Many people are drawn to the high dividend yields of business trusts and REITs, but don’t seem to understand the structure well. The article provides some basics of business trust as well as the difference between a REIT and a business trust.
One of the main differences between a business trust and a REIT is that REITs can only hold real estate assets while a business trust can hold pretty much any asset, including real estate and under development properties. REITs can only borrow up to 35% without a credit rating and maximum up to 60% with a credit rating while trusts do not have any leverage caps.
REITs are also required to pay out 90% of earnings and do not have to pay taxes on profits while there are no such requirements and benefits for business trusts. Unlike REITs, each business trust operates in a different sector and it is important to understand the sector well before investing. For example, many investors got burnt by the shipping trusts as dividends dropped since IPO due to the poor performance of the shipping industry.
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Since business trusts are valued mainly based on their ability to provide dividend, the most important valuation method would be dividend discount model (DDM). So if dividends drop, the stock price would definitely drop, leading to a double whammy. It is important to understand how the trusts generate their cash flows and whether it is stable in the long run and sustainable.
Another key consideration in business trusts is the life of the assets. Unlike real estate, most of the assets in trusts have a fixed usable lifespan, such as ships, incinerators etc. As such, depreciation tends to be very high and it is important to take note of the age of these assets as their income producing ability tends to decrease as they are near to end of life. There has to be a balance between capital expenditure and depreciation to ensure they are not just aging the fleet without replacing them to drive up cash flows.
About the Author
Calvin Yeo is the Managing Director of Doctor Wealth Pte Ltd (www.drwealth.com), which is an online financial planning platform. He is also a Chartered Financial Analyst (CFA) as well as Certified Financial Planner (CFP).