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What’s the difference between a business trust and a REIT? Quite a lot.

Ravinder Kapur

Investors need to be aware that  there are important differences between Real Estate Investment Trusts (REITs) and Business Trusts. The confusion usually arises because both are listed on the Singapore Exchange as “trusts.”

A REIT can only own and operate income-generating real estate assets. An investor who wants to benefit from the property market can deploy funds in a REIT. The management of the organisation handles all the administrative hassles associated with property ownership.

Additionally, you can invest even a small amount. Buying property usually means spending hundreds of thousands of dollars. An investment in a REIT can be for as little as a few thousand dollars.

Even investors with limited funds can benefit from the return that rental properties generate. If the price of the real estate owned by the REIT increases, the unitholder will gain as the market value of the units that are held will increase. There are a total of 33 REITs listed on the Singapore Exchange.

A REIT differs from a Business Trust in one basic way. While the former has to be involved in real estate a Business Trust has no such restriction. It can operate in any field.

Although there are several Business Trusts that are involved in the property market, they do not need to limit themselves to this area. The 21 Business Trusts listed on the Singapore Exchange include the Arcadia Golf Trust, which operates golf course assets in Japan, and the NetLink NBN Trust, which provides internet connectivity.

In addition to the type of activity that they can conduct, REITs and Business Trusts have some other important differences:

 

Management

A trustee-manager runs a Business Trust. This implies that the same entity owns the assets of the trust and manages them as well. In the case of a REIT, these two functions are handled separately.

Why should that matter? As a REIT involves two separate entities (a trustee who owns the assets, and a manager who runs operations) governance will be handled differently. Additionally, it is more difficult to remove the trustee-manager of a Business Trust.

The trustee-manager can be changed only if 75% or more of the unitholders of the Business Trust vote in favour of doing this. In the case of a REIT, the percentage of unitholders required to remove the manager is only 50%.

Another difference in the management structure is the requirement regarding the composition of the Board of Directors. The majority of a Business Trust’s Board must comprise of independent directors. This ensures a greater degree of independence. In the case of REITs, only one-third of the Board needs to be independent.

The following charts illustrate the differences in the manner in which the two types of institutions are managed:

 


Source: SGX

 


Source: SGX

Gearing

The amount that Business Trusts and REITs can borrow to finance their capital requirements also differs. Prior to July 2015, REITs were subject to a two-tier borrowing limit. Those REITs that did not have a credit rating were permitted a gearing of 35%.

This meant that the total amount that could be borrowed could not exceed 35% of the equity of the REIT. If the trust had obtained a credit rating, gearing up to a ceiling of 60% was allowed.

This rule favoured REITs that were willing to get themselves rated by an external debt-rating agency. Obtaining a rating requires an institution to reveal a number of details to the rating agency. Consequently, governance standards rise and the management follows better business practices.

But in 2015, the authorities withdrew this requirement and permitted all REITs to have a maximum gearing of 45%. However, this has probably not affected governance standards as REITs would continue to obtain debt ratings to retain their access to the debt markets.

Business Trusts do not have to adhere to any limitation regarding borrowing limits.

 

Distribution of profits

You are practically assured of a regular stream of income if you invest in REITs. These trusts are required to distribute at least 90% of their taxable income in the form of dividends each year. If they do not pay investors the required level of dividends, they can lose their tax-exempt status under the rules framed by the Inland Revenue Authority of Singapore (IRAS).

Dividend payments by a Business Trust work differently. Unlike a REIT, they are not required to make a minimum level of payouts. In fact, the dividend that a Business Trust distributes is not based on its accounting profits. It can be declared out of its surplus operating cash flows. This means that the distribution per unit from a Business Trust can be in excess of its earnings per unit.

 

Which should you invest in?

Choosing between a REIT and a Business Trust is actually quite simple. It depends upon your investment objectives. If you are looking for a passive investment that provides a regular return, your first choice should be a REIT.

The rule that they must distribute 90% of their profits ensures that you will receive a substantial dividend income. Of course, the REIT should own real estate assets that generate an adequate level of rental income. It should also be well managed and profitable.

Over the last five years, Singapore’s REITs have given an annualised return of 8.4%.

While REITs are focused on owning and managing properties, a Business Trust could operate in any area. Consequently, the potential of each Business Trust would have to be analysed on its own merits.

One factor that must be kept in mind is that there is no borrowing limit for a Business Trust. If the trustee-manager takes on excessive loans, it could put the trust in trouble during a business downturn. This is exactly what happened to the Greenship Bulk Trust that is currently in the process of being closed down. Investors should conduct a thorough due diligence exercise before buying the units of a Business Trust.

(By Ravinder Kapur)

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