Investing in Real Estate: Real Estate Investment Trusts

Grab a drink, this is a long posting.
 
I left out my posting on Ajinomoto in favour for REITs as I am looking for opportunities in another vehicle of investment a.k.a diversification, and this time by exposing myself to real estate properties. Apologies to those who looked forward to Consumer stocks, I will continue to post them when I have the time. Why not buy and sell property instead of REITs? Because REITs suit me, me only la with some pointers as below:

• Direct buy/sell requires large liquidity; cash in hand. I do not have that privilege, I am talking bout RM40,000 to RM100,000 depending on which property. And I will never borrow to do investment.
• Chasing for tenants can be tiring and chumbersome, this is handled by the trust managers of REITs. No headaches on seeking right tenants or collecting rentals, no running around.
• There is bigger risk in direct buy/sell as there are more stakes involved such as big capital spending & time spent.
• REITs do not suffer from upfront charges like unit trusts. You can buy and sell REITs from Bursa Malaysia just like any other typical stocks. Thus, what you need to do is sell your units when unit price is higher than NAV, or just sit back and wait for dividend cheque which happens every quarter.

What is a Real Estate Investment Trust?
REIT is a company that owns and operates income-producing real estate which covers commercial real estate sector. REIT can also lend money directly or indirectly to other companies to finance acquisition of real estate properties. REIT gives an average investor the opportunity to invest in commercial estate by purchasing a stake in a portfolio that they would not otherwise be able to purchase on their own. These companies are then able to finance their operations by raising money from your money through sales of common stocks.

There are established guidelines in Malaysia for a company to qualify itself as a REIT. This comes from SC (Securities Commission Malaysia) which I find difficult to get the latest one, all Malaysian website sux btw. Some of the info here might not be correct (I will update it once I get the data). This is after all an ongoing research which I just started a week ago, "Kelian" me ma.

• Allow up to 70% foreign shareholding in REIT companies. Still need the 30% for Bumiputera quota, burdens man.
• REIT not allowed to acquire non-income generating real estates like vacant land or under construction real estates more than 10% of total asset value.
• NO explicit requirement of minimum payout ratio in guidelines BUT...
• Tax exemption at REIT level provided that 90% if its income is distributed as dividend to shareholders.

Analyzing REITs: Qualitative Factors
Stability
REITs are generally viewed as more stable than other investment types besides bonds and fixed deposit because of the dividend requirement if SPECIFIED. A high payout ratio means more cash back in the hands of the stockholders on a regular basis, therefore stabilizing returns. It is also more stable due to the underlying real estate operations. Properties are hard, tangible (can touch and hold ahhh..) assets that do not fluctuate in value as quickly as other assets. Contracts in commercial real estate industry also tend to be long term in nature (I.E. leases 5 years or more by tenants).


Timing
Because the nature of being illiquid when we deal with hard assets, there should be a lag between a REIT performance and with the rest of the economy since tenants are locked into their rents until their leases expires. There's a writeup by BizTheStar on how REITs behave in relation to our KLCI here.


Operations
Investment Strategy. What does this REIT do? Determine the specialization of the REIT. Examples: YTL-REIT is focused predominantly on the retail trade via investment into Starhill and Lot 10 shopping complex. UOA and Tower REIT have their attention on office space. KPJ Healthcare REIT on investments in hospital buildings.

Portfolio Composition. Once a strategy has been identified we must look at its current portfolio health.

1. Size: Number of buildings and number of sq feet. The larger the more diverse but more complex in terms of managing the portfolio and driving growth.
2. Geographic distribution: Focus on certain markets so their relative strengths and weaknesses of its strategy must be assessed.
3. Quality distribution: Does it hold high-quality class A/premium properties or cheap one? Holding cheap ones and redevelop them into higher quality assets can be a possible strategy for the REIT so take note.
4. State-of-service: The breakdown of buildings that exists and in-service (being currently utilized by tenants) vs those that are still under construction or in development stage (for further growth).

Other Business Lines. Does it have other sources of revenue instead of rents and mortgage interest? Such as consultation work or third-party property management services.


Operating Metrics. To assess performance of portfolio & potential for growth or decline.

1. Occupancy/vacancy & trend in occupancy/vacancy over the years: A good rate will be 90% or above though vacancy provides the opportunity to increase operating income by renting the space to tenants.
2. In-place rents vs market rents: This piece of info might be difficult to get and the answer for this metric might be ambiguous. If in-place rents are much lower than market rate then higher income can be achieved by charging higher rents to future tenants.
3. Lease expiration schedule a.k.a rollover schedule: It is important to know how committed these tenants are when leasing the properties. Potential upsides of increasing rents can be obtained when a given lease expires at the right time such as when the economy and consumer sentiment is doing very well.
4. Leasing activity: As measured by number of leases signed, number of sq feet leased and average rental rates achieved. Again this might be hard to obtained.
5. Tenant financial strength and diversification: Which is the ability of a REIT's tenants to pay their financial obligations (I.E. mortgages, rents). Can get this easily via revenue contributions from top 10 tenants in the REIT company report.

Pipeline. Talking about the future of the portfolio. Reference to acquisitions, dispositions and new development that the REIT is expected to undertake for the future.

1. Development: Number of developments, total sq feet, the location, project costs and timing of launch.
2. Acquisitions & Dispositions: Absolute price in terms of price per sq feet and important to consider that in relation to comparable sales. Also the timing and size of the buy and sell of properties.

Growth strategy. Seek to understand how the company derives it earnings through growth. It is via acquisitions or developments? By raising rents? Upgrading the tenant base? Get to know the likelihood of success and failure is critical to unlock the hidden gems.


Most of the information above needed to analyze REIT can be found by reading through the company's report & dissecting them. First, you need to answer yourself on what kind of investment you are looking for (investment strategy of the REIT), what is your financial goal & the risks you are willing to take. Once answered, we then only look at the fundamentals of the company via operational performance; where the most of the fun & learning begins.

A little bit more advanced research starts here as we are dealing with financial ratios so I will try to slot in simple illustrations to make it easy for people to understand.
Analyzing REITs: Quantitative Factors
Funds from Operations
FFO is a key measure of bottom line financial performance of REIT excluding gains or losses from sales or property and depreciation of assets. We exclude those because we are looking to capture recurring performance. Real estate is different than other investments as property rarely loses value and often appreciates unless we go to war with Singapore or Indonesia and surrender.

1. FFO per Share (net income/number of share outstanding): just like EPS measure for other stocks, a measure of how much earnings you get per share that you own per one financial year usually.
2. FFO Yield (FFO per Share/REIT stock price): much like ROE, the per ringgit return of investment. A measure of if you pay RM1, how much you get in % returns for the next financial year. If 10%, you get RM1.10.
3. Price-FFO Multiple (inverse of FFO Yield calculation): similar to P/E ratio for normal stocks. It is used to tell how many years it will take to recoup your initial investment capital back 100%. Say Price-FFO is 6, it means you will take 6 years to get back exactly RM1 on top of your initial RM1 investment. In other words, takes you 6 years to double your investment.
4. AFFO (FFO minus recurring capital costs). I personally will use this for cash flow evaluation for a number of reasons:

• More precise measure of leftover cash as it deducts out capital expenditures needed to maintain existing portfolio of properties. You need money to maintain your house too from time2time, exactly the same picture here.
• Because it is more precise, it is a better predictor of REIT's future capacity and capability to pay dividends.
• The final financial ratio that is used for price evaluation of the REIT and also I will use it to look for growth.

Dividends
The dividend payout for a REIT must be high, higher than bonds or FD rate to make it as an appeal to investors. Does this mean REIT has higher risks? Not quite true in Malaysia as our properties remain relatively undervalued in comparison to other Asean regions, thus still room for growth.

1. Dividend per Share (dividends paid/number of shares outstanding): though past performance does not guarantee future returns, a consistent and growing dividend is always a good sign, ilham!
2. Dividend Yield (Dividend per Share/REIT stock price): div yield for REITs are generally higher than other stocks or bonds fyi. 6%-8% or 10% as an optimistic yield rate (excludes capital appreciation).
3. Payout Ratio (FFO per share/Dividend per share): a measure of how much earnings are distributed to shareholders. I.E. Sunway REIT has promised 100% for the first two years 2011-2012 and 90% for subsequent years.

Operating Leverage
An important notion to consider. This refers to the breakdown of variable expenses (costs that can be adjusted based on sales volume) and fixed expenses (costs that can't be adjusted in short-term). Let me give an example, a REIT company has to pay all its real estate taxes/mortgages/maintenance (fixed) even if it is not fully occupied, say 40% occupied. This means high fixed expenses, hence said to have high operating leverage. Revenue can be lost due to vacancy which is difficult to offset by cutting expenses since fixed costs are relatively high and hard to adjust. Vacancy rates have to be very closely watched if you are involved in real estate investment. A good measure that I could think of is using ROA (return on assets=net income/total assets), a measure of how much profit a company earns for every dollar of its assets which include cash in hand, accounts receivable, property, equipment, inventory and furniture.

Capitalization Rate
Another measure of yield on investment using the formula (AFFO/asset value). A high cap rate implies that buyers are demanding high yield on their investment, thus there is good investor sentiment. This is an important gauge to know the interest of the overall market towards a particular REIT or its investment strategy (investors buy the idea). You can compare this ratio to a REIT's FFO yield which should roughly be the same, if not further check is required to find the smoking gun (accounting tricks?).

Net Asset Value
Commonly known as NAV which is the theoretical value that would be received if all of a REIT's real estate assets were sold now at market price minus away all liabilities (debts and etc). So NAV per share is practically (total assets-total liabilities)/number of shares outstanding. Once evaluated a REIT's NAV can be compared to the current stock price as a valuation metric. Example needed I know :)

• NAV per share is RM10, stock price is RM12. This would mean a premium of 20% over NAV (RM12/RM10 - 1 = 0.2 or 20%). Measure of the degree of optimism about future growth of the REIT that has been incorporated into the stock price. So what you need to do is evaluate this optimism via qualitative & quantitative factors to answer "Does it makes sense or it is overvalued to buy now?"
• NAV per share is RM10, stock price is RM6. This would mean a discount to its NAV of 40%. It could mean two things, one a hidden gem OR worse investors thinking, questioning and sitting on the fence about the potential of the REIT. Again, evaluation of this pessimism via qualitative & quantitative factors to answer "Should I buy this opportunity or this opportunity does not look like it's going to fly?"

Leverage
One of the really most critical aspect of REIT is its leverage structure. What are the various financing methods they use to carry out their operations. Leverage means using resources in which others have in exchange for what you can give back. In REITs, they use other people's money in exchange for their expertise in managing properties and give 90% of the returns back. To answer this evaluation we need to ask a few simple questions:

1. How much leverage does the REIT uses? (total debt/total market capitalization) to indicate amount of borrowings outstanding.
2. How comfortably can the REIT afford its debt payment? EBITDA/(interest expense + dividend) a measure of breathing space it has when it comes to servicing its debt payments.
3. What is the REIT's liquidity position? careful alignment of cash flow via schedule of debt maturities. It is imperative to know how the REIT funds those debts. It could be:
• short-term using cash in hand, revolving credit facility like our credit cards; spend now pay later concept.
• long-term via sales of its assets, new equity value from public may be issued.

Indices
Pretty simple. A good way to know if your REIT is performing better than average is to compare it against specialized indices for benchmark. This is more of an informative scorecard than comparing it to a normal main board which has many hundreds of companies that are not related to real estate at all. BUT too bad, our Malaysian market does not have such index for REITs as this investment vehicle is still at its infant stages which just started in 2005. What to do? No choice la, compare against its peers then. I will use the Div Yield as a first cut comparison.

In a Nutshell
There you go, a comprehensive overview of how I would be analyzing and contemplating a REIT company, the same applies to how I checkout other types of stocks, just to give you a feel of it. There are 12 listed MREITs (Malaysian REITs) in our stock market now and soon to be 13 with Sunway (the largest in market cap) joining the boat in early July 2010. Risk level in investing in REITs would be from low to medium range. (low-FD, high-equities)

• Yes, I will be taking some time to drill each and every one of these companies. Be patient I will post them in time. Zui kelian me la.
• Yes, it may seem hard to understand all those crap I just mentioned above if not everyone would be wealthy. Learn and be rewarded.
• Yes, earning $$ from investment is way more rewarding than getting my paycheck because it is not hard work but smart work. No sweat needed.
• Yes, we can do it together just email me your interest at nick_allianz@hotmail.com.

When aboi becomes ah man perhaps then I would venture into direct buy/sell for the fun of it. For now MREIT would be a good choice as alternative asset class for investment in real estate. Remember it is never wise to borrow money to invest which is the same as when you spend using your credit card.