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Kyith - How Does The Perfect REIT Look Like in The Eyes of Experi..
Kyith - How Does The Perfect REIT Look Like in The Eyes of Experi..
Kyith - How Does The Perfect REIT Look Like in The Eyes of Experi..
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kyith (/users/kyith)
Before reading this article, it is advised to read my article on How does a REIT Grow? Why a Low Dividend
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4/21/2018 kyith - How Does the Perfect REIT Look Like in the Eyes Of Experi...
Yield REIT Grows Better and More Attractive than High Dividend Yield REIT
(http://investmentmoats.com/money-management/reit/how-does-reit-grow-over-time/)
I see this as a continuation of that article in terms of understanding how REIT works, what are the better
rental properties, what are the better management structure.
(http://investmentmoats.com/wp-
content/uploads/2018/04/20180415-the-perfect-REIT.jpg)
1. Triple Net Lease are preferred. The investors tend to prefer that the properties have expenses that are
borne not by themselves but by the tenants.
Expenses tend to fluctuate and likely increase over time. And why & how all these expenses occur is the
subject of dispute between the property owner and the tenant.
If it is a contract where the tenant takes care of majority of the costs, it becomes easier for the property
investor.
In overseas REIT markets, there is a specific segment of REITs that focus on Triple Net Lease properties.
They are mostly retail malls but can be of industrial and commercial nature.
In the Singapore context, not many REITs have properties in the triple net lease structure. The more
prominent ones are the healthcare REITs, First REIT and Parkway Life REIT(check them out on my
Dividend Stock Tracker (http://investmentmoats.com/DividendScreener/DividendScreener.php))
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In Singapore and Hong Kong, most of the REITs tend to have a shorter lease duration. This is perhaps due
to land scarcity and it is a better structure where the economy is hot and rents can revised up.
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Since a large part of your property’s value is tied to the quality of your tenant, your property value
nosedives. The financing companies and banks see you as a credit risk and have reservations in letting you
refinance o r debts
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refinance your debts.
In short, the quality of the tenant may be the most important factor.
The robustness, predictability of the cash inflow is determine by your tenant. Since the value of the property
is tied to the discounted aggregate future cash inflow, your tenant is very important.
“I learned over 40 years ago the biggest danger to a REIT is not the cost of capital or
finding properties to buy at a reasonable cap rate. It is having a tenant unable to pay
the rent and then facing costly eviction, repair, and repurposing efforts. Perhaps the
most danger exists when repurposing/re-leasing cannot be accomplished profitably
In short, perhaps part of due diligence is understanding and modeling the events
needed to threaten the financial survival of the REIT. I can live with a REIT never
growing or increasing its dividend. I cannot live with a REIT that significantly cuts its
dividend or which is on the road to bankruptcy..” – Older Experienced Investor
4. The Property Owner or REIT functions essentially like a Financing Company. You may have the question
in your head: why would someone pay all the expenses and taxes, and tie to a rental lease for a long time?
The main reason is that they wishes to keep the property off their balance sheet.
If you are a listed company, you are often measured by your investors based on your return on equity.
Your equity is your total assets minus your total liabilities. If you have less assets your equity goes down.
Your return on equity looks much better.
This concept is not new and there are many examples of financing.
For example, we buy a second hand car. In some countries, the poorer folks are able to buy the cars with
no down payment.
They pay back the principal and an interest on the loan from the financing the second hand car dealership
or from a financing company.
They do that because, they cannot afford to pay the price of the whole car in full. Some of these buyers will
eventually default because they cannot pay.
These car dealership cum finance company earns because the interest they charge on the loan is so high
(this has been a subject of moral controversy), that before the car owners default, they have paid a large
chunk of interest. The car dealership repossessed the car, touch it up and sell to another person.
The car itself is an asset of limited lifespan but its an asset that allows the real business to work. That is the
financing.
You are willing to pay for the car this way because you cannot afford the full price, but need the car.
Another example is your new mobile phone from your telecom company. The concept is the same. Most
people cannot afford or don’t want to spend $1000 upfront for an iPhone or Samsung Galaxy.
The telecom company lets you own the asset (handphone) first then lends you the debt which you pay off
from your recurring phone bill.
You buy a new handphone because you need to use it (for different reasons), yet unwilling to pay the full
price upfront.
In the property context, most of us need to live in a residential property, but we cannot afford to pay for a
$300,000 full price. So we get a bank to give us a loan and we pay them back in interest and principal. We
pa for all the cost of operating that ho sehold
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pay for all the cost of operating that household.
For a financing company, what the REIT earns is from the spread between cash inflow, and the cash
outflow.
For triple net the cash outflow is mainly the interest on debt. For double net commercial properties, it is the
interest and the maintenance expenses.
Thus for those triple net properties, changes in interest rates affect them a lot, just like the car financing
companies.
When interest cost rise, the margin they earn decreases.
Your rent revenue cash inflow is tied to a long lease and therefore cannot increase as fast. Your margins
erode.
For those on double net lease, if inflation comes into play, your interest and maintenance costs increases
which becomes a double whammy.
Thus, even during periods of low inflation, the REITs usually structure a 2-3% annual rental escalation
because historically there is inflation.
The most problematic is when the interest rate rise is greater than anticipated.
When the retail investors feel the uncertainty of the future net cash flow, they will sell the REIT or value the
REIT at a lower price. Or that they are certain future net cash flow will be much lower.
5. Higher Quality Portfolio leads to Higher Share Price, Leading to Lower Cost of Capital.
The characteristics mentioned above puts the REIT in a position where its recognized to have quality.
If the manager is reasonably good, and the REIT has good institution support, the share price of this REIT
tends to trade at a higher valuation.
This makes cost of equity cheaper.
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The above slide is taken from a USA Triple Net Lease REIT Realty Income. It illustrates the relationship
between higher stock price, trading above book value and the growth in AFFO.
AFFO stands for adjusted funds from operation, and in local Singapore context it is something close to the
Income Available for Distribution.
Suppose your REIT trades at a 6% dividend yield. That becomes the WACC or weighted average cost of
capital that the new property you wish to acquire, will need to beat.
To make the acquisition accretive, your shareholders will not accept you buying a property with 100% new
equity financing, through rights issue, preferential offering, share placement, if the net property income yield
is less than 6%.
If the net property income yield is 8%, this could add 3.5% to your REIT’s AFFO or income available for
distribution, purely by this acquisition.
Now instead of 6%, suppose your REIT trades at 9%, to be accretive, you need to find new property that
have a net property income yield of greater than 9%.
It becomes difficult to find yield accretive property.
In this case you will need to:
1. find lower yielding property, finance partially by debt
2. go for lower quality property which usually trades at a higher net property income yield, but comes
with more risks/baggage
Thus the total return you get from the REIT (Total return = Dividend Yield + Annualized Capital Growth) is
9% (+ whichever organic rental escalation it has)
For the previous example the Total return would be 6% +3.5% (+ whichever organic rental escalation it has).
The total return profile is different. However, the REIT that trades at a higher price, lower cost of equity,
have more opportunities to grow its cash flow.
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Lower stock price -> Higher cost of capital -> Narrower Spreads -> Lower Growth Rate -> Lower stock price.
3. The Financing Company Model gets Squeezed. Since we talked about the allure of the financing model,
it becomes a problem if the cost of debt rises.
If the lease is long, the escalation is fixed, the cost of debt could increase in a much faster rate than the
rental escalation could rise.
The margin, or the income available for distribution gets squeezed.
Since the REIT is valued based on the aggregate of future cash flow, the REIT will trade at a lower
valuation.
This very much depends on whether the REIT manager can secure financing that matches in tenure to the
lease.
I shared more about stuff on REITs like this in my section on REIT (http://investmentmoats.com/reits-training-
center/) where I go deep into the weeds of investing in REIT. It is FREE and available:
(http://investmentmoats.com/reits-training-center/)
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(http://investmentmoats.com/money-management/reit/review-of-singapore-commercial-reit-2016/)
Review of Singapore Commercial REITs for 2016
The quarter for financial reporting done by all the Commercial REITs is almost over. This is the last quarter of
2016 and it looks like the REITs have made it through a rather challenging year. It …
INVESTMENTMOATS.COM
(http://investmentmoats.com/money-management/reit/review-of-singapore-commercial-reit-2016/)
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$Frasers Com Tr(ND8U) (/stocks/SGX:ND8U) is a commercial reit that is under the radar when mentioned
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