With interest rates on the way up, an argument can be made for avoiding Real Estate Investment Trusts or REITs. After all, why choose a distribution that is not certain, when it is possible to get a guaranteed return from money in the bank.
Right now, it is possible to earn around 1% on US dollar deposits. And if market estimates are right, another six interest rate hikes by the end of 2019 could lift deposit rates to 2.5%.
But that would still be less than the average yields on Singapore and Malaysian REITs of about 6%, even though their pay outs could be risker. Question is whether the premium is worth the risk?
Before we address that question, it is worth bearing in mind that REITs must pay out 90% of their income to investors, regardless.
The distribution is not discretionary. If the REIT makes money, then it must pay out most of it to unitholders, if it wants to enjoy a favourable tax status.
Secondly, REITs have often been viewed as a proxy for bonds. But unlike bond prices, the share price of REITs doesn’t necessarily fall when interest rates rise. So, we shouldn’t assume that all REITs could be adversely affected by rising interest rates.
In fact, a REIT’s performance is influenced by two factors, namely, the prevailing credit conditions and the state of the economy. If either the economy is doing well, or credit is readily available, then REITs should perform well too.
So, unit holders could continue to receive uninterrupted distributions. But it is important to choose the right REITs – not just the one with the highest yield.
One way to evaluate REITs is to look at how much we are paying for every dollar of profit they make. With shares, the price-to-earnings can be helpful. But with REITs the P/E ratio can be almost useless.
Cash is probably more relevant than earnings, which tend to be complicated by accounting rules that require REITs to depreciate their properties.
Property values tend to rise over time, rather than fall. But general accounting rules require properties to be depreciated over their lifetime. So, the reported profit number could underestimate the “true” profit. REITs also tend to hang on to their properties for ages.
These assets are carefully chosen to generate long-term income. In fact, we should probably run a mile, if a REIT buys and sells its buildings too frequently.
Consequently, Funds from Operation (FFO) can be a better gauge of profit. It adjusts for depreciation, amortisation, and any gains or losses from property disposals.
Currently, the median Price-to-FFO for Singapore and Malaysian REITs is a high, but not-too-demanding 17. It means that we are paying around $17 for every dollar of cash generated. Hektar (KLSE: 5121.KL) is valued at 14 times Funds from Operation, while Frasers Hospitality Trust (SGX: ACV) is valued 20 times.
Almonds and pistachios
A common problem with comparing different REITs is that it can be a bit like pitting almonds against pistachios. That’s nuts.
How do we compare, say, a REIT with prime properties in the Central Business District with another that owns a portfolio of suburban malls?
One useful way is to look at their capitalisation rates. It is a measure of the annual rental income that REITs generate from their properties.
Currently, the median capitalisation rate for Singapore and Malaysian REITs is around 5.3%. It means that they could generate roughly $5.30 of rental income from every $100 of property assets. SPH REIT (SGX: SK6U) sports a cap rate of 5.2%, while AIMS AMP (SGX: O5RU) has a cap rate of 6%.
A high capitalisation rate is not necessarily better. It could mean that a landlord is charging too much rent, which might not be sustainable over the long haul.
By the book
Finally, we should never lose sight that REITs are property assets. So we should consider carefully how much we are paying for every dollar of their net assets.
One way is to look at their book values. Since the properties held by REITs are appraised regularly, the book value should provide a reasonable gauge.
Currently, Singapore and Malaysian REITs are, on average, trading at around their book values, though some are trading at quite a hefty premium.
With more than 50 REITs listed on the Singapore and Malaysian market, investors are spoilt for choice. That can be both a blessing and a curse.
Choice is never a bad thing. Some REITs can be quite outstanding, some are mediocre, while some could disappoint. So, choosing the right ones for our portfolios is crucial.
Focussing on yields may provide us with instant gratification. But for long-term investors, considering the sustainability of distributions can be more satisfying over the long haul.
A version of this article first appeared in the Business Times.
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