The Motley Fool

1 Red Flag To Avoid When Investing In REITs

Real estate investment trusts (REITs) have grown in popularity since they debuted on the Singapore stock market in 2002. Besides their high and consistent yields, REITs also give investors exposure to real estate at a fraction of the cost it takes to buy an actual property in Singapore.

That said, not all REITs perform equally. Some have the potential for long-term sustained high returns, while others will lag the market. So how do we separate the wheat from the chaff?

In this article, I have identified one red flag that is a tell-tale sign that could spell poor returns for REIT investors.

Misaligned manager incentives

One might assume that REIT managers always have unitholders’ interest at heart. However, this may not necessarily be the case. In many cases, especially in Singapore, the remuneration model creates a conflict of interest between a REIT manager and its unitholders.

An example is Keppel REIT (SGX: K71U) where its manager fees are calculated by adding (1) a base fee of 0.5% per annum of the value of all its assets; and (2) 3.0% of the net property income of the trust.

Based on this compensation structure, Keppel REIT managers can earn higher compensation so long as the REIT’s asset base increase, even if there is a decline in distribution per unit (DPU). Additionally, Keppel REIT managers are entitled to receive an acquisition fee at the rate of 1.0% of the acquisition price and a divestment fee of 0.5% of the sale price.

Source Keppel REIT Annual Reports

From the table above, we can see that distribution per unit decreased each year from 2014 to 2017. But at the same time, the manager’s compensation increased each year, illustrating how misaligned the manager incentives are.

To earn a higher manager fee, Keppel REIT manager simply needs to increase its asset base and try to recycle its assets frequently to achieve the acquisitions and divestment fees.

Such a compensation structure may incentivise REIT managers to pursue a growth-at-all-costs strategy. This can be done by raising capital via equity offerings, which may ultimately dilute the interest of the unitholders. A growth-at-all-costs strategy can also lead to rash acquisitions that may not be DPU-accretive over the long-term.

The Foolish bottom line

The incentive package for REIT managers can give investors clues as to whether the manager interests are in line with unitholders. In the case above, it is obvious that the incentive structure creates a conflict of interest between the REIT manager and unitholders.

The managers have pursued a strategy of increasing the REIT’s asset base, which has ultimately resulted in lower DPU each year. Investors should ensure that any REIT that they invest in has a manager that has unitholders’ interest at heart.

The Motley Fool's purpose is to help the world invest, better. Click here now for your FREEsubscription to Take Stock -- Singapore, The Motley Fool's free investing newsletter. Written by David Kuo, Take Stock -- Singapore tells you exactly what's happening in today's markets, and shows how you can GROW your wealth in the years ahead.

Like us on Facebook to keep up to date with our latest news and articles. The Motley Fool's purpose is to help the world invest, better. 

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 owns units in Keppel REIT.