Sunday, 1 September 2013

REITs Are Not Forever Attractive

REITs have been an attractive asset class since their introduction in Singapore in July 2002. They provide regular distributions with opportunities for capital gains. However, unlike shares, REITs are not exactly forever. The main reason is because the assets that REITs hold are mostly leasehold properties with expiry dates. When the leaseholds expire, they will lose the properties and will no longer be able to lease them out for rental income. Of course, REITs can always renew the leaseholds and/or buy new properties to rejuvenate their asset portfolios, but that will mean going back to the shareholders for money. Let us consider the case of a single-property REIT.

The assumptions adopted in this example are as follow:

Leasehold period 100 years
Purchase price  $100M
Equity  $50M
Debt  $50M
Rental yield 6.5%
Interest rate 3.0%
Discount rate 5.0%
Distribution rate 90.0%

Based on the above assumptions, the property will generate annual rental income of $6.5M, incur interest costs of $1.5M in the initial year and generate distributable income of $5.0M. As the REIT will distribute 90% of its distributable income, it will return shareholders with $4.5M in distributions. As for the remaining $0.5M, let's assume that it will be used to reduce the debt, thereby reducing future interest costs and increasing distributions to shareholders.

Based on Discounted Cash Flow (DCF) valuation, the annual distribution stream of $4.5M (gradually increasing to $6.5M as the debt is being paid off) for 100 years will be worth around $95M. The DCF valuation hovers above this initial value for the next 65 years. However, as the property nears its 100-year leasehold expiry, the DCF valuation will drop rapidly. See the figure below.

Figure 1: Valuation of Single-Property REIT over Time

To continue to operate beyond the 100-year leasehold of the property, the REIT will have to raise capital to renew the leasehold or buy a new property. It could do this in 2 ways: conserve cash from the distributable income in subsequent years, or raise fresh capital from new or existing shareholders. The first method will lead to a drop in distribution to shareholders for a prolonged period of time (e.g. if it choose to conserve all of the distributable income of $6.5M, it will need at least 7.7 years to raise $50M in equity). This is not very palatable to investors.

The second method of raising fresh capital could maintain and even raise the distributions to shareholders in the short-term. However, it comes at a cost of dilution of shares and reduced distributions in the future. From the figure above, it can be seen that the closer to the end of the leasehold period of the existing properties, the less the existing shares are worth and the more new shares need to be issued to raise the same amount of capital.

Now consider the case of a REIT that regularly adds a 100-year leasehold property to its portfolio every 20 years by raising fresh capital. For the first 20 years, it will have only 1 property. For Year 21 - 40, it will have 2 properties, so on and so forth. By the 80th year, it will have 5 properties. Beyond that, the no. of properties will remain constant at 5, as every new addition will only replenish another whose leasehold has expired.

Let's assume that the deal for every leasehold property remains the same, i.e. $100M purchase price, 50%-50% funding by equity and debt, 6.5% rental yield, 3% interest cost etc. The DCF valuation of the REIT over a 200-year period is shown below.

Figure 2: Valuation of Multiple-Property REIT over Time

Several observations can be made from the above figure:
  • The jump in DCF valuation from every additional property reduces over time. When the property portfolio is small, every additional property represents a large % increase in the portfolio size and distributable income. However, as subsequent properties are added, the increase becomes progressively smaller.
  • The DCF valuation increases for the first 5 properties and decreases thereafter. For the first 5 properties, there is increase in the portfolio size and distributable income, leading to increasing DCF valuation. Beyond the first 5 properties, there is no net increase in the portfolio size and distributable income. At the same time, the no. of shares is increased from every capital raising exercise. Hence, the DCF valuation decreases thereafter.
  • At some point in time (200 years in this example), the DCF valuation will be below that at initiation and will continue to decrease.

Figure 3 below plots the no. of shares to be issued for each property acquisition. Due to the increasing DCF valuation for the first 5 properties, the no. of new shares to be issued decreases. Beyond the first 5 properties, the DCF valuation decreases, leading to increased no. of shares issued. The key point to note is that although the leasehold properties can expire, the shares issued previously will never expire. So, over time, there will be a lot of shares outstanding.

Figure 3: No. of Shares Issued for Every Additional Property

In conclusion, REITs may have been an attractive asset class to-date. However, it is important to note that the assets that REITs have are mostly leaseholds with expiry dates. As REITs rejuvenate their property portfolios to replace leaseholds that expire, it often means dilution and reduced distribution for shareholders. REITs are not forever attractive.

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  1. i don't like REIT... they r sux.... =_="

  2. Hi Chin Wai,

    I aim to grow my dividends to cover my expenditure one day but even so, I am pretty cautious of investing into REITs.

    As an asset class, their returns should logically not exceed that of more traditional businesses providing goods and services. Otherwise, any business with sufficient capital will give up and become a property owner instead. No?

    1. Hi 15 HWW,

      Yes, barriers to entry for property holding are fairly low. Every company could be a property owner, so that will assure only normal economic profits for that industry.