Real Estate Investment Trusts commonly known as REITs are often looked at favourably by dividend-focused investors. And it’s not hard to see why.
REITs have to pay out at least 90% of their taxable income as dividends to shareholders to enjoy tax transparency. Thus, if investors can invest in good-performing REITs, their dividends would likely increase over time, in addition to benefitting from any potential capital gains.
With this exciting prospect of increasing dividends and capital gains, it then begs the question, How does an investor find a good REIT to invest in? Are there any specific metrics that investors can use to better sieve out good-performing REITs in the long run?
The short answer is definitely yes! In this article, I will detail an 8-step framework that you can use to better improve your odds of investing in good-performing REITs over the long run.
Do note that it will never be a 100% success rate as there will always be specific information not privy to retail investors and other black swan events. Nevertheless, using this framework has allowed me to generate both increasing dividends and market capital gain from my REIT investments.
If you are more interested in a video you can watch it below:
Else, let’s get right into the framework.
Step 1: Knowing a REIT’s property portfolio
Before even looking into the financial numbers, investors need to know what a REIT is about and how it makes money. This means knowing what properties the REIT has in its portfolio and from which geographical region it derives its revenue.
By knowing these two aspects, investors would better understand what drives the REIT, its respective risks and growth prospects (more on this in the latter parts of the framework).
For example, if we look into Capitaland Ascendas REIT, we can see that it invests in industrial, data centres, logistics and business/science park properties.
In terms of geographical regions, most of its properties are in Singapore with others being in the United States, Australia and Europe.
Once we know what type of properties the REIT invests in and where these properties are, we can then move on to the next crucial step, crunching the financial numbers.
Step 2: Assessing a REIT’s top and bottom line performance
This is where the real analysis starts. To fully assess a REIT’s top and bottom line performance, investors have to go through its annual reports over the years.
There are three key aspects to note, the REIT’s overall revenue, net property income and distributable income, which can all be found in the income statement. Needless to say, these figures should ideally be increasing year after year.
Also, I like to personally look at these numbers over a period of 5 years to see the general growth trend. You could also opt for a longer period based on your preferences and criteria.
Revenue
When it comes to a REIT’s revenue, a majority of it would be rental income from its tenants. At times there could also be other revenue sources such as parking income or rental income supports.
Using the example of Keppel DC REIT, its ‘other income’ portion of the overall revenue consists of rental top-ups.
Besides looking at the overall figure, investors should also note how much each property and geographical segment contributes to the REIT’s overall revenue. This way, investors can have more visibility into a REIT’s business operations.
Looking at Keppel DC REIT again, we can see that much of its revenue comes from colocation data centres and Singapore.
By knowing which segments are a REIT’s main revenue drivers, investors can better assess future and past revenue growth trends.
Net Property Income
A REIT’s net property income would be the next thing investors should look at after the revenue. The net property income is derived simply by subtracting property operating expenses from the total revenue.
An increasing net property income means that a REIT’s total rental income can offset any increase in property-related expenses.
Do note that property operating expenses generally refer to property maintenance-related expenses and utilities, meaning the direct cost of managing the day-to-day operations of the REIT’s properties. It does not include any property-related enhancement initiatives, such as reconfiguring office space or major property refurbishments.
Investors may also want to calculate a REIT’s net property yield and see if it’s increasing over the years. Net property yield is derived by dividing the net property income by the REIT’s total property portfolio valuation, expressed as a percentage.
Distributable Income
A REIT’s distributable income is basically what is given out as dividends to investors. Thus, an increasing distributable income means that the pool of dividends paid out is also increasing.
Besides assessing a REIT’s distributable income growth, it is also important to note any distribution adjustments made. You can find a complete list of adjustments in the REIT’s distribution statement.
Noting a REIT’s distribution adjustments allows an investor to assess if the final distributable income amount is ‘artificially inflated’.
Some of the ways in which REITs can inflate their distributable income is by including distributions from past divestments or paying a large amount of management fees in units. Thus, while distributable income might be increasing on the surface, investors are actually worse off due to an enlarged unit base diluting the actual dividends received.
Step 3: Assessing if a REIT is generating positive returns
To truly know if a REIT is generating positive underlying returns, investors should look at its net asset value (NAV) and distributions per unit (DPU). Having both values increasing means that investors are holding an appreciating asset and receiving more dividends.
A REIT’s NAV can typically be found in its balance sheet. It represents total shareholder equity, excluding any non-controlling interests, over the total number of units in issue.
A declining NAV could signify the following possible issues with the REIT:
- Declining property portfolio valuation
- Liabilities increasing at a faster rate than assets
- An enlarged unit base due to dilutive management actions (this would negatively impact DPU too), regarding acquisitions or general management of the REIT
Besides NAV and DPU, investors should also look at a REIT’s adjusted funds from operations (AFFO). AFFO is basically how much cash the REIT generates from its business after accounting for regular capital expenditure (Capex). You derive this figure by subtracting recurring Capex costs from the REIT’s net cash from operating activities (in the cash flow statement).
Lastly, investors can compare a REIT’s dividends to the AFFO to see if it is sustainable. If a REIT’s dividends exceed its AFFO, it implies that net cash generated from the REIT’s operations does not fully cover the dividends paid out. It also means that the REIT is using debt to fund either Capex or the dividends paid out.
Do note that some REITS do set aside cash to be reserved for Capex in their distribution statement.
Thus to get a clearer picture of dividend sustainability, this amount should be added back to the declared dividends before dividing it with AFFO.
Step 4: Assessing a REIT’s financial health
After considering a REIT’s returns and dividend sustainability, you would want to look at its financial health next. After all, REITs are highly leveraged instruments and debt management would thus directly impact their performance and growth trajectories.
When it comes to a REIT’s financial health, these are the main aspects to look out for:
- Aggregate leverage (commonly known as gearing)
- Interest coverage ratio
- Average debt cost
- Average debt tenor
Aggregate leverage
A REIT’s aggregate leverage is derived from gross borrowings expressed as a percentage of its total asset value. It shows how leveraged the REIT is in relation to the assets it owns.
Currently, MAS has set an aggregate leverage limit of 50% for all REITs in the Singapore market. Do note that this 50% limit is only applicable to REITs with an adjusted interest coverage ratio of more than 2.5 times. Else, the limit would be 45%.
Should the aggregate leverage limit be breached, a REIT would not be able to incur additional borrowings and have to find ways to bring down its aggregate leverage, either by selling its properties or doing a dilutive equity fundraising.
Typically, I prefer investing in REITs with an aggregate leverage of 40% or less. This provides the REIT with ample headroom to either take on more debt for growth or deal with negative portfolio valuations.
It is also useful to note that perpetual hybrid securities are not included in a REIT’s aggregate leverage if they fulfil the below conditions:
Thus, investors should pay extra attention when REITs issue such perpetual securities as it allows them to legally exceed the aggregate leverage limit while placing the REIT in an overall weaker financial position.
Of course, this is not to say all issues of perpetual hybrid securities are bad, it comes down to whether it is done in a financially sustainable way or not.
Interest coverage ratio
The interest coverage ratio (ICR) shows how well a REIT can afford the interest payments of its debt. It is derived by dividing a REIT’s 12-month trailing EBITDA by its 12-month interest expense and borrowing-related fees.
A more accurate representation of a REIT’s ability to pay for its interest is by using adjusted ICR instead. The parameters for adjusted ICR are similar to that of ICR but include the distributions of hybrid securities in the calculation of interest expense and fees.
In terms of an acceptable ratio, I generally prefer REITs with an ICR and adjusted ICR of at least 4 and 3.5 times respectively.
Debt cost and tenor
Closely related to a REIT’s ICR is its average weighted debt cost. Naturally, investors would want this value to be as low as possible as it equates to lower interest payments for the REIT.
A low average weighted debt cost also shows that the REIT management is competent in managing interest rate risk, through the use of interest rate swaps and proportioning of fixed and variable rate loans.
Besides average debt cost, investors should also look into a REIT’s debt maturity profile and tenor. A well-spread-out debt maturity profile ensures that a REIT does not have huge refinancing concerns in any given year.
For example, we can see a well-spread debt maturity profile in Capitaland Ascendas REIT.
With less than 20% of debt being up for refinancing per year, it allows room for Capitaland Ascendas REIT to navigate prevailing interest rate cycles.
Debt tenor-wise, there are advantages and disadvantages to longer or shorter tenors. While longer debt tenures allow a REIT to lock in an interest rate over a specified period, this might not be beneficial in a high-interest-rate environment.
On the flip side, shorter debt tenures allow a REIT to be more sensitive to prevailing interest rates but these REITs are then ‘forced’ to refinance at more regular intervals.
Ultimately, REITs should utilise both long and short-debt tenures to effectively navigate different interest rate environments. Thus, a ‘good’ debt tenor should ensure both a sustainable debt maturity profile and debt cost for the REIT.
Step 5: Evaluating tenant risk and property performance
Moving on from the financial numbers, the next step is to consider a REIT’s tenant profile and property attractiveness.
Tenant risk
When assessing tenant risk, investors should look into the REIT’s top 10 revenue-contributing tenants. This gives investors a clearer picture when assessing the overall riskiness of a REIT’s earnings.
Using the example of Capitaland Ascendas REIT again, we can see that the top tenant only contributed 3.2% of monthly gross revenue. In total, the top 10 tenants contributed around 16.7% of monthly gross revenue.
This shows that Capitaland Asecendas REIT is not overly exposed or dependent on one tenant for its revenue. Thus, any financial impact from potential non-renewals of lease agreements would not be that significant.
Besides a REIT’s tenant revenue contribution, it’s also important to look into the sectors/industries that tenants are in. Doing so allows investors to see whether a REIT’s revenue is derived from growing or sunset industries.
As seen above, a majority of Capitaland Ascendas REIT’s tenants are in growing sectors. This would likely translate to better overall tenant retention and tenant demand.
Property attractiveness
Having tenants in growing sectors/industries is just one side of the coin to healthy tenant retention and demand. The other side of the coin is how attractive the REIT’s properties are to potential tenants.
Investors can assess the attractiveness of a REIT’s properties by looking at its occupancy rate. A high occupancy rate means that the REIT’s properties remain attractive in the market.
There are a few factors which can determine the attractiveness of a REIT’s properties, such as:
- Property location (nearby amenities and accessibility)
- Property appearance (whether it is well-maintained and modern looking)
- Rental pricing in comparison to similar nearby properties
- Property specifications
- Human traffic (for retail REITs only)
These above factors are in addition to the general market demand or country/state-specific demand inhibitors or drivers.
Besides the occupancy rate, investors may also want to consider a REIT’s weighted average lease expiry (WALE). This provides an overview of how often lease renewals occur. A declining or increasing WALE also shows whether newly signed leases are shorter or longer.
As we can see from the above comparison of Capitaland Ascendas REIT and Fraser Centrepoint Trust, retail REITs generally have lower WALEs than industrial or commercial REITs. This is to be expected as shopping malls need to constantly refresh their tenant mix to ensure continued visitors.
Thus with a shorter WALE, FCT is more exposed to potential revenue fluctuations, as observed by the amount of gross rental income due in a year, as compared to Ascendas REIT which has a longer WALE.
Step 6: Judging a REIT’s management team
A crucial portion of REIT analysis often missed by investors is the track record of the management team.
To assess a REIT’s management team, investors can consider some of the following aspects:
- Has the management been making accretive acquisitions?
- Have acquisitions or divestments benefitted the REIT?
- Have past divestments been done at a profit?
- Is the management team managing the REIT prudently?
- Has the management team performed any dilutive actions? (i.e. doing a dilutive equity fundraising)
By assessing the track record of a REIT’s management team, investors can observe if the management is aligned with the interests of unitholders or not.
Most of the time, a good REIT management team should coincide with a positive REIT performance, be it in terms of long-term capital gain or increasing dividends paid out. This is because if a REIT is well-run and growing sustainably, it will attract market attention sooner or later. This commonly results in a premium being placed on the valuation of such REITs, which in turn makes it easier for REIT management teams to continue growing these REITs.
However, investors should note that assessing the track record of a management team would probably take a few years. Hence, this might automatically exclude investing in newly listed REITs.
Step 7: Assessing a REIT’s growth prospects
After looking at all the REIT’s numbers and management team, it’s time to consider its growth prospects.
A REIT’s growth prospects can be split into two categories, sector-specific prospects and property acquisition opportunities.
Sector-specific prospects are related to the property market in which a REIT’s properties are in. For instance, for REITs with Singapore industrial properties, investors would want to consider the rental and occupancy trend of the industrial sector (from the JTC website).
The same consideration should also be given to overseas properties as market demand and trends would differ between countries and states.
For property acquisitions, much would depend on a REIT’s mandate and its sponsor.
Using Capitaland Ascendas REIT as an example, we can see that its mandate is to invest in tech and logistics properties. Thus, any new property acquisitions would likely adhere to this mandate.
Sponsors also play a crucial role in a REIT’s growth as they can provide a pipeline of potential property acquisitions for the REIT.
From the example of Keppel DC REIT, we can see that there are potential properties that can be acquired from the sponsor at the appropriate time. This provides another avenue of potential growth for the REIT besides just the open market.
Step 8: Determining a suitable valuation & entry price
And we have finally come to the last step of the framework. Phew!
This step involves finding the appropriate valuation and entry price for a REIT.
Valuation
Personally, I look at the price-to-book ratio and dividend yield when valuing a REIT. You can find these values of any REIT easily through the MorningStar website.
Investors can choose to compare the current values to the 5-year average values. This gives a rough sense of the relative historical market valuation of the REIT.
However, doing so would be reliant on past performance and data of the REIT, which might not account for current developments of a REIT. Thus, instead of relying solely on these values, I prefer a more holistic approach to a REIT valuation.
In addition to using the past 5-year averages as a benchmark, investors can also consider any current or future developments which may negatively impact the REIT. Such developments may include a slowdown in the rental market and non-renewal or rental default of a major tenant.
With this information, investors can then work backwards to reach a dividend yield and corresponding unit price, after taking into account a certain margin of safety. Do also ensure that this yield has a suitable risk premium over the ‘risk-free’ rate (i.e. the yield of T-Bills).
Determining the entry price
Using the previously calculated price during the valuation process, it can then be compared against the REIT’s recent support level prices.
Using the price chart of Keppel DC REIT, its recent support levels are in the $1.60 to $1.65 range. Hence, potential investors of Keppel DC REIT can see how wide these prices are from their calculated valuation and make a more informed decision of whether to invest in the REIT right now or not.
This can also help to reduce instances of FOMO (fear of missing out). After all, if you are investing for dividends, your entry prices play a crucial role in determining your overall returns.
Conclusion
I hope that with this 8-step framework, investors can take a more structured approach in their REIT analysis. While this framework will not guarantee a 100% success rate, it should bolster your chances of investing in REITs that perform well over the long term.
Also, do not treat this framework as the be-all and end-all when investing in REITs. Investors should still do more research into the specific REITs that they are invested in.
After all, it is only when you know your investments inside out (as much as possible) would you then have the conviction to hold during tough market periods.