5 things to look for in REITs

Investing in Real Estate Investment Trusts (REITs) can be hugely rewarding. Besides providing investors with exposure to a variety of real estate, REITs also enjoy tax benefits and pay out regular and stable dividends (technically REIT dividends are called distributions but let's not split hairs here) each year.

But as with any asset class, not all REITs will perform equally. Investors need to be able to sieve the wheat from the chaff. With that said, here are five things to look out for that can help you choose the best REITs to invest in.

1. A STRONG EXISTING PORTFOLIO

Investors should look for a REIT that has a good line-up of properties in its portfolio. As a guide, here are some qualities to look out for:

• A diversified portfolio of properties, which ideally includes both Singapore and off-shore assets
• Properties that have a long or free-hold land lease
• Highly sought after sites that could appreciate in value over time
• Properties that are located near to public transport or residential hubs (in the case for retail REITs)
• Characteristics that suggests tenants are willing to continue renting the space such as a high tenant retention rate, history of positive rental reversions and a high occupancy rate

2. CAPABLE AND HONEST MANAGEMENT

Managing a portfolio of properties is no easy task. Managers of the REIT need to maintain a good working relationship with tenants, upkeep the property and carry out strategic asset enhancements to keep the property desirable.

On top of that, managers also have to sell underperforming assets and recycle the proceeds into investments that can grow over time. REIT managers need to make use of low-interest rate environments to grow the portfolio, whilst maintaining a safe capital structure.

With that said, here are some qualities to look for:

• A long track record of stable returns for unitholders
• A track record of good capital-allocation decisions
• A low frequency of private placement (sale of equity only to privileged investors) equity fundraising that dilutes minority unitholders

3. A SAFE CAPITAL STRUCTURE THAT CAN BE OPTIMISED FURTHER 

Ideally, investors should look for REITs that still have room to grow in the future. One way that a REIT can grow is to take on more debt in the future to buy assets that can increase its dividend per unit.

In Singapore, REITs need to maintain a capital structure that has not more than 45 per cent debt and 55 per cent equity. Investors should look for REITs that have debt levels well below this regulatory ceiling. While there is no hard and fast rule here, I prefer REITs that have a debt-to-asset ratio of not more than 35 per cent.

The interest expense should also be manageable. REITs will usually provide investors with a snapshot of how much interest they have to pay relative to their earnings. This is called the interest coverage ratio. The higher the interest coverage ratio the better as it suggests the REIT earns more than enough to cover interest payments.

4. A GOOD AND HONEST SPONSOR

The REIT sponsor is usually also one of its major shareholders. It is responsible for providing the REIT with a pipeline of properties and may also have a stake in the REIT managers.

With such a big say in how the REIT is run and the possibilities of conflict of interest, it is therefore absolutely vital that you trust that the sponsor will treat minority shareholders responsibly.

To determine if a REIT has a good sponsor, investors need to look at the sponsor's track record in both sponsoring and managing REITs.

Mapletree Investments Pte Ltd in Singapore is one example of a good sponsor that has treated minority shareholders responsibly in the past.

5. A DECENT VALUATION

Last but certainly not least is a decent valuation. While some investors prescribe the use of the price-to-book ratio to determine value, I prefer the dividend yield. REITs are a buy-and-hold vehicle and usually do not rapidly recycle their assets.

As such, REITs may trade below or above their book values for extended periods of time. For instance, REITs that own properties located in Hong Kong tend to trade at a discount to book value because of the relatively low rental yield of properties in Hong Kong.

On the other hand, the distribution yield gives investors a much clearer idea of how much returns they can actually expect to make.

An investment return in a REIT is the addition of the current yield plus any capital appreciation. As such, investors should look for REITs that have high yields rather than low book values.

THE FINAL TAKEAWAY

Of course, REITs that displays the first four characteristics listed above will likely not sport the highest yields in the market. Investors need to determine for themselves what's a good price to pay for a REIT that exhibits these favourable characteristics.

From experience, if a REIT fits all the characteristics above but trades at a slight premium to the market (ie lower distribution yields compared to the other REITs), they still tend to do much better than their peers over time.

This article was first published on The Good Investors. All content is displayed for general information purposes only and does not constitute professional financial advice.