Dissecting REITs

One of the dreams of many Filipinos is to have their very own house and lot. Aside from being a good store of wealth for future generations (“pamana”), real estate has always been a huge source of wealth creation due to value appreciation.

To a large extent, real estate ownership is one of the big reasons why the “rich keep getting richer.” As billionaire industrialist Andrew Carnegie once said: “Ninety percent of all millionaires became so through owning real estate. More money has been made in real estate than in all industrial investments combined.”

But what if I tell you that there is now an opportunity to not just own your dream house, but also a piece of your favorite mall, a posh five-star hotel or a prime office building in BGC? Surely, you will think I am crazy as these properties will cost an unfathomable amount, making them completely out of reach for most investors.

Democratizing wealth

Real estate investment trust or REITs directly address that obstacle, democratizing real estate ownership for every Juan. For a few thousand pesos, an investor can own a portion of not just one but a portfolio of prime properties, while sparing them the enormous time and effort required to manage and maintain these properties.

Investors can easily purchase and sell REITs, similar to how one would buy shares of publicly listed companies on the Philippine Stock Exchange. What differentiates a REIT from other listed companies are the assets it holds.

A REIT must dedicate itself to only owning and operating real estate properties that generate recurring income, thus promising to deliver consistent returns to its shareholders.

A REIT offers investors an investment alternative that falls between a fixed-income instrument (like bonds and time deposits) and common stocks. Like fixed income, REIT investors could generally expect a steady dividend stream because REITS are required by law to declare dividends to its investors. These dividends are often significantly better than what investors can earn on time deposit rates.

In addition, REIT investors also get to benefit from the long term appreciation of its underlying real estate assets, often translating into an increase in the share price of the REIT. Of course, this share price could go up and down depending on many market factors that are both within and outside the control of the REIT.

Sounds too good to be true?

However, unlike a fixed income instrument wherein an investor’s returns are generally guaranteed, the REIT does not guarantee a fixed return to its investors in the sense that its obligation to declare dividends is subject to the availability of unrestricted retained earnings.

This would generally depend on the actual performance of the underlying real estate assets—the rental rates, occupancy rates, operating costs, etc. But if the REIT performs well, it is required to declare at least 90 percent of its distributable income as dividends to its investors. This feature distinguishes a REIT from other publicly listed companies.

It is very important that investors properly scrutinize the REIT they are investing in to differentiate the good from the not so good.

Beyond the upfront dividend yield the REIT is offering, REIT investors should also consider several factors which would affect the long term stability of the dividend yield, the appreciation potential of the underlying assets and the future share price performance potential of the REIT. So what should investors consider when investing in a REIT?

Location, location, location

In buying or investing in real estate, the #1, #2 and #3 rules are always location, location, location.

Not all locations are created equal. Since the rise of cities in ancient times, human beings have always gravitated towards strategic locations.

For this reason, great locations have consistently outperformed mediocre ones. Attractively located real estate assets have historically performed better during good times, and have been more resilient during bad times. Strategically located real estate with good support infrastructure—access to transportation network, close proximity to key amenities, less prone to flooding and disaster and good safety and security—will attract the best people. And the best people will attract the best people in a continuous positive feedback loop.

In the Philippines, the lack of strong central planning and the limited public infrastructure investment have made private sector masterplanned developments popular. You simply need to ask yourself, “Where do people want to go to live, work or play?” From a location perspective, you go where you think people want to go. Simple as that.

Sponsor

The sponsor of a REIT serves three critical roles.

First, as a business partner. The sponsor will continue to participate as a major shareholder and the operator of the REIT post-listing. You want to do business with a sponsor you can trust.

Second, as your employee. The sponsor will most likely assign the fund manager and property manager for the REIT. These are the parties responsible for managing the portfolio of real estate assets on the investor’s behalf in exchange for a fee. They will maintain the property, find tenants, buy and sell real estate assets to optimize the portfolio, and mail investors their dividend checks.

You want to work with a sponsor who is good in what it does. In addition, operating an office is very different from operating malls or hotels. Only work with the sponsors that are the best in those asset classes.

Third, as a source of growth pipeline. Aside from the dividends and the property value appreciation, a significant source of value creation in REITs is through the acquisition of additional assets.

One of the best REIT sponsors in Southeast Asia is a company in Singapore called Capitaland, which has successfully created significant value for its investors over the years through a combination of steady dividend stream, organic growth and value accretive acquisitions. You want a sponsor that has a significant supply of future projects it can potentially inject into the REIT either in terms of already completed projects or projects that are under development.

Quality of assets

This is, in a way, self-explanatory as you are buying into a portfolio of real estate assets, after all. In the same way that a well built house with premium furnishing will attract a premium over an average house, the same applies to the assets that go into a REIT.

Premium Grade A buildings, for example, are expected to attract premium tenants that tend to demonstrate loyalty and pay higher rents, compared to Grade B or other lower category developments. Eventually, a REIT with superior asset quality generates higher and more sustainable recurring income in the long-term.

Quality of tenants

As a property owner, you will naturally want to be choosy on who you want to rent your property to. You want a tenant who pays on time, will stay for the long term to ensure stability of income and will take care of your property.

Depending on your beliefs, you may not want to rent out your property to gaming operators even if they are willing to pay a higher rent. Similarly, it is important for investors to find REITs with high-quality tenants that check all the same boxes.

Tenants such as business process outsourcing (BPO) firms and multinational companies tend to have better credit quality and are expected to stay in a property longer. This reduces the uncertainty for investors, minimizes the element of surprise and provides stability in the returns. Therefore, paying a premium for properties where the tenant has demonstrated loyalty and has limited risk of leaving can be justified.

Helping offices attract higher quality BPO tenants is a Peza (Philippine Economic Zone Authority) accreditation. With Peza no longer giving any designations in Metro Manila, Peza-accredited office buildings will likely be in short supply and therefore attract better rent in the longer term.

REIT structure

The REIT structure is likewise important. A REIT that owns land gives you participation in the perpetual capital appreciation potential of the underlying land but will put some restrictions from a foreign ownership perspective.

If you buy a REIT that only owns the building but not the land, you will need to carefully scrutinize the land lease structure to make sure that the lease is sufficiently long and the REIT’s ability to at least get back the fair market value of its building assets, instead of the building just reverting for free to the owner of the land. In addition, an investor may only want to consider a REIT that owns all or substantially all of its property assets instead of just financial contracts which provide less security to the investor.

Fees

Another important but often overlooked factor to consider is the fee structure that the fund manager and property manager charge the REIT. While it is fair for them to charge the REIT a fair fee for value and services they provide the REIT, some fund managers and property managers may charge significantly more fees than others.

Investors should also be on the look out for hidden fees and charges such as acquisition and divestment fees as these represent potential value leakages for investors. A smart investor always reads the fine print.

Final thoughts

REITs are certainly an exciting investment opportunity for every Juan de la Cruz to participate in the long term value creation in the economy. But like all investments, investing in REITs carry its own risks. That is why it is important for every investor to do their own homework and use the various tools and advisors at their disposal to properly evaluate and assess the risk and return potential before committing to any investments.

The author is the president of the Financial Executives Institute of the Philippines (Finex)