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SI Research: Investing In REITs – A Word Of Caution

Jimmy Ng

Amidst heightened market uncertainties, huge funds are pouring into Real Estate Investment Trusts (REITs) led by heavy institutional purchases, as they are often deemed to be the more defensive counters. This caused FTSE ST REIT Index to surge by more than 18.2 percent since the beginning of the year and led many to wonder if they could have missed the boat. However for investors who are considering taking the leap of faith now because of their fear of missing out, we do have a few pieces of advice here for them to pay close attention to.

More REITs Seeking Public Listing

Backed by strong demand, we saw two US Hospitality Trusts’ initial public offering in the month of May 2019, barely two weeks apart from each other vying for investors’ dollars. Namely ARA US Hospitality Trust and Eagle Hospitality Trust, both offerings were successful in raising gross proceeds of US$498.0 million and US$452.8 million respectively.

While both trusts boosted of distribution yield at the high side of above 8 percent, one needs to be mindful that the income of hospitality trusts are generally more volatile due to the shorter term of stay as well as being more susceptible to the influence of economic cycles. Moreover, with the majority of foreign trusts’ assets based overseas, investors ought to pay more attention to country-specific and foreign exchange risks. In the face of the lower interest rate outlook coupled with the escalating US budget deficit, we are not so optimistic on the near-term strength of the US dollar.

Last week, Prime US REIT – which owns a portfolio of 11 office properties across the US – filed its preliminary IPO prospectus on 28 June 2019. Meantime, there have been rumours on the street that Ascendas-Singbridge is considering a REIT listing on the Singapore Exchange (SGX) with a portfolio of 33 office properties in the United States that the group has recently acquired. On top of that, Mapletree Investments which currently manages four listed REITs on the SGX, has also expressed interests to add two more REITs in the next four to five years backed by its overseas assets in student accommodation and logistics. In any case, we could probably look forward to more public offerings in the next couple of years.

Increased Fund Raising Activities

As REITs are required to pay out at least 90 percent of their taxable income each year in order to enjoy tax-exemption benefits, they tend not to hold too much cash in their coffers and would need to raise funds from unitholders for their acquisitions and assets enhancement plans. With the current higher unit prices, it also poses as an appropriate time for REITs to raise capital through private placements and equities offerings.

Just last month, Frasers Centrepoint Trust completed a series of fund-raising activities comprising a private placement of 155.2 million new units to institutional and accredited investors as well as a preferential offerings of 28.8 million new units to existing unitholders, raising total gross proceeds of approximately $437.4 million meant for the acquisitions of PGIM Real Estate AsiaRetail Fund and a 33.3 percent stake in Waterway Point. The fund-raising activities received overwhelming response from institutional and retail investors alike, with the private placement 2.3 times over-subscribed and the preferential offering also almost 2 times subscribed.

Following which, ESR-REIT launched a private placement of its own this month issuing up to 195 million new units to raise proceeds amounting to $100 million for the acquisition of a property at 48 Pandan Road, financing of asset enhancement works for two existing properties as well as paring down of existing debts. The placement was approximately 2.5 times subscribed, despite the fact that distribution per unit (DPU) would dip slightly by 1.1 percent after the proposed transactions based on pro forma estimations. As of writing, details of ESR-REIT’s preferential offering to existing unitholders have not been announced.

Concurrently, Cromwell European REIT (CEREIT) had also completed a private placement recently to raise EUR150 million for the purchase of six properties located in France and Poland. According to the management, the new properties have a net initial yield of 7.4 percent in comparison to CEREIT’s existing office assets yield at 5.8 percent. Hence, the acquisitions are expected to be DPU-accretive with potential rental upside.

While fund raisings are inevitable for REITs to acquire assets for inorganic growth, investors should be wary of REITs that expand their portfolio too aggressively resulting in higher gearing. In times of tighter credit, these REITs may find it more challenging to refinance their debts. Furthermore, REIT investors are strongly advised to keep aside a sum of ready funds to be prepared for rights subscription as and when they arise, so as not to have their holdings diluted during the process.

Given that CapitaLand has been actively divesting assets in a bid to lighten its balance sheet post its merger with Ascendas-Singbridge, as well as an increasing likelihood of OUE Lippo Healthcare to inject its Japanese properties into First REIT, we would not be surprised to see more fund-raising activities being announced by REITs down the road.

Is Lower Interest Rate Beneficial To REITs?

The FOMC meetings in June 2019 concluded on a dovish note with Fed chairman Powell signaling that the central bank is ready to cut rate if necessary. Consequently, analysts are predicting two rate cuts this year and a potential cut may come as early as July this year.

Because of their leveraged structures, it is generally accepted that a lower interest rate environment bodes well for the outlook of REITs. Low interest rate implies lower financing expenses, which in turn translates to higher earnings and increased distributions to unitholders. However in reality, is this always the case?

There are two sides to a coin. We are of the opinion that cutting interest rate is inherently an expansionary monetary policy to stimulate the economy. When central bank cuts interest rate, it literally implies that the economy is not doing very well. Going a step further, if the weak economy is not conducive for businesses to grow and expand, chances are they would not be motivated to rent bigger space. And in the worst case scenario, they could even default on their rental payments altogether when the going gets tough. This does not paint a promising picture for REITs when their very lifeblood is threatened, before we could even talk about lower interest expenses or higher payouts.

Take for instance when US Federal Reserve slashed its benchmark interest rate to near-zero level during the sub-prime crisis back in 2008, the REITs did not perform exceptionally well either. Instead, they sank along with the general markets.

Compressed Yields

As REITs climb in unit prices, their yields are also being compressed at the same time. CapitaLand Mall Trust, widely regarded as a blue-chip REIT due to its consistent growth in net property income and distributions since debut, saw its price reaching an all-time high of $2.67 as at 1 July 2019. Nevertheless, its yield also dipped below five percent, more than one standard deviation below the mean of its historical yield. On that note, the traditional role of REITs to serve as income stocks in one’s portfolio has been greatly compromised as a result of their current hefty price tags. That said, a wise investor should seek to fully understand the characteristics, advantages and shortcomings of an investment, before hastily parting with his hard-earned money.