust generated S$98.6m in cash from its operating activities. Let’s assume that FY 2013’s operating cash flows will be S$100m for brevity’s sake. Putting necessary capital expenditures aside, the trust has to use that cash, along with its cash-hoard, to fund interest expenses, debt-repayment and distributions to unit-holders.

The trust had borrowed S$587m at an average interest rate of 2.2% per year. That amounts to annual interest expenses of around S$13m. Next, S$293m of the borrowings would have to repaid in three years, with the remaining S$294m due in five years. That works out to an average of around S$156m per year in debt repayment for the first three years.

OUE H-Trust also showed distributions amounting to S$61.3m for FY2012 and for brevity’s sake again, we can work with S$65m for distributions.

So, if we slap the numbers together, this is what we’ll end up with:

Operating cash flows S$100m in
Cash on balance sheet (as of 31 March 2013) S$10m
Distributions to unit-holders – S$65m
Interest expenses – S$13m
Average debt repayment in first three years – S$156m
Net-Balance – S$124m

At the end of the day, it’s possible that OUE H-Trust will meet a capital short-fall and that’s where we see how it “may have to obtain additional debt or equity financing or both to meet [its] distribution obligations”.

Just to be sure, it’s not just OUE H-Trust and SPH REIT that faces such an issue. Most REITs face the same issue where they have to do distribute at least 90% of their Specified Taxable Income, which usually comprises a large chunk of a REIT’s cash flows. The obligation to distribute most of their cash flows to investors places a lot of restrictions on REITs’ ability to allocate capital according to pressing-needs, unlike a normal business.

That’s not to say that REITs can’t be successful investments. Singapore’s oldest REIT, CapitaMall Trust has given a total return (inclusive of distributions) of 250% since July 2003 while First REIT’s total return stands at almost a 100% since Nov 2007. But ultimately, REIT-investors have to be comfortable with the risks of the REIT’s debt-refinancing as well as the stability of its cash flows.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.