What can go wrong with Reits?

In Property on 25/11/2010 at 5:19 am

Reits’ attraction are dividend yields of 5 — 9% when compared with the paltry 0.125% offered on bank deposits.

So what can go wrong? Plenty as a recent ST article reminds (extracts below). My value-add to the extracts is to suggest that one should add a margin of safety by buying those Reits that trade at a substantial discount to their lasted reported NAVs. This is not possible if one focuses on TLC/ GLC-related Reits, though there is an exception but there are reasons for the exception.  BTW, this might be useful when thinking of investing in Reits.

… the best way to enhance returns is to resort to bank borrowings to finance their property purchases. That is why they look their best in a low-interest rate environment.

To give an example, let us suppose a

Reit raises $500,000 from investors and borrows another $500,000 to buy a $1 million property which gives an annual rental income of $40,000.

If the bank charges 1 per cent interest on the loan, this will give the Reit an income of $35,000, after deducting the $5,000 in interest payment.

This works out to a 7 per cent return on the $500,000 put up by investors, even though the rental yield is only 4 per cent.

… If interest rates rise sharply – as they did during the global financial crisis two years ago – investors may suffer a plunge in dividend payout, as the increased debt servicing costs eat into the rental income.

Using the same example, if loan interest shoots up to 4 per cent, this will jack up the interest payment to $20,000, cut the Reit income to only $20,000 and almost halve the investors’ return to 4 per cent.

Still, this is not the biggest problem … In late 2008, the global credits market froze up completely after the collapse of investment bank Lehman Brothers, and the global financial system teetered on the edge of collapse as banks trimmed their credit lines to customers sharply.

As most Reits had resorted to short-term borrowings to finance their property purchases, some of them faced difficulties in refinancing their debts as the lending dried up almost completely … some banks were reluctant to accept the properties offered to them by the Reits as collateral, even though they were still producing healthy rental incomes.

Fortunately for the Reits, the frozen credits market thawed after a few months, as central banks across the globe flooded the financial system with trillions of dollars of fresh money.

Besides assessing the quality of properties in the Reit’s portfolio, an investor should also ascertain its sponsor’s financial health and willingness, as well as ability, to inject fresh money into the Reit if it is hit by a credit crunch.

One good example is CapitaLand. Early last year when things were at their bleakest, it stood fully behind its retail Reit, CapitaMall Trust, when it made a $1.23 billion cash call.

Three months later, CapitaLand also injected fresh funds into its commercial office Reit, CapitaCommercial Trust, when it made a $828 million cash call.

  1. I think Mr Goh may have gone overbought on the part about REITS resorting to short-term loans…

    As per my understanding, banks typically do not give out short-term loans on property unless they are for bridging purposes…and these loans cost quite a bit more

    Not sure if he looked at total loan amount…

    If the total amount did not change, then there is a plausible explanation is that what was a term loan has been reclassified from long-term liabilities into short-term due to its impending maturity…

    • Possibly, but what could have happened is that Reits taking out bridging loans could have had problems finding longer-term loans either because the assets became worth less or lenders became choosier when lending longer term.

  2. Not true – industry insiders know that the banks are running out of “good” candidates to lend money to…hahah

    And REITs – along with property developers – are typically considered as “good” candidates because they have assets as back up 🙂

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