Following our Report Card Series on REITs , we zoom in on the three things that investors should avoid when making investment in any REIT. These three factors can significantly improve returns by avoiding REITs that are not worth our investment.
Avoid Choosing REITs based on Dividends
It might sound counter intuitive, but investing in REITs shouldn’t be just focusing on the potential dividend yield of the REIT.
What do we mean by that?
First, ask yourself this question.
Why does a troubled REIT like Sabana REIT have a double-digit yield of 11.8 percent in the past year compared to Keppel DC REIT’s 5.6 percent? Isn’t Keppel DC REIT supposed to be of better quality and growth prospects than Sabana REIT?
To answer that question, we first have to look at the total return that both REITs yield in the past year (let’s use CY2016 for a fair comparison).
In 2016, Sabana REIT share price fell by 25 percent (even if we exclude the significant drop in Jan 2017 from the rights issue announcement!). Now compare that with Keppel DC REIT’s performance over the past year of 18 percent gain. Even after getting an 11.8 percent yield from dividends, shareholders of Sabana REIT are still making a loss of 13 percent!
ESSENTIAL TERMS That You Must Know before you invest in REITs
So that you can select the right REITs for your portfolio
This is in stark contrast to the shareholders of Keppel DC REIT, which made 23.6 percent in 2016.
As investors, we tend to have selection bias in focusing on REITs that have higher dividend yields and avoid those that have lower yields. This selection bias stems from our thinking that the return we get is purely from dividends, which isn’t true!
Apart from dividends, we would expect to make capital gains as well. So rather than looking at dividend alone, we should instead be looking at the total return that we can generate from the REIT.
Avoid REITs With Poor Macro Outlook
REITs stand for Real Estate Investment Trust. This means that investing in REITs are like investing in real estate, albeit without property cooling measures like ABSD. As for any real estate investment, the macro outlook of the economy influences the returns of the investment. For REITs, there are five sub-sectors: Office, Retail, Industrial, Hospitality and Healthcare.
Each sub-sector has a different outlook considering the economics factors affecting them.
There are still outstanding REITs within each sub-sector. However, the opportunity cost of investing in outstanding REITs of sub-sectors with poor macro outlook is still high. The capital could be put into better use in sub-sectors that have good growth potential.
For example, we know that the retail sub-sector is facing a lot of headwinds in the year ahead due to uncertainty in the global economy as well as increasing competition from ecommerce players in the region.
Although REITs such as CapitaMall Trust remains an outstanding REIT in the retail sub-sector, why not place our capital in Keppel DC REIT instead where there is clearer and more visible growth?
Avoid REITs With High Gearing
Most REITs typically use debt to finance the acquisition of new properties into their portfolio. Thus, investments in REITs will expose investors to interest rate risk. This means that as interest rate increases, it will negatively impact the earnings of REITs and thus, affect the distribution for REITs.
To determine the relative amount of debt a REIT has, we use gearing ratio as a gauge. Gearing ratio represents a REIT’s amount of debt over its total assets. As the ratio increases, it signifies the more debt the REIT has over each unit of asset. Investors are exposed to higher interest rate risk when REITs are over-leveraged (high gearing level).
While we are not saying that all REITs with high gearing ratio shouldn’t be considered, we need to keep in mind that higher gearing ratio exposes our portfolio to higher interest rate risk.
Interested To Learn More About REITs?
If you want to learn more about investing in REITs, find out more about our REITs Investing Fundamental Course.