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4 Types of REITs to Avoid

Real estate investment trusts (REITs) allow investors to gain exposure to the property market with very little capital outlay. On top of that, these investment vehicles usually have dividend yields that are way higher than the general market, making them even more attractive.

Having said that, not all REITs make good investments. Here are some types of REITs that investors should be wary of.

Highly-leveraged REITs

REITs in Singapore have a gearing ratio limit of 45%, as mandated by the Monetary Authority of Singapore. The gearing ratio is calculated by taking a REIT’s total borrowings and dividing it by its total assets.

Generally, I prefer REITs to have a leverage ratio of below 35%. This ensures that if the economy were to take a sudden downturn, there would still be a margin of safety before the 45% limit is breached.

If the 45% cap is hit, the REIT will have to raise funds through other means such as through a rights issue or private placement to pare down debt and bring its gearing ratio down to a more palatable level. During the 2008-2009 Global Financial Crisis, some REITs had to undertake rights issues at considerable discounts to their-then unit prices to keep their debt levels manageable.

Excessive private placements

Private placements happen when a REIT sells its units to a specific group of investors. Unlike a rights issue where retail investors such as you and me can participate, private placements are reserved for a select group of investors such as institutional investors or wealthy individuals.

An example of a REIT that recently conducted a private placement exercise is CapitaLand Commercial Trust (SGX: C61U). The commercial REIT raised gross proceeds of S$217.9 million from a private placement to partially fund a new acquisition in Germany. The placement, which comprised of 130 million new units, were offered at a price of S$1.676 apiece. The issue price was at a discount of around 3% to the volume-weighted average price for the REIT for trades done on 16 May 2018.

It can be seen that existing unitholders were diluted as a result of the private placement as they could not take part in it. Any REIT that has conducted excessive private placements should be avoided as retail unitholders will have their stakes in the REIT diluted in the future if more placements are organised.

Declining distribution per unit

Investors in REITs should look out for consistent growth in the distribution per unit (DPU). An increasing DPU in every year signals to the market that the REIT’s assets are stable and can attract quality tenants. On the other hand, a falling DPU shows that a REIT is struggling to increase rents and its prospects are likely not that great.

For example, healthcare REIT, First Real Estate Investment Trust (SGX: AW9U), has seen its annual DPU climb from 8.30 Singapore cents in 2015 to 8.57 Singapore cents in 2017. In contrast, AIMS AMP Capital Industrial REIT (SGX: O5RU), an industrial REIT, has been facing headwinds in its industry and this shows up in its falling DPU over the years; in its fiscal year ended 31 March 2016 (FY2016), the REIT paid a DPU of 11.35 Singapore cents, but this had declined to 10.30 Singapore cents in FY2018.

At their current unit prices, First REIT has a distribution yield of 6.7% while AIMS AMP Capital Industrial REIT sports a yield of 7.3%. Based on their yields alone, AIMS AMP Capital Industrial REIT looks more attractive. But when we look at the REITs’ DPU track record, First REIT looks better.

Therefore, when investing in REITs, we should not rely on a REIT’s distribution yield alone. We should also look at its DPU track record to make a more-informed decision.

High valuation

I generally avoid REITs that have a price-to-book (PB) ratio of above 1 and a distribution yield of below 6%.

The PB ratio is calculated by taking the market price of a REIT and dividing it by the REIT’s latest net asset value (also known as book value) per unit. Any ratio above 1 shows that the REIT is trading at a premium to its net asset value, which is assets minus liabilities.

In some cases, a high premium is warranted as the REIT is perceived to be a stable one. Back to the examples of First REIT and AIMS AMP Capital Industrial REIT, the former is selling at a 30% premium to its book value while the latter is selling at just 3% above its book value. The market perceives First REIT to be better than AIMS AMP Capital Industrial REIT, thus pricing it at a higher valuation.

I also prefer REITs to have a distribution yield of over 6% in order for them to be commensurate with the risk taken on to hold them. REITs are generally riskier instruments due to the high borrowings that they have to take on, and as mentioned earlier, if credit freezes up during an economic downturn, REITs could suffer.

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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 CapitaLand Commercial Trust and First Real Estate Investment Trust. Motley Fool Singapore contributor Sudhan P owns units in CapitaLand Commercial Trust.