How to Evaluate a REIT

Although REITs have become popular due to their high distribution yield, we can see that there is a gradual shift towards high-quality REITs with sustainable yields, especially after COVID-19.

Hence, it is no different than investing in stock – investors now need to identify REITs with good business traits and are trading at a good value.

Therefore, in this article, we will be highlighting how to evaluate a REIT based on a set of common factors.

1. Industry Type

COVID-19 has demonstrated how the REIT industry type matters more than before.

While the hospitality and office properties usually belong to the group which offers relatively higher yields, it is no longer the case now with travelling ground to a halt and more people shifting towards remote working/working from home now.

On the other hand, industrial and retail REITs seem to be more resilient judging by how trade activities and shopping continue to stay robust.

Hence, investors should now pay attention to the sector(s) and which countries REITs play in to evaluate the growth prospects and risks going forward.

2. Management’s Track Record

Another point to consider when investing in REITs is to aim for sustainable growth in both distributions per share (DPU) and Net Asset Value (NAV) of the REIT. This is because the former provides stable yield and the latter will offer increased capital appreciation.

And this is where a strong management team comes into play. For example, a good REIT manager can create value for unitholders by sprucing up their older assets in order to improve tenant quality and/or increasing the plot ratio through asset enhancement initiatives (AEI).

In addition, a well-managed REIT would engage in proactive capital recycling - divesting mature assets for gains and reinvest back by acquiring new accretive assets.

3. Leverage Ratio

First and foremost, investors need to understand that REITs are leveraged investments that take on a manageable level of debt to buy properties and generate rental yields to shareholders.

However, debt is a double-edged sword that cuts both ways. If a specific REIT lies too close to the MAS’ current stipulated gearing ratio of 50%, the REIT may not have the headroom to borrow for accretive acquisitions and may have to issue rights to shore up capital.

Lastly, the higher a REIT’s gearing ratio, the more susceptible and sensitive to interest rate events and global macroeconomic conditions too.

4. Capitalization (cap) rate

For those who may not have heard of the capitalization rate, it is a measure of the rate of return that is expected to be generated on a real estate property.

The cap rate is useful when analyzing an individual property or to get a better grasp on an entire investment market by taking the average of multiple properties.

Its formula is shown as per below:

Capitalization Rate = Net Operating Income ÷ Property Value

Imagine that the REIT buys a property for $100 million and it generates net operating income (NOI) of $7 million. It will mean that the property is acquired for a 7% cap rate.

In general, a high cap rate above 6% is desirable but it can also change as long as the REIT manager has plans to boost the NOI in future.

5. Weighted Average Lease Expiry (WALE)

The WALE is one of the main metrics used to assess the health of a REIT by measuring the average time to expiry of existing leases of properties in a REIT.

For example, if a REIT’s WALE is 5.3, this means current leases have an average of 5.3 years before the end of the contract.

By and large, a longer WALE provides assurance to investors during an economic downturn as the tenants are locked into their tenancy agreements for a longer time. However, on the flip side, these REITs will not be able to negotiate for higher rents when the economy improves as well.

Hence, a well-staggered lease expiry profile will minimise the number of leases that are slated to expire in any given year, thereby reducing vacancy risks.

6. Credible Sponsor Backing

According to REITAS, a REIT sponsor usually provide the properties that are injected into the initial portfolio of the S-REIT around the time of its initial public offering (IPO).

The sponsor also typically own significant stakes in the REIT and may continue to provide a pipeline of assets to the REIT post-IPO.

There are plenty of benefits a REIT can enjoy from a credible sponsor:

• A sponsor is able to manage a pipeline of projects and regularly inject valuable properties into the REIT’s portfolio

• The REIT also usually has the right-of-first-refusal (ROFR) of the Sponsor’s properties. This means that the sponsor will offer properties to the REIT first before offering it to any third-party companies.

• Typically lower interest rates on bank loans due to the backing of a strong sponsor

• In the event of an economic downturn, a strong sponsor is able to help support the REIT through the tide

Long story short, a financially strong and reputable sponsor is able to provide immense support to the REIT’s future growth.

Conclusion

While the above list is not exhaustive, these 6 factors present a good starting point for investors when evaluating which REITs to invest in.

One can also look at how the REIT can blend into part of your investment portfolio by assessing your own risk appetite, investment time horizon and asset mix in your portfolio.

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