Tips on evaluating a Reit

The Business Times
Cai Haoxiang
24/2/2014

JUST as people are judged by what they wear and how they look, real estate investment trusts (Reits) are usually judged by their yields and net asset values (NAVs). This is an overly simplistic approach that can catch investors off-guard when a Reit turns out to be riskier than they thought, or when professional valuations of properties implied by the NAV change drastically when economic conditions and market sentiments turn.

Yield, or more precisely historical yields here, refer to the distributions per unit a Reit paid investors in the past year divided by its current share price. NAV refers to the most recent valuations of the Reit's assets minus its liabilities like debt. Investors tend to look at whether a Reit's share price is trading at a premium or discount to its NAV per unit to see if there is scope for price appreciation.

High yields do not mean a Reit is an attractive buy, however. Yields are related to risk and growth potential, as investor Bobby Jayaraman pointed out in his 2012 book on Reit investing, Building Wealth Through Reits. The safer the Reit and the higher its growth potential, the lower its yields will be. This is because high demand from investors for these assets pushes up their price, thus lowering yields.

At a price of around $1.90 per unit and 10.27 cents per unit paid out in 2013, CapitaMall Trust (CMT) is trading at a yield of just 5.4 per cent, meaning investors get paid $5.40 out of every $100 invested every year, assuming distributions stay constant.

This seems low now compared to other Reits. But it was even lower. Last May, before the Reit market took fright at the withdrawal of monetary stimulus by the US, CMT was trading at a historical yield of just over 4 per cent. The market was happy to pay 4 per cent not only because CMT is seen as stable but also because CMT had shown a repeated ability to increase distributions year after year. CMT's 10-year return is about 10 per cent a year if dividends are reinvested, according to Bloomberg.

Think of a Reit's yield as the inverse of the price to earnings (PE) multiple that investors are willing to pay for companies: investors are happy to pay 50, 70, even 100 times historical earnings for a fast-growing company if its profits can double each year for the next few years.

More growth potential

Similarly, with low interest rates and risk-free 10-year Singapore bonds trading at yields of 2.5 per cent, investors are happy to get what extra yield they can by buying a steadily growing Reit at yields of 5, 4.5 or even 4 per cent.

Thus, low yields can reflect a Reit with more growth potential than its peers. A Reit can also trade at low yields also because it is seen as less risky, and thus less vulnerable to price fluctuations. Since tapering fears began last May, CMT prices have fallen about 20 per cent from their pre-taper fear highs. By contrast, Lippo Malls Indonesia Retail Trust, another Reit with shopping malls but based in Indonesia, had seen its price fall over 30 per cent. Its 2013 distributions were 3.25 cents, giving a yield of over 8 per cent now.

Why is the market now willing to pay 5-plus per cent for one Reit and 8 per cent for another? Both have shopping mall assets, which are theoretically more resilient to economic downturns than hotels or commercial properties.

But Lippo Malls is perceived to be riskier than CMT as Indonesia has faced capital outflows in the past year, and its currency had depreciated by some 20 per cent against the Singapore dollar. This translates into lower income for Singapore investors. Currency risk is hedged, but this incurs additional costs. Lippo Malls' debt is also denominated in Singapore dollars, and it has to hedge its income flows to ensure its Indonesian income can be converted back to the more expensive Singapore dollar.

Lippo Malls also borrows at a higher cost compared to CMT. It is borrowing at interest rates of 4-6 per cent. Last November, it placed out close to 250 million new units to investors, raising $100 million to strengthen its balance sheet and refinance debts. Raising equity is costly and dilutes the stake of existing shareholders. By contrast, CMT recently borrowed $350 million from investors at a cost of just over 3 per cent.

Annual fluctuations

Higher yields thus do not necessarily make Lippo a more attractive buy, just as lower yields do not make CMT a bad buy.

Lippo is also trading at a discount to its NAV, while CMT is trading at a premium. The argument for buying a Reit that is trading at a discount to its NAV is that over the long run, Reits generally trade at the value of their assets. This makes intuitive sense, because in a situation of stable economic growth, a Reit should be able to sell its properties at just about what they are valued at.

But keep in mind that NAVs fluctuate every year as Reit properties are revalued. Since Reits do not buy and sell properties every other day, Reits with particular characteristics can also trade at a permanent premium or discount to their NAVs, just as consumer and healthcare stocks generally trade at higher PEs than, for example, manufacturing stocks.

On what basis are properties valued? Let us take a look at the notes to the 2013 financial statements of AIMS AMP Capital Industrial Reit. "The valuations of the investment properties were based on capitalisation approach, discounted cash flow (DCF) analysis and direct comparison methods," it said. In both the capitalisation approach and the DCF approach, income is divided by the cap rate or the discount rate to come up with a value. But the final value is very sensitive to what rates are used. The rates used depend on what kind of growth and risks valuers ascribe to the properties.

As for direct comparison methods, when property is compared to recent equivalent transactions, value tends to be overstated during good times.

Valuation is not an exact science. Looking at yields and NAVs is a start. But what makes a good Reit investment goes beyond these two superficial measures. It takes time to know a person well enough to make an assessment of his or her character. Investors should thus also observe the actions taken by a Reit over a period of time before deciding whether it is a good investment at its current yield and NAV.