Wednesday, June 20, 2018

REITS Are Falling - Will This Continue?

REITS have been falling lately and my portfolio was not spared either. There are a few reasons to this which I will simplify and explain in this article. Investing in REITS have been a favourite among investors due to its income generating feature which provides good dividend income for investors. Typically, we can look at around 5%-7% dividend yield investing in REITS. Will this be sustainable going forward?

The Rise of Interest Rates

The main reason for the drop in REITS price is due to the rise in interest rates. Why is this rise in interest rates so damaging to REITS in the first place? To explain it simply, the main cause is because the rise in interest rates make REITS investment less attractive. There are 2 main reasons to this:

1. Interest expense reduces distribution of income

REITS are required to payout 90% of its taxable profits to shareholders in the form of dividends. As such, they have little left at the end of the day and thus have to take on more debt to boost their returns. This is the nature of a REIT's business.

All debts have interest payable just like we pay interest on the loans we take up. When interest rates increase, the interest expense which a REIT has to pay generally increases as well. There are some strategies to mitigate this which we will look further into later in the post below. The increase in interest expense reduces the cash flow that is available to pay shareholders and thereby reducing its distribution income and the dividend yield.

2. Attractiveness of REITS decreases

Building up from the above factor, as distribution income and dividend yield reduces, it makes REITS less attractive as an investment bearing in mind the risk which is involved as compared to safer assets like bonds or fixed deposits.

Furthermore, in a rising interest rate environment, those safer assets such as bonds or fixed deposits have their rates increased as well thereby making them a more attractive investment option. This is called the risk free rate.

The Rise of Other Alternative High Yield Investments

If you've not noticed, there are many alternative safe investments out there now. Additionally, the rates which these safe investments give are going up as well. Just take a look at Singapore Savings bond which is capital guaranteed and still have the flexibility to sell anytime without losing any capital. The interest rates it gave earlier this year was about 1.2% for first year but it has risen to 1.72% for the June issue. If you put your money there for a period of 10 years, the average return per year is at 2.63%. Not bad for a capital guaranteed investment. For REITS, we still can get higher dividend yield at more than 5% but the question is will people want to take the risk to get that additional 2%+ return?

From the subscription rate of the Singapore Savings Bond, it is oversubscribed every month for the past 3 months. This shows that people are rushing in to invest their money inside There was another bond which was launched by a Temasek Holding subsidiary, Azalea Asset Management. It offered retail investors a coupon of 4.35% per annum which is really quite high. Even though there should be higher risks associated with this kind of high yield, the bond was still oversubscribed by 7.4 times which again shows the interest of the retail investors in this kind of higher yield investments.

All these alternative high yield instruments started to come most probably because of the higher interest rate environment as well. In a rising interest rate environment, it actually signals the recovery of the global economy and these government or privately owned funds are more likely to issue bonds to raise money because they are more confident of getting back a higher return for the money they borrow.

Another capital guaranteed interest generating instrument, the fixed deposit accounts, have been neglected for quite some time now due to the low interest rates environment. However, if you notice, banks have actually started to raise their fixed deposit rates again. I just checked and saw that DBS 1 year fixed deposit rate is at 0.60% now. I think it was lower just a few months back. Banks are in the business of loans and they have been raising their rates for mortgage loans as well as for other loans as well. The demand for loans have probably picked up as the property market recovers and also better business environment for businesses to expand. The banks are willing to raise their interest rates they give for deposit accounts in order to get more money to loan out at a higher rate.

How To Check If Your REIT Will Suffer?

Coming back to REITS, does all the above factors mean that its the end for REITS now? It may not be the case actually. As mentioned earlier, rising rates signal a better business environment and may benefit REITS which rents out its business space to various businesses. However, as REITS have to pay high interest expense, it is a balance now whether they are able to generate more income even as interest expense increases? There are a few things we can check to see if our REIT will survive or suffer:

1. Percentage of debt on fixed and variable rate
2. Gearing ratio
3. Weighted average debt maturity
4. Average cost of borrowings
5. Interest coverage ratio

What we essentially want to check is in the balance sheet. Fortunately, we don't have to calculate or dig the financial statements as most REITS regularly report their debt profile in easy to read slides. There are quite a few terms which may be new to some of you. Let me explain more in detail as simply as I can.

Let's start off with this REIT called Frasers Centrepoint Trust (FCT). I like this REIT a lot because of its defensive nature. Its malls are located in the suburban areas such as Causeway Point in Woodlands and Northpoint at Yishun.

Below shows one of the slides which FCT has for its Q2 2018 financial results. We can see the gearing ratio, the interest coverage ratio, the percentage of borrowing on fixed rates and average cost of borrowings etc.

One look at the slides, we can see that FCT gearing ratio is at 29.2% which is not too high for a REIT. The gearing is calculated as the total outstanding borrowings over the total assets. It has 56% of its borrowings on fixed rates which is quite low in my opinion. I've seen most other REITS already have more than 70% of their borrowings on fixed rate. However, this also explains why the average cost of borrowings for FCT is only 2.4% while if we compare for another similar retail REIT, Capitaland Mall Trust, their average cost of borrowing is higher at 3.2%.

For its interest coverage ratio, it is 6.64 times which is quite good. For interest coverage ratio, it is calculated as the earnings before interest and tax (EBIT) divided by interest expense. This means the lower the ratio, the more the company is burdened by debt expense. This is expected to be lower when interest expense increases due to higher interest rates.

The last thing we should be looking at is the weighted average debt maturity. For this, most REITs would have a slide as well which is easy to refer to. The reason why we have to look at this especially in rising interest rates environment is because when the debt is about to mature, the company will have to refinance its debt. During rising interest rates environment, refinancing will definitely be more costly. We can expect the interest expense to increase once the debt matures and it is refinanced at a higher interest rate. On the other hand, some REITs may choose to pay down its debts if they have the funds to do so.

For FCT, it has $91m of borrowings maturing in FY2018. These are unsecured bank borrowings. With the banks already raising their rates, if FCT were to refinance this loan, the interest will most probably be higher.

REITS Prices Are Falling - Will This Continue?

I would think there are actually opportunities to invest in REITs again as the prices continue to fall. We just have to evaluate and make sure we buy at a discount to NAV and also take into consideration that dividend may fall in the future as interest expense increases. We can also take reference to the risk free rate such as the 10 year Singapore government securities bond which is known to be default free. Using this rate, we can determine the yield spread of REITS dividend vs this risk free rate. There are people who use standard deviation to determine a good price for REITS but I will not go into this which is too technical for this post. In simple terms, it is just to gauge the attractiveness of the dividends given by a REIT as compared to the interest we can get in a default free asset.

Some REITs are managed better than others so its important to separate the good from the bad. By looking at its balance sheet, it will tell a lot on how the management is prepared to handle this rising interest rate environment. Just look through the slides of a few REITs and I'm sure you will be able to see it for yourself as well.

Want to learn more about dividend investing in REITS and how to value them correctly? Check out this online REITS masterclass here

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