Reits look good, for now

Nov 15, 2010
CAI JIN

By Goh Eng Yeow, Senior Correspondent

IT IS a time of plenty again for Singapore real estate investment trusts (Reits), as rentals soar and loan servicing costs drop precipitously.

In the past month, Reits have begun to make a big comeback on the local initial pubic offering (IPO) scene.

Mapletree Industrial Trust - a Temasek Holdings-linked Reit which owns factories, business parks and industrial buildings mostly in Singapore - recently raised $1.19 billion.

Another, Sabana Shari'ah Compliant Industrial Reit - backed by locally listed Freight Link Express Holdings - is hoping to muster up to $700 million, if it successfully launches its offering.

And those two may just be teasers. DBS Bank - a market leader in helping Reits with listings and other forms of fund raising - expects a lot more such IPOs here in the coming months.

Its head for asset-backed structured products, Mrs Eng-Kwok Seat Moey, said recently that a number of sponsors had long been keen to launch Reits, but conditions in the past two years were simply not right.

Still, despite the palpable market buzz around Reits, many investors are still ignorant of what they are getting into.

The big draw are the headline-grabbing projected dividend yields of 7 per cent to 8 per cent offered by these Reits. That looks highly tempting when compared with the paltry 0.125 per cent interest typically offered on bank deposits.

But it is instructive to understand what Reits are all about and the potential pitfalls that may arise when times are not quite so rosy.

Reits are 'closed end' funds, which operate in a similar manner to unit trusts. But unlike unit trusts, which raise funds to invest in shares, Reits specialise in income-generating real estate assets, such as shopping malls, offices, industrial buildings, warehouses or hospitals.

Funds raised in a Reit IPO are used to buy a pool of properties which are then leased out to produce rental income - later distributed to investors as dividends or distributions.

A Reit will also appoint a manager - usually its sponsor or major shareholder - to manage its properties.

For the sponsor, the big attraction is the management fee which is paid to it as the Reit manager.

As this fee is charged against any income earned by the Reit, it may be in an investor's interest to find out how it is structured. This is because a hefty management fee may eat into any profit produced by the Reit and result in a lower dividend payout.

For 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.

But here is the rub: 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 which could confront a Reit if another financial crisis were to erupt.

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.

As the global credit crunch hit Singapore, 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.

But one lesson that should be learnt is not to assume that the eye-catching high yields offered by Reits come risk-free.

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.

CapitaLand's move sent an unmistakable message to bankers and investors of the strong backing it was giving to the two Reits.

Looking ahead, as more Reit IPOs look set to come onto the market, investors should ask if other sponsors can offer a similar level of commitment to their Reits - or if their overriding objective is to earn that mouth-watering fee that comes from managing the properties in the Reit when times are good.

Once the champagne is popped and the headline-grabbing dividend yield is forgotten, these are the tough issues which a hard-headed investor must take into consideration before he puts his hard-earned money into a Reit.

engyeow@sph.com.sg