REITs: Professional Insights on Investment Metrics and Valuation

Analysing and valuing REITs can be tricky. This episode, we'll discuss some ratios to look at. Industry veterans help us understand their assessment criteria. So if I was a retail investor focused on safeguarding my nest egg without a whole amount of time to scrutinise individual stocks, I would really be thinking about how to protect my downside when it comes to investing in REITs. So I would advise going for quality companies at a reasonable price. How do we define quality? I think the first thing would obviously be the balance sheet. It relates to really whether the REITs dividend is adequately covered by its operating earnings. What that means is, is the REIT generating enough cash flow from its underlying business stream after paying off interest costs to give you the dividend that you are receiving. Or is it actually borrowing from banks to pay you the dividend? If it is borrowing from banks to pay you the dividend, then whatever it is paying you is not sustainable and may fall off at one point in time. The starting point of a REIT valuation is its balance sheet. And if you look at the balance sheet, the largest line will be the property assets. It is important at the same time not to neglect the debt commitments. So one metric used to analyse REITs is NAV. NAV is defined as net asset value. It is defined as the total value of the properties owned by the REITs minus its liabilities. If the reported asset values are reliable, NAV provides a very good snapshot of the intrinsic value of a REIT's asset holding. In particular, in Singapore, as REITs' asset values are carried at fair value, which is determined by independent and professional valuers at least annually. Secondly, we have the price to NAV. So REITs derive their income from a portfolio of assets that they own. In other words, they are asset-backed investments. A common metric used to evaluate REITs is the price to NAV, which is calculated as the share price divided by the net asset value per share. Price to NAV ratio above 1 indicates that the market values the REITs at a premium, while a price to NAV discount below 1 would suggest that the stock is priced at a discount. REIT stocks that are traded at a discount are often seen as offering more value to investors than those that are priced at a premium. And depending on the stage of the property cycle and asset characteristics of the sub-cycle, a REIT may trade below or above its NAV. For example, the industrial sub-sector, which comprises of new economy assets such as warehouses, data centres and high-tech buildings, usually trades above the price to NAV. These assets cater to industries benefiting from the secular tailwinds of the digital economy and are perceived to be future-ready. So demand for space in these assets are expected to grow on the back of technological developments, as more companies execute their respective digital transformation plans. As such, investors are more willing to pay a premium for REITs owning these assets. Conversely, REITs owning assets which are more susceptible to cyclicity, such as the retail and hospitality assets, tend to trade at a discount to price to NAV. Due to the business cyclicity faced by these trades, asset owners may face devaluation risks, which will affect the REITs gearing ratio and credit spreads when refinancing loans. Or have to accept below-valuation offers when selling these assets in down cycles. Another metric used to analyse REITs is their distribution yield. REITs are attractive to investors because they offer high dividends. Distribution yield is calculated as the annual dividends per share divided by the current stock price. Analysts use distribution yield to evaluate the income generated by the REITs relative to its price, and then they use this to compare the valuation across different REITs. While a high distribution yield may indicate that the REIT is undervalued or providing higher income returns, it is important to consider other factors as well. For example, property with high risk or low growth potential, such as leasehold properties in the non-prime areas, tend to have higher yields. Leverage, the use of sheet debt, is another way which REITs use to boost distribution yield. To account for this risk, investors demand an additional risk premium in their required return. Again, the dividend yield that a REIT generates is going to be a function of two things. The types of assets that it owns, as well as prospective future growth. Retail assets in Singapore, for instance, industrial assets, trade at slightly higher implied cap rate valuations than do assets like office. As a result of that, the dividend yields on retail REITs and industrial REITs tend to be higher than that of office REITs. So, an understanding of the underlying asset class which the REIT is in will help you to get a better sense of what dividend yield is the fair dividend yield for the REIT and thus allow you to exploit market inefficiencies if a REIT is trading below what it should be trading at because of the underlying asset class that it is in. So, when determining the attractiveness of an investment, we compare the forecasted DPU yield against firstly, other investment opportunities such as other yield securities, the interest rates on fixed deposits, T-bills and government bonds. Secondly, the REIT's historical DPU yield. Thirdly, the sub-sector average DPU yield. And lastly, the required return for the investor's perceived level of risk associated with the REIT. As REITs also need to conform to gearing and interest coverage ratio thresholds, breaching these thresholds will impact the REIT's ability to borrow funds as well as pay out dividends. So, this brings us to our third metric which is the Adjusted Interest Coverage Ratio or Adjusted ICR for short. The Adjusted ICR is used to determine how easily a REIT can pay its interest on its outstanding debt and hybrid securities and is calculated as the EBITDA divided by the interest expense and distributions to perpetual security holders. That's really a measure of how easy it is for the REIT to repay its interest out of its operating earnings. Now, this metric is important because interest can be as much as 20 to 30% of a REIT's total income. It can really, really impact your earnings if the interest rate goes up and interest costs go up. If your operating earnings is inadequate to cover the interest cost in a situation where rates go up sharply, you could have REITs breaking the covenants with banking creditors and getting into trouble. So, the interest coverage ratio, that's a very, very important metric to look at. The Gearing or Leverage Ratio. Gearing is calculated as the total loans divided by the REIT's deposited properties. Essentially, the debt divided by the total assets that the REIT has. After January 2021, REITs with an Adjusted ICR above 2.5 times are subject to a 50% gearing limit while REITs with Adjusted ICRs below 2.5 times are capped at 45%. As REITs generally try to maintain some buffer from the regulatory 45% gearing limit, this gives them some financial flexibility to act opportunistically on acquisitions, as well as safeguard against asset devaluations which will cause gearing to rise. Generally, a lower gearing ratio is preferred and REIT managers and investors prefer REITs with gearing levels of below 40%. It's different strokes for different REITs quite clearly, but the going standard in Singapore is in the mid-30s to 40% range. That's what we would consider a healthy level. The next thing that I would look at is the management team's track record. Have they been making decisions that are accretive to REIT earnings and helping the REITs to grow dividends over time? Or have they been deploying capital into value-destructive deals, which has diluted the dividends per share and caused the dividends per share to fall? So, focus on the management's track record. What kinds of deals have they been doing? I start off by saying valuation of a REIT starts with the asset portfolio. Asset value drives the valuation of a REIT. But I want to emphasize as well, the management is also crucial and should be considered in the evaluation. A good REIT manager can boost revenue and operating margins through proactive asset management, economies of scale, and prudent capital management. So, in summary, a REIT is more than just a collection of properties. It is an enterprise that can justify a valuation even above NAV. But this premium must be earned through a consistent track record of strong earnings as well as a solid growth plan moving forward. As we've heard from our experts today, understanding the key metrics and ratios is essential to making informed decisions when investing in REITs. Whether it's analyzing distribution use, price-to-NAV ratios, or assessing the quality of a REIT's assets and management, these insights are invaluable for navigating the complexities of the real estate investment landscape. By staying informed and paying close attention to these factors, investors can better position themselves to make sound investments that align with their financial goals. We hope this discussion has provided you with the knowledge and confidence to make smarter REIT investment choices. See you in the next one!