I have been asked by some friends about why anyone would buy expensive REITs. Indeed, dividend yield and price to book (P/B ratio) are very important numbers when it comes it REIT investing. Afterall, REIT investors invest for dividends. And we don’t want to pay more than what the portfolio is worth. Yet, there seems to be a steady stream of buyers queueing up for these expensive REITs.
The short answer to this is that these “expensive” REITs have a track record and a high potential to increase their dividends (or “DPU” in REIT speak). Here are three main reasons why this is so:
Almost every REIT manager is owned by its sponsor. This creates a conflict of interest whereby the sponsor- controlled REIT may buy properties from the sponsor itself at inflated prices. The main safeguard for such circumstances is that under SGX rules, the directors who are representing the sponsor (non-independent directors) have to recuse themselves from the purchase decision. So the approval decision lies mainly with the independent directors. Unfortunately, as many have pointed out, a lot of independent directors are independent only on paper.
Good REITs have a track record of a board that take their fiduciary duties seriously and properly. And I am not talking about the number of awards won by a board. As a minority investor, there is only one test to pass: That boards approve acquisitions only when they are DPU accretive.
Some people may be skeptical that good governance and truly independent directors actually exist. They do. And when investors find out which are the ones with good governance, they will be willing to pay a premium for that.
2. Asset Quality
It matters a lot that a REIT’s portfolio is made up of high quality properties, and that the REIT manages to maintain at least investors’ perception of the overall quality of their portfolio.
Naturally, just like high/low quality bonds, higher quality properties are valued at a higher valuation and therefore lower yield. For example, Tampines Mall is considered high-quality popular mall that will always have almost 100% occupancy as compared to the KINEX Mall in Katong. An investor considering both may be willing to buy Tampines Mall at a 4% yield, but would only buy KINEX Mall at 7% to compensate for the fluctuating occupancy and rent.
By having a portfolio of high-quality properties, the REIT trades at a lower yield. So when it buys properties of a slightly lower quality, the acquisition is almost certain to be DPU accretive. On the other hand, REITs with lower quality portfolios will never be able to buy higher quality properties at DPU accretive prices.
Of course, REITs with high quality portfolio must also resist the temptation to go wild buying low quality properties. After all, they will have trouble doing share placements at high prices if the acquisition target is big and lousy. What they can do – and have done – is to take advantage of their valuations to buy lower quality properties slowly without drastically altering the portfolio. Thereafter, they can do Asset Enhancement Initiatives (AEI) to renovate and improve the quality of these properties and bring the overall portfolio quality up to mark, before repeating the cycle again.
3. Low cost of equity
I had assumed in the discussion on Asset Quality that the REITs were trading at book value. In reality, this is not always so. Expensive REITs with good quality portfolios tend to be over rewarded by the market with share prices above book value. This causes even more benefits to the expensive REIT.
Remember that REITs have regulatory gearing ratio cap and generally low cash on hand given that they distribute 90% of its income. So when REITs acquire properties, they will need to fund the acquisition with a mix of debt and equity – equity meaning issue new shares via share placement or rights. These sources of funding collectively make up the Weighted Average Cost of Capital (WACC).
Expensive REITs therefore have a naturally lower WACC than cheap ones. They can raise more money by issuing fewer shares. This means that the same property at the same price and rental yield could be DPU accretive to the expensive REIT but DPU dilutive to the cheap REIT. Indeed, for expensive REITs that are trading quite a bit above book value, almost all properties at market price can be DPU accretive. This is why the expensive REITs tend to be more acquisitive than the cheap ones.
Note: This purpose of this post is not to argue that it is better to buy expensive REITs, but to highlight that there are some pros (not only cons) for doing so.