The Motley Fool

3 Major Risks Associated with REITs Which Investors Need to Be Aware Of

Investing in real estate investment trusts (REITs) seems like a sure-win, with most of them reporting decent growth in distribution per unit and paying regular, stable distributions to unitholders. There have not been any problems or issues reported for any REITs recently, unlike the troubles faced by companies which have encountered cash flow problems or faced bankruptcy petitions. However, REITs are not immune to teething issues, as illustrated by what occurred during the recession in 2008-2009.

Most of the issues surrounding REITs during that period involved the seizing up of the financial industry. As REITs are heavily dependent on capital markets and the real estate market, the freezing up of capital and the collapse of the property market resulted in major problems for some of the REITs.

Let’s look at three major risks for REITs which investors need to be mindful of.

1. Refinancing risk

Regulations stipulate that REITs need to pay out at least 90% of their earnings as a distribution to unitholders. REITs, therefore, have to rely heavily on external borrowings and leverage to fund their operations. Hence, refinancing risk is one of the major risks for any REIT. This relates to the inability of the REIT to refinance its debt due to stress on the lender’s side, as banks would be vulnerable to collapse during a major financial crisis and would need equity injections to recapitalise.

2. Valuation risk

Valuation risk is the risk that the property values within the REIT crash during a crisis, resulting in loan covenants with financial institutions being breached. This is highly possible as property is an illiquid asset class, and distressed sellers for properties could severely depress prices during a downturn, causing property valuation firms to factor in a significant discount to book value. If loan covenants are triggered, this would result in loans being immediately repayable on demand and may cause the REIT to go bankrupt.

3. Capital markets risk

Assuming REITs are unable to refinance their loans, they could, in theory, turn to equity markets to raise capital in order to shore up their balance sheet. However, if equity markets are collapsing due to a bear market, it means there would be low demand for fundraising. The REIT may also need to issue new equity at a significant discount to the market price, which will result in massive dilution for all existing unitholders. If the REIT is unable to raise sufficient funds to pay back the debt which comes due, it may be forced into liquidation.

Risks may show up when least expected

Though the above risks reared their ugly head during the recession in 2008-2009, it should be noted that it has been almost a decade since then and the same risks could show up at any moment. It pays to be prepared as there would be no warning as to when the next crisis may hit us. Therefore, investors need to ensure they are not overly-exposed to REITs as a sector, ensure that they choose REITs with only a small portion of their debt to be rolled over in the next few years, and also own assets that are able to hold their value during downturns.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.