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How Can A REIT Lower Its Leverage Ratio?

A real estate investment trust’s (REIT’s) ability to make yield-accretive acquisitions depends largely on its gearing ratio. The gearing ratio is the amount of debt a REIT owes as a percentage of its total assets. The lower the gearing ratio, the more debt a REIT can take on to fund acquisitions and to build its portfolio.

As such, looking out for REITs with low gearing ratios can be rewarding. However, because REITs are obligated to pay at least 90% of its distributable income to unitholders, their capacity to lower their gearing ratio through retained earnings is limited. So, what are the ways a REIT can use to lower its gearing ratio?

Equity funding

Perhaps the easiest way that a REIT can lower its gearing ratio is by sourcing for more equity financing. By increasing its equity capital, the asset base of the REIT grows, thereby lowering its gearing ratio in the process.

There are a few ways that REITs can source for additional equity capital. The first and perhaps most obvious way is through the sale of new units. This can be done through a rights issue where existing unitholders can purchase additional units. The sale of new units can also be done through a private placement or through preferential offerings to existing unitholders.

Most REITs in Singapore also have a distribution reinvestment plan where existing unitholders can opt to receive their distributions in units instead of cash. This provides the REIT with an additional source of equity funds.

Lastly, REITs can sell perpetual securities, which are essentially securities that have no maturity date. As the REIT does not have to pay back the principal amount, perpetual securities are considered a source of equity financing, rather than debt.

However, as you may have guessed, there are certain downsides to using equity financing. First, by issuing more units, a REIT will increase the existing unit base and dilute existing unitholders’ interest in the process. Perpetual securities, also pose their own disadvantages as the REIT needs to pay interest on these securities forever, or until they get converted to units.

Revaluation of assets

Another way that a REIT’s gearing ratio decreases is when its properties are revalued upwards. To me, this is the more sustainable method of lowering its gearing ratio as unitholders’ interest is not diluted in the process.

Let us take the following scenario. A REIT has total assets valued at $1 billion and total borrowings of $350 million. It therefore has a gearing ratio of 35%. The next year, the REIT’s assets get revalued upwards by 20% and its total asset value increases to $1.2 billion. Its total borrowings remain unchanged at $350 million. Because of the revaluations, the REIT’s gearing ratio has dropped to 29.2%. Consequently, the REIT now has more headroom to take on more debt to grow its portfolio.

The Foolish Takeaway

A REIT’s ability to lower its gearing ratio can have a positive impact on the long-term growth of the REIT. By looking out for REITs that have a stellar lineup of properties with the propensity to appreciate in value, investors can pick out the best REITs that can grow and outperform the rest.

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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.