With interest rates set to rise this year and REITs having generally richer valuations compared to last annum, many investors may be tempted to switch from REITs to safer assets such as treasuries or corporate bonds.
However, I feel that switching from REITs to bonds may end up dragging your investment returns over the longer term – even as interest rates rise. Don’t get me wrong, I absolutely agree that treasuries and corporate bonds are perhaps safer options than REITs. Bonds and treasuries have a stable coupon rate and the principal (if held to maturity) is more secured than REITs. The rising interest rate environment will also increase the yield on both bonds and treasuries, while it will be a drag to a REIT’s profitability due to a generally higher interest expense.
Having said that, REITs still possess much greater long-term potential than both treasuries and bonds. REITs generally have a higher yield, and the property market — despite its cyclical nature — historically always ends up outperforming bonds and treasuries over the long term. So here are three reasons why I will still choose REITs over other income-producing assets.
REIT prices in Singapore surged last year, as most investors were bullish about the property market. However, even at these prices, REITs still offer unit holders a much higher yield than most bonds and treasuries. At the time of writing, the lowest yielding REIT has a distribution yield of 4.67%, while the highest is yielding 8.71%.
The 30-year government bonds are 2.9%, while one-year treasury bills have a yield of just 1.59%. High yielding corporate bonds have a coupon rate of 3 to 5.3%. Even perpetuities, where investors do not get their principal back, have a yield of just 6%.
You may be wondering how sustainable REIT’s yields are. Well, REITs in Singapore have historically performed very well. Properties also tend to grow in value, meaning the REITs book value will increase over time. This makes it an even more attractive proposition for investors.
Limited downside risks
As with any publicly traded security, REITs are susceptible to volatility and changes in prices. Distributions per unit may also decrease over time. However, the long-term trend of REITs in Singapore suggests that REITs are unlikely to underperform for extended periods.
REITs in Singapore need to maintain a gearing ratio of 45%. Because of that, REIT managers, no matter how gung-ho, have to keep their balance sheet in check for the authorities. Although it may limit their growth, it means that they are unlikely to face liquidity issues.
Real estate also tends to have a much more consistent and stable income stream than companies. This means that volatility in REIT prices have historically been much lower than traditional stocks.
Finally, and perhaps the most appealing aspect about REITs, is the fact that REITs, unlike bonds are able to grow its distributions each year. If a REIT manages its capital well and is able to improve the yield on its properties, they can grow its distributable income, rewarding shareholders in the process.
For instance, some REITs listed in Singapore have grown its DPU by 6-7% a year. That means that in 10-12 years, its DPU would have doubled. If an investor had initially purchased the REIT at a yield of 6%, he would be enjoying a 12% yield on his investment. This is a huge upside that REITs have over bonds and treasuries, which have a fixed rate throughout their lifespan.
The Foolish bottom line
As an investor, I am always looking for the best risk-reward investments. As shown from above, REITs undoubtedly have a much larger reward profile than bonds and treasuries. Furthermore, the limited downside risk makes them a relatively safe investment. I am confident in saying that investors who choose REITs over bonds will most likely feel very happy about their decision over the long term.
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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 Jeremy Chia doesn’t own shares in any companies mentioned.