In order to know how to invest in REITs, we need to understand 10 key financial metrics described below. REITs are real estate investment trusts that primarily own and operate income-produce properties using funds from individual investors pooled together.
REITS allow retail investors to invest and earn dividends from high quality real estate assets without having to fork out the high quantum required to purchase these properties. Here we will not go through all the different types of REITs. But rather, we will discuss 10 general financial metrics that will help you assess your investment options.
Apart from the potential dividend yield, these financial measures will help you weigh the risks and value associated with particular REITs.
How To Invest In REITs Overview
How To Invest In REITs: Trust Structure And Sponsors
First, we need to understand what is a trust.
Trust is a legal agreement setup and governed by a Trust Deed where one party, known as Trustor/Grantor/Settlor, transfers to another party, known as Trustee, the right to hold title to the assets and manage on behalf of a 3rd party, known as Beneficiary.
REITs are established and governed by a Trust Deed. They are a type of professionally managed collective investment scheme. Their primary business is to manage, acquire and finance income producing properties.
Generally, REITs also have sponsors, who are usually real estate developers, but not necessarily. They provide support to the REIT by injecting their properties into the REIT. Further support comes in the form of providing the REIT rights to acquire the sponsor’s properties in the future pipeline. Often, the sponsors themselves may be the major unitholder of the REIT they sponsor.
How To Invest In REITs: Sector Categories
As a quick overview, REITs can generally categorised to various sectors as below:
- Retail (E.g. Shopping malls, Retail spaces and Shophouses).
- Offices (E.g. Office buildings)
- Industrial (E.g. Warehouses and Factories)
- Residential (E.g. Apartments and Condominiums)
- Healthcare (E.g. Hospitals)
- Others (E.g. Data Centre)
10 Key Metrics: How To Invest In REITs
1. Net Property Income
Net Property Income (NPI) = Revenue – Property Expenses
The first metric we need to know when evaluating REITs is Net Property Income. This is the equivalent of gross profits for usual businesses. Just that in the cast of REITs, revenue will be derived from rental income from its portfolio of properties.
Property expenses are typically made up of property management expenses, interest payments, property insurance, property tax, valuation fees, marketing expense, utility bills and depreciation and amortization of assets.
2. Capitalization Rate (Cap Rate)
Capitalization Rate (Cap Rate) = Net Property Income / Property Value x 100%
Cap rate tells you what the rate of investment return from a property asset is, if one were to acquire the property fully in cash.
This is the yardstick that REITs’ managers use to evaluate the opportunities when assessing for yield accretive acquisitions. In addition, Cap Rates will be used to compare with borrowing cost to ensure the viability of the acquisition.
As investors, you can benchmark the Cap Rates of the REIT’s properties with that of the market.
Net Property Income Yield (NPI Yield) = Net Property Income / Revenue x 100%
The NPI yield is the equivalent to the operating margins of a business. As such, it can serve as a measurement to compare different REITs in the same asset class. This will tell you how efficient the managements are in managing their revenues and expenses.
Distribution Per Unit (DPU) = Distributable Income / Total Number of Units
The DPU represents the amount of dividend paid to each of the units that unitholders own over a specific accounting period.
In order to enjoy tax benefits, Singapore REITs will need to distribute at least 90% of its net income. It can choose to retain the remaining for expansion purposes.
It is important to note that REITs derive their distributable income from their operating cash rather than accounting profits. Therefore, the two figures can differ substantially due to non-cash components when accounting for its net income. Examples include depreciation and loss or gain due to asset revaluation.
Distribution Per Unit Yield (DPU Yield) = Annualized DPU / Unit Price x 100%
The annualized DPU is the sum of all the dividends declared for the financial year. DPU yield tells investors how much return on investment are they getting based on the share price they have bought. For instance, if the DPU yield is 6%, and you have invested $10,000 worth of units, you will expect a yearly dividends payout equivalent to $600.
As much as DPU yield is a convenient number to compare, it should not be the only assessing factor. A high DPU may not necessarily translate to a good investment. It could mean a higher risk associated with the particular Trust. Or perhaps, there’s a temporary short-sightedness in the market that presents an investment opportunity.
Net Asset Value (NAV) = Total Assets – Total Liabilities
NAV is also the same as the total equity of the Trust. It tells you how much cash will remain if all its assets are sold to pay off its liabilities. A high NAV means that the business is asset rich with low debt levels and high equity.
Net Asset Value Per Unit (NAVPU) = Net Asset Value / Total Number of Units
NAVPU is the net asset value for each of the units of the unitholders own.
Price-to-Book Ratio (PB Ratio) = Unit Price / Net Asset Value Per Unit
Generally, asset heavy business like a REIT will have their share prices vary within a range of NAVPU related to an asset class. The PB ratio allows investors to compare and value a particular Trust.
REITs in the defensive sectors, such as healthcare and suburban retail real estate, usually command a higher PB ratio. Comparatively, cyclical sectors like in the industrial and hospitality properties will have lower PB ratio.
If PB value drops due to some temporary market shortsightedness, it can present a good window period for investment.
Theoretically, if a REIT is trading at a PB ratio below one, it implies that the Trust is undervalued. It’s better off to sell off all its assets to pay all its liabilities and return the difference to the unitholders. However, you will observe that great assets, especially defensive ones, tend to have a PB value above one. On the other hand, REITs with poorer properties portfolio can have their PB ratio hovering consistently below one.
Moreover, the unit price of a REIT is dictated by how the market perceive its future earnings. There could be adverse news or short-term fear on the prospects of the Trust leading to a discounted valuation. Investors can use the past PB ratio to compare with the current trading price in order to value the Trust.
Gearing Ratio = Total Debt / Total Assets Value x 100%
The ratio tells you how much debt, hence leverage, is used relative to the REIT’s assets. MAS impose a gearing limit at 50% to prevent REITs from overleveraging. Therefore, REITs with gearing ratio close to the 50% ceiling may imply lesser headroom for the Trust to increase borrowing to fund future growth.
However, that doesn’t mean that the REIT is unable to acquire new properties. Adding new properties will translate to higher asset value. Hence, Trusts can use debt to acquire new property so long as it does not exceed 50% of its value. But that will imply that the Trust has to have sufficient cash for the remaining payment. Otherwise, funds can be raised through equity financing, such as rights issues or new share placements.
Interest Coverage Ratio (Interest Cover) = Net Property Income / Interest Expense
This financial measure tells investors how easily a REIT service can its interest payment on outstanding debt. The higher the interest cover, the higher margin of safety for the trust to service its interest and debt repayment.
Typically, higher gearing will result in higher interest expense, and therefore leading to lower interest cover. However, branded REITs’ managers may be able negotiate for lower interest rates. This is because they tend to have better credit rating and management. The result is a higher interest cover.
Investors should strive to invest in REITs with an interest cover of at least 5 and monitor to ensure that there is no deterioration in its interest cover of their holdings. In the event that interest cover falls below 3, one should consider re-evaluating the REIT. And Perhaps even consider selling some holdings to manage risk.
10. Weighted Average Lease Expiry (WALE)
The weighted average lease expiry (WALE), while not a financial measurement, is an important metric to measure a REIT’s portfolio risk of facing vacancy and loss in rental income.
WALE measures tenants’ remaining lease in years and is typically weighted with tenants’ occupied area or respective rental incomes relative to the total income provide by all tenants.
- Tenant A: Occupies 20% of rentable area; Lease expires in 3 years.
- Tenant B: Occupies 30% of rentable area; Lease expires in 1 years.
- Tenant C: Occupies 50% of rentable area; Lease expires in 5 years.
WALE = (0.2 x 3) + (0.3 x 1) + (0.5 x 5) = 3.4 years
The lower the WALE, the higher the tenancy risk in the near term. Any recession expected in the soon can affect the rental income of the REIT adversely. Therefore, as investors, we want to see a well distributed lease expiry profile as well. This ensures that downturn occurring in any particular year will not have devastating effect on the REIT’s financials.
Summary: How To Invest In REITs
There you have the 10 key financial metrics to help you know how to invest in REITs. While there are other factors to consider when evaluating individual Trusts, these will help you get started with assessing the financial statements and annual reports of publicly listed REITs. So, start researching and find some good REITs to invest.
Keep learning and happy investing!
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