5 years back, REITs were a favourite. It was simple then - interest rates were all time low and investors were flush with cash. This made alternative investments like REITs look like a god send for their 4-5% yields.
Fast forward, things have changed. Interest rates has gone up and people now demand a higher equity risk return for REITs. The result: REITs are now valued at 6-10% yields. Of course, their property income are not able to grow as fast for dividend expansion and hence share prices have fallen to match market expectations.
Is this a Market Cycle?
The answer is a resounding yes, markets move in cycles of europhia and fear. This causes the expected risk return for shares to go higher or lower.
Right now, we are at a peak interest rate cycle, so as investors we know why the interest rate cycle is roughly heading.
Stick to Strong REITs
However, this does not mean that buying any REIT now will strike the jackpot. There are a few lines of thoughts investor have to know:
(i) REITs can be poorly or greatly managed in their capital allocation. High interest rates will reveal the excessively leveraged ones (Case in point Manulife US REIT and Suntec REIT). Such REITs are forced to offload assets at the low point of a property cycle.
(ii) REITs allow their sponsors (capitaland, mapletree, keppel etc) to offload their assets at opportune time to the benefit of the sponsors. It is up to how nice sponsors are to REIT unitholders
(iii) REITs tend to survive even the poorly managed ones! All they do is undertake a massive dilution on unitholders by share rights and then survive; Case Study: Macarthur REIT in 2000s-2008, poorly managed with sponsors offloading its assets at profits and highly gearing the REIT, GFC came in 2007 and the REIT massively diluted shareholders
Year to date, it is renamed as Aims Apac REIT but shareholders are still 40% underwater a decade on.
(iv) The brand name of sponsors are important because they enable the REIT to get access to much cheaper capital than others. Case study: Capitaland REITs are able to get 0.75%-1.0% lower in interest somehow compared to other REITs in the same sectors/country
This is why looking at the leverage ratio and interest rate coverage ratio (ICR) as well as brand names are important. A few REITs despite the vacating of tenants have still clocked in ICR of above 3.0, this is commendable because it shows their resilency. Personally, I am looking at REITs which now carries (a) strong sponsor brand name, (b) has leverage ratio of below 40% and (c) ICR of above 3.0 times.
REITs with such attributes should be able to withstand the high interest rates and benefit when low interest rates start to kick in.