Financial Statements of REITs

Investors looking to invest in REITs should approach investing from a businessman’s perspective. Someone investing in a retail REIT have to physically visit the malls and look at the quality of the tenants and number of shoppers thronging the malls. The investor also has to know how to read the financial statements of the REITs. The financial statements reveal two things: the revenue-generating ability of the properties which determine the return on capital and the financial strength of the REIT.

The financial statements of REITs are divided into several sections. They are the statements of total returns, statements of distribution, statements of financial position (or balance sheet), statements of changes in unitholders’ funds, statements of cash flow and statements of portfolio. The name of the statements may vary between different REITs.

Revenue generating capability

The statement of total returns helps an investor to find out the revenue generating ability of the REIT. Always look at the numbers under the “Group” heading. The group refers to the trust and all its subsidiaries which are created for acquisitions or for issuing financial programmes like medium-term notes.

Gross revenue tells us how much revenue the REIT has collected from its tenants. This figure fluctuates depending on the occupancy rates, whether leases were renewed at existing rates and the rental amount. For retail REITs, it’s always good to compare the rentals of specific malls over the years to get an idea of the rentals trends. Ideally, we want rentals to inch up yearly. If they have not, ask why revenues have declined? Have occupancies or rentals dropped?

Net property income (NPI) is similar to gross profits of a company. This is the amount of profit it makes from its rental operations after deducting property expenses like maintenance expenses, property tax and insurance expenses. NPI divided by the revenue gives the NPI yield. This ratio can be compared across different REITs as a measure of operating efficiency. Larger REITs have higher efficiency, usually. In general, property expenses should not offer major surprises as they are mostly fixed to a proportion of gross revenue.

NPI divided by property value gives the property yield. This is an important metric to assess the attractiveness of a REIT. The property value should be taken at the time when you purchase the REIT and this can be found in the balance sheet under non-current assets. This property yield can increase due to asset enhancement and general property appreciation. This yield signifies the earning power of the properties. There is another metric, the distribution yield (more often reported), which refers to the dividend yield as a percentage of investor’s purchase price. This is not a good measure of a good REIT as compared to the property yield.

The NPI undergoes further deductions like trustee fees, management fees and finance costs to give the net income. In return for the management fees paid, an investor gains the ability to dispose of his units in a liquid market and also enjoy the lower cost of financing the trust enjoys versus what he could have negotiated directly. In that view, these two advantages are worth the REIT manager fees.

The distributable income (from statements of distribution) is usually higher than the net income as the non-cash part of the management fees (if paid in units) are added and fair value gains/losses are added subtracted/added. One should scrutinize the various additions and subtractions that lead from net income to distributable income. One shouldn’t just compare the distribution income across various periods.

The investor will also have to look at the future prospects of the REIT. What we look at so far is the past performance of the REIT. The most important numbers are the tenant occupancy rate, current rental rate versus market rate for similar properties and the number of leases expiring over the next few quarters. Also, the investor has to look into if the current rental is sustainable over several cycles. Can leases up for expiry be renewed at higher rates?

Financial position

Next, we will look at the REIT’s financial standing. To analyse a REIT’s financial capability, looking at gearing alone is not enough. Gearing ratio is the total debt divided by total assets. A lower gearing is not necessarily better than one with a higher gearing. An investor needs to look at how well it can service the debt and how easily it can raise funds from various sources.

Unlike a company, a REIT does not have much retained earnings to fall back on in bad times to pay interest expenses. So, the key question is, can the REIT pay interest expenses during a crisis when rentals are low and vacancies high? The answer lies in a ratio called the interest coverage. The NPI divided by interest expense is the interest coverage ratio. Banks and rating agencies consider anything above 3x to be safe. One should pay close attention to this number, especially when a REIT gears up for acquisitions.

Another important ratio to look at is the debt/market capitalization. Anything above 0.6 is quite risky.

Also, look at whether the REIT refinances its obligations early and raises funds during good times rather than last minute. A strong REIT usually avoids or limits short-term loans. Rights issue should also be done prudently without large discounts.

The financial statements also give details on the properties “locked” by loans. The more “free” properties a REIT has, the more flexibility it has to gear up for acquisitions.

Here are is a checklist investors can use when looking into REITs. (Checklist courtesy of Nick from valuebuddies.com. Reproduced with his permission.):

Quantitative -

1) Is the business truly defensive? Has its revenues and distributable income remained consistent throughout the past 3 years? Is there growth in the DPU? What is its NPI yield? Is there an increasing trend? When does the rental lease expire? Is it hedged against inflation? What is its rental security deposit? What is its occupancy rates – is it volatile?

2) What is its gearing levels? Do the debts mature in less than 18 months time? If so, does the economic conditions allow for easy refinancing?

3) Is there any unfinanced acquisitions? Do the REIT meets its loans covenant? If asset valuation drops by 20%, can its Loan to Valuation covenant still be met? What is its interest cover ratio? Is there buffer room in case of interest rates hike?

4) Do the Management engage in asset enhancement schemes to boost DPU? Has it been successful in the past? Has its NPI yield increased?

5) What is its yield? Does it make sense for it to be trading at such yield levels (compare with SGS bond yield and peers)?

Qualitative -

1) Does the Management time its equity fund-raising exercise well ie not raising new equity when its unit prices are significantly under-valued?

2) If the Management is a serial acquirer, has its past acquisitions truly benefited the REIT? There is a difference between expansion and diversification. Diversification leads to a reduction in the overall risk profile. Expansion doesn’t – it just leads to more of the same assets. To test – examine the quality of the tenants, geographical risk etc.

3) What is the sponsor’s relationship with the REIT? Does it function as merely a property developer or does it act as a Tenant as well? Does the sponsor consistently divest its assets at full valuation or does it divest only at opportune time (bonus: below valuation)? Does the Sponsor treat its REITs as an ATM machine or as a partner?

4) What are the REIT plans for the future? Where does it seek to expand? How does it intend to do it?

Types of REITs

There are various types of REITs operating in various sectors. REITs are also priced differently by the market due to quality of management or the REITs perceived growth potential and perceived risks, among others. However, the fundamental reason is the type of properties that the REIT owns. There are basically 5 different sectors of REITs listed in SGX. These sectors are retail, office, industrial, hospitality and health care.

Retail REITs

CapitalMall Trust (CMT) was the first REIT to be listed. Shopping mall REITs are popular among investors as they can know about the business and how it’s performing by just visiting a mall. CMT’s Junction 8 mall has attracted more than 28 million shoppers in 2009. Singapore malls attract such high patronage as shopping malls have evolved into family entertainment venues.

Retail malls require a large amount of space so their supply is limited by the government. Malls are built only if the area has the ability to attract shoppers.

Retail assets also lend themselves well to asset enhancement. This leads to continual growth in net asset value (NAV) of the REIT and capital growth without the need for acquisitions which involve heavy financing. For example, Fraser Centrepoint Trust, was able to use asset enhancement to increase average rentals in its Anchorpoint mall by 41% recently.

Capital growth for malls has also been strong over the years. Plaza Singapura was acquired for $700 million by CMT in 2004 and its latest valuation stands at $1 billion.

Retail malls are also quite recession-proof. Their occupancy was held at a steady rate of around 90% during several crises such as dotcom bust, SARS and the recent financial meltdown. Also, there was no distressed sales for malls in the recent crisis as owners appreciate the long-term potential of retail malls.

Long-term fundamental drivers like population growth, increased tourism and rising wages also bode well for malls in the future.

Thus, due to these reasons, retail REITs tend to be excellent long-term investments.

Office REITs

The economics of office properties are somewhat inferior to that of retail malls. The commodity-like nature of office space makes over-supply a bigger problem than retail properties. Office properties are highly cyclical given the time it takes for new supply to come on-stream. Asset enhancement is also much less effective for office real estates than for malls.

The market recognizes such risks and usually demands a higher yield for office REITs.

Industrial REITs

Industrial REITs can be broadly classified into business parks, light industrial and warehouse/distribution centres.

Industrial REITs offer limited capital gains when compared to other types of REITs as there’s minimal scope for asset enhancement and relative ease of building new industry properties. The exceptions are large ramp-up logistics properties which need high capital and land usage.

Historically, occupancy rates of industrial REITs have seen high volatility depending on the economic cycle. In Q4 2009 (when economy was emerging from the crisis), the rate was at 80%. In 2003 and 2004, occupancy rate was only 70+%. Compare this with suburban malls where occupancy has stayed above 95% despite the crisis and SARS.

Factory space does not have good fundamentals in Singapore as compared to business parks and warehouses. This is because several companies have relocated to cheaper locations to increase profits.

Before investing in industrial REITs, investors should recognize why these REITs are trading at higher yields and take extra caution to investigate the assets owned by these REITs.

Hospitality REITs

This category includes both hotels like CDL Hospitality Trust (only hotel REIT listed in SGX) and serviced apartments like Ascott REIT. Hotel REITs dampen the volatility in their business by negotiating master lease agreements for the long-term with a hotel operator. For example, CDL Hospitality, has 20-year leases for its hotels. This gives a minimum fixed revenue plus a variable part linked to the hotel operator’s revenues and gross profits.

CDL Hospitality, which derives 50% of its revenue from fixed lease portion, saw the fixed portion of its income yielding around 5% when investors dumped the stock during the recent crisis! Hotel operator default is very unlikely to happen as the master leases are indirect wholly owned subsidiaries of the sponsor, which also has a large stake in the REIT. In CDL’s instance, Millennium & Copthorne is the sponsor of CDL Hospitality and owns 40% of the REIT.

Hotel REITs are economically sensitive and exhibit high volatility in room rates and occupancy. Hotel revenue per available room (or RevPar) can shoot up quite a bit and provide strong income growth. This ratio is the key metric used in the hotel sector as it takes into account occupancy rates and average room rates. Declining RevPar during times of high tourist growth means over-supply of hotel rooms. This in turn means depressed earnings for the sector till addition supply is absorbed.

The service residence REITs suffer less volatility as quite a number of the stays are more than 12 months and this provides some stability. However, these REITs are riskier than other types of REITs with long leases.

Thus, investors who research on tourist demand and hotel room supply can reap huge rewards from these REITs.

Healthcare REITs

There are two healthcare REITs listed in SGX. One is First REIT and the other is Parkway Life REIT. These REITs are deemed to be the most stable of the all the REITs, given their long-term master lease agreements and the sector the REIT is operating in. For example, First REIT has three core Indonesian properties that are on 15-year leases with an option to renew for another 15 years. The base rent is subject to an increase every year equal to two times Singapore’s consumer price index (CPI). The variable component of the rent is pegged to gross revenue growth of the master lessee’s healthcare business.  This can be equated to a high-yielding bond with inflation protection (through the CPI component) and growth (through the variable component).

The master lessee usually takes care of maintenance, taxes and insurance means low overheads and limited need for capital unless acquisitions are pursued. Another key area which an investor must understand is the strength of the master lessee and the actual revenues the hospital is generating which ultimately determines the sustainability of the payouts to investors.

Investors should also be aware that these REITs are more susceptible to interest rate fluctuations than other type of REITs given their bond-like characteristics. Those investors willing to stomach a bit more risk, healthcare REITs are excellent defensive investments.

Value investing for long-term

Why is value investing good for the long-term? The main reason is due to the theory of “reversion back to the norm”. Something that is undervalued won’t stay as such for the long-term. As the market catches up, the undervalued stocks will catch up as “investors” (or traders in this instance) look for new stocks that hasn’t risen that much or has stayed beaten down for some time. Market will always re-value companies that are fundamentally strong, higher.

A current example I can think of is that property investors investing in Hong Kong and Singapore are heading to Tokyo to invest as prices are still cheaper there. After a while into the future, properties in Tokyo will become expensive too as more investors jump on the bandwagon and brings prices up (reversion back to the norm).

Putting net profit margins into perspective

The profit margin tells you how much profit a company makes for every $1 it generates in revenue. For example, if the net profit margin is 30%, company makes $0.30 for every dollar generated in revenue. It is calculated by using:

(Net income ÷ Revenue) * 100%

Personally, I look for net profit margins to be higher than 20% (exceptions made for certain companies for underlying reasons).

Always compare the net profit margin with that of similar companies. Comparing margins with peer group provides an excellent way of judging performance of the management team. If the margin of a particular company is always consistently higher than those of similar companies operating in the same sector, then as a business and as a management, the company has found a winning formula. The higher-margin business has built up a dominant market position, effective way of generating high margins and a culture that enables it to do very well in the long run.

What has been driving the company’s margins?

It is imperative to understand what forces have been driving the company’s high margins. This will affect the sustainability of such margins and potential risks. For example, if margins have risen due to a temporary price increase in a volatile commodity, the higher margins will prove to be transitory and margins will reverse when prices decline.

Similarly, temporary boosts to margins from lower raw material costs are likely to unwind relatively quickly and it owes nothing to prudent management. However, a sustained effort by management to improve and source for more cost-effective/higher quality components is likely to offer longer term benefits.

If margins are boosted by solid volume growth, good pricing, new product developments and improved product quality, then it’s good. Not only margin expands but the company’s position and profile in the market will be boosted.

If margins are slim, is there any risk of going into a loss?

Low margins can mean significant risks as there is little chance for anything to go wrong. If margins are low due to things already going wrong, it may not take a lot to see profits swinging into losses. For example, a contractor with net profit margin of 1% may run into problems with a large contract and quickly see losses.

The risks are substantially higher if the business is highly volatile and subject to wide swings in volume and pricing.

If margins are a lot higher than that of competitors’, can the figures be believed?

Margins that are significantly greater than the competitors should be closely looked into. They may genuinely represent superior efforts from management – better products produced at a much lower cost. However, such margins can also reflect a less prudent approach to accounting – low depreciation charges, recognizing profit earlier than sensible. Henceforth, it is well worth being aware of any accounting issues that are flattering net profit margins.

Similarly, if a company is generating high margins for producing a basic commodity, scrutinize the basis for high margins.

Putting P/E ratio into perspective

A low P/E ratio doesn’t necessarily mean that the company is undervalued and is a prospective buy. On the other hand, a high P/E ratio also doesn’t mean that the company is overvalued and we should chuck it aside.

A company with low P/E ratio may not mean that it is attractive (or undervalued) due to the following reasons:

• company has uncertainty over its prospects for earnings
• company is operating in a highly cyclical sector
• company is serving volatile markets
• company is operating in a sector with overcapacity and weak pricing power
• company is operating in a sector with low returns consistently
• company operating in a mature sector, with little prospect for growth
• company is ex growth
• company has poor management with no convincing strategy for growth
• company has poor cash generation
• company has a weak balance sheet

Whereas a company with a high P/E ratio may not mean that it is overvalued due to the following reasons:

• company has an excellent growth record and prospects for growth
• company is operating in a high-growth sector
• there’s high confidence in company’s forecasts
• predictable/stable returns
• strong market share
• high barriers to entry
• strong pricing power
• high margins and excellent returns
• superior management with excellent growth strategies in place
• strong cash generation
• strong balance sheet

P/E ratios also have advantages and disadvantages.

Advantages of P/E ratio:

• easy to compute
• widely used so it’s easy to find a company’s P/E ratio
• takes forecasts into account
• earnings is a measure of what is generated for shareholders

Disadvantages of P/E:

• does not take debt/financial structure of company into account
• gearing up/share buy-backs increase earnings (‘financial engineering’)
• earnings are prone to manipulation by management
• does not take cash generation into account
• presents difficulties in assessing quality of earnings

Thus, P/E ratios must always be compared with companies of the same sector and with the overall market P/E. Various matrices must be looked at (not only P/E ratio) before investing in a company as well.

What are REITs?

REITs are short for real estate investment trusts. REITs pol money from investors and debt from banks to buy revenue-generating properties. These properties are then rented out and the rentals received are distributed to investors as dividends. REITs have to distribute at least 90% of their income to shareholders to enjoy tax exemption.

REITs are popular due to the reason that they are exempt from tax at both the corporate and individual level. Contrast this with ownership of physical property which requires paying of property tax on the value of the property as well as income tax on rental income. Also, investors can own properties by investing in REITs without the risks that come with owning physical properties.

The gearing for REITs is limited to 35% unless a satisfactory credit rating is obtained. In this case, gearing can be increased up to 60%. Gearing is the percentage of total debt/total assets.

Given below is an example of a REIT’s trust structure.

(Source: Ascendas REIT)

REITs are managed by a REIT Manager who oversees the day-to-day operations, property management and plans for acquisitions.  The REIT Manager is similar to a listed company’s senior Management. The major difference is that the management of a listed company is internal while the REIT’s manager is external. In the example above, Ascendas Funds Management Ltd is the REIT manager.

Each property has to be managed by a property manager. Generally, the REIT Manager and the property manager are the same. If the REIT Manager lacks the expertise, it can hire an external property manager to manage the properties. In the example above, Ascendas Services Pte Ltd is the property manager.

Some REITs have a sponsor as well. A sponsor is the property developer which has a significant stake in the REIT Management team and will have a stake in the REIT as well. The sponsor’s properties form the REIT’s pipelines of assets to be purchased. REITs sponsored by developers  will provide  higher visibility  with  a steady stream of acquisitions. Sponsor-linked REITs are in a more favorable position to embark on inorganic growth through acquisitions compared to non-sponsored REITs, which will be exposed to the competitive acquisition market. In the example above, Ascendas is the sponsor for A-REIT. Ascendas’s properties will form the REIT’s pipelines of assets to be acquired.

The Trustee is the custodians of the REIT assets and ensures that the Management follows the Trust Deed. They are not connected to the REIT Manager and work independently.

What are some of the benefits when investing in REITs?

• Generates regular cash flow in the form of dividends from the rentals and this provides passive income
• Yield is much better than buying bonds
• Allows portfolio diversification
• Professionals manage the properties “on your behalf”

Now, let’s look at some of the risks involved.

• REITs are cyclical in nature. It is imperative to invest during the right economic cycle (when economy is recovering after a crash).
• Interest rate fluctuations can eat into/increase earnings accordingly.
• REITs tend to be highly leveraged. During a crash, REITs must be able to pay out their interests in time without going into deep trouble.

If investors manage their risks well and are well-informed in what they are investing into, REITs can be great investment vehicles!