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How To Choose The Best REITs To Invest In?

When it comes to investing in real estate investment trusts (REITs), most investors look at the distribution yield as part of their decision-making process. However, the distribution yield of a REIT tells us nothing about the sustainability of its distributions, nor the strengths or weaknesses of the REIT’s business.

Instead of focusing solely on a REIT’s distribution yield, REITs investors should also look at other factors. Only then can they make a more informed investing decision with a REIT. Here are the important factors I look at.

Growth in the basic numbers

Firstly, I like to investigate whether a REIT’s gross revenue, net property income (NPI), and distribution to unitholders are growing consistently on an annual basis.

Gross revenue is the income that a REIT earns through rent, operation of car parks, and so on. After deducting property-related expenses such as property management fees, property taxes, and maintenance expenses, we arrive at the NPI figure.

The chart below is an example from First Real Estate Investment Trust (SGX: AW9U) that shows growth of its gross revenue and NPI from 2007 to 2017. First REIT is a healthcare-focused REIT.
Source: First REIT 2017 earnings presentation

I also look at whether a REIT’s distributable amount and distribution per unit (DPU) are improving consistently every year, apart from its gross revenue and NPI. Taking First REIT as an example again, its distributable amount and DPU can be seen to be rising steadily from 2011 to 2017 from the following chart:Source: First REIT 2017 earnings presentation

Property yield

The property yield is the NPI divided by the valuation of the properties held in a REIT’s portfolio. This metric reveals the intrinsic strength of the REIT’s underlying properties, and is more critical than calculating the REIT’s distribution yield (as the distribution yield is a function of the REIT’s unit price).

In 2017, First REIT had an NPI of S$109.5 million and S$1.35 billion in investment properties. This equates to a property yield of 8.1%. Property yields in the range of 5% to 9% are great, in my opinion.

The property yield can then be compared on either a yearly basis to look for trends, or with other REITs operating in the same industry. For example, Parkway Life REIT (SGX: C2PU), another healthcare REIT, only had a property yield of 5.9% in 2017. In another instance, the two retail REITs, CapitaLand Mall Trust (SGX: C38U) and Frasers Centrepoint Trust (SGX: J69U), had property yields of 5.8% and 4.9%, respectively, in 2017.

Gearing and interest coverage ratios

The gearing ratio and interest coverage ratio reveal the strength of a REIT’s balance sheet.

The gearing ratio is calculated by dividing the total debt of a REIT by its total assets. As of 31 December 2017, Parkway Life REIT had a gearing ratio of 36.4%. REITs in Singapore have a gearing limit of 45%, as required by the Monetary Authority of Singapore.

The interest coverage ratio is derived by dividing a REIT’s NPI by its finance costs. At the end of 2017, Parkway Life REIT had an interest coverage ratio of over 10. This shows that even if the REIT’s NPI were to decline by 60%, it would still be able to service its debt. I like to look for an interest cover ratio that is above 4.

Other metrics to look at

Investors must also look at general operating metrics such as the REIT’s portfolio occupancy rate, and other metrics specific to a REIT. Two REIT-specific metrics for retail REITs would be shopper traffic numbers and tenants’ sales. For hospitality REITs, investors can look at the revenue per available room and average daily rate.

I also like to look at a REIT’s funds from operations (FFO) and adjusted funds from operations (AFFO). FFO strips off cost-accounting methods such as depreciation of investment properties that may inaccurately distort a REIT’s cash-generating ability. The FFO is akin to the operating cash flow of a company, while the AFFO is like a company’s free cash flow.

Only after looking at all the factors mentioned above do I look at the distribution yield of a REIT, which is a valuation metric. Other valuation metrics involve looking at the REIT’s capitalisation rate, net asset value, or replacement cost.

The Foolish takeaway

Recently, my Foolish colleague, Jeremy Chia, highlighted in his article that Cache Logistics Trust (SGX: K2LU) had a distribution yield of 8.3%. This is one of the highest yields in the Singapore stock market.

However, after digging a little deeper, investors would realise that the REIT has a relatively high gearing ratio, and an unhealthy interest coverage ratio. These factors could ultimately put Cache Logistics Trust’s DPU at risk. Therefore, Foolish investors should always look beyond distribution yields when buying REITs.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. The Motley Fool Singapore has recommended units of First Real Estate Investment Trust, Parkway Life REIT, CapitaLand Mall Trust and Frasers Centrepoint Trust. Motley Fool Singapore contributor Sudhan P owns units in CapitaLand Mall Trust.