Real estate investment trusts or Reits are a popular investment here in Singapore. Perhaps it is our love of the property sector that makes them appealing. Or maybe it is because of our yearning for regular income that makes us like them.
I suspect it could be more of the latter that is at play. In many ways, Reits can be thought of as a proxy for bonds. They even behave a little like those fixed-income instruments. Of course, it can be argued that many blue chip stocks have bond-like characteristics too. That is because they also have the ability to deliver almost-dependable dividends.
Consequently, when there is a possibility that interest rates might rise, then the price of their shares - just like bond prices - could fall. Conversely, when the market believes that interest rates could stay low or even fall, then their share price could rise.
But Reits can be even more sensitive to interest rate movements than ordinary shares. That is because investors who buy Reits are constantly reviewing their prospective yields rather than the prospect of any share price appreciation. For some, it is about jam today rather than jam in the future that counts.
So when the market believes that an interest rate increase is on the cards, then shares in Reits could fall - sometimes quite disproportionately. Put another way, investors are comparing the yields on Reits with the yields they could achieve from risk-free returns such as those of government bonds.
That is why it is important to consider buying Reits when they are attractively valued. This could provide a good margin of safety. But what exactly is an attractive valuation? A common approach is to look at yields. It is quick, it is simple, and it is widely reported. But that could also be a mistake.
Reits are required to pay at least 90 per cent of their distributable income as dividends. So, managers have no discretion over how much they would like to reward unit holders and how much they should keep. Currently, the median yield on Singapore Reits is about 7.2 per cent. That is roughly three times higher than the dividend yield for the entire market.
The yields on smaller Reits tend to be higher than those of the larger ones. Larger Reits are generally those with a market value of more than $2 billion. The median yield for these larger Reits is about 5.9 per cent. CapitaLand Commercial Trust and SPH Reit are yielding around 5.7 per cent, which is about one-fifth lower than the market average for Reits.
The yields on smaller Reits, on the other hand, are about one-fifth higher than the average. For example, Cache Logistics and Aims AMP Capital Industrial Reit sport historic yields of 9 per cent and 8.7 per cent, respectively. So, from the perspective of yields, smaller Reits appear to be cheaper than larger ones.
There is another way to value Reits, which is to look at how much it costs to buy a dollar of their assets. Currently, we are, on average, paying about 86 cents for a dollar of their assets. In other words, we are buying Singapore Reits at a 14 per cent discount to their net assets. The discount is across the board. So there is little to choose between the larger and the smaller Reits.
Another way is to look at how much we are paying for a dollar of earnings. But the usual way of comparing price to earnings is not very helpful when valuing Reits. That is because general accounting principles may not always be an accurate representation of a Reit's true performance.
For instance, properties are unlikely to depreciate over time. In fact, they could even rise in value. So it is better to look at how much we are paying for a Reit's funds from operation rather than from its earnings. That would help compensate for regulatory accounting aberrations such as depreciation, amortisation and non-recurring profits from the sale of properties.
In Singapore, we pay around $13 for every dollar of cash generated by Reits. Curiously, there is little to choose between larger Reits and their smaller peers. It is unexpected because, intuitively, larger Reits should be more attractive to deep-pocketed institutions. Big investors tend to lean towards bigger stocks for their liquidity. After all, it can be difficult to buy needle-moving quantities of smaller Reits without owning the whole thing outright.
The upshot is that here in Singapore there is little to choose between large and small Reits. We pay roughly the same for the stream of earnings, regardless of the size of the company. At the current yield of around 7.2 per cent, we could, in theory, double the value of our investment in around 10 years, if Reits could maintain their distributions. That doesn't seem too outrageous at all, provided you have the patience.
This article was first published on Dec 19, 2016.
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