Investing in REITs can be rewarding but it also comes with risk.

There is excitement building up for Elite Commercial REIT, the first mainboard initial public offering (IPO) of the decade, and also the first to be denominated in British Pounds.  

As luck would have it, I was invited to an analyst briefing conducted by the REIT manager (Elite Partners Capital) and managed to dig up more information about the REIT during the question and answer session.

RISK AND REWARD

The REIT's 7.1 per cent dividend yield seems like a juicy proposition for yield-hungry investors, so I decided to focus on the risks related its property portfolio to assess if the high yield was really too good to be true.

With that in mind, there are three aspects of Elite Commercial REIT that I feel represent potential red flags for investors and should be marked as "noteworthy" for investors who wish to balance risk against reward.

1. RENTAL ESCALATION CLAUSES

Elite's portfolio of 97 properties all has built-in rental escalation clauses that allow for rental increases that are in line with the inflation rate.

The clauses allow for a minimum escalation of 1 per cent and a maximum of up to 5 per cent on the base rent for each building. The presence of this clause is beneficial for the REIT as it allows rental income to scale up in line with inflation.

That said, these escalations do not kick in until April 2023, or around 3 years from today.

The rent increases will be accrued and compounded, though, but will not take effect on a base rental until the stipulated date.

This structure implies that the REIT will technically not be able to increase its rental income through inflation-adjusted means, and will have to rely on either asset enhancement initiatives (AEI) or acquisitions to boost rental income.

The problem here is that costs and expenses will still continue to escalate in line with inflation, which means that from FY 2020 through to FY 2022, the REIT may encounter lower levels of cash flows should revenue stay flat while expenses head up.

2. 70 PER CENT OF PROPERTIES HAVE A "BREAK CLAUSE"

The REIT's prospectus said that 99 per cent of the REIT's gross rental income is derived from leases with the UK government via the Secretary of State for Housing, Communities and Local Government.

In addition, leases representing around 70 per cent of total revenue have a "break clause" that allows the tenant to terminate the lease after five years (i.e. in 2023).

This clause essentially allows the UK Government to terminate the leases prematurely, but the catch is that it will need to inform the REIT of its intention one year before the break clause takes effect (i.e. by 2022).

Though most of the properties form an essential part of the UK Government, being leased out to the DWP (Department for Work and Pensions), there is still no assurance or guarantee that the leases will not be terminated, as alluded to in my next point.

3. THE UK GOVERNMENT SCALING DOWN

The UK Government had recently conducted a property rationalisation exercise and had reduced the total number of properties it leases from around 1,050 properties to 850 properties.

According to management, this move was a one-in-20 year event and is not a regular occurrence - and is part of the Government's intention to reduce its real estate footprint and consolidate resources.

Of note is that the Government has gone asset-light many decades ago and has not owned any real estate for years, but instead leases it from private operators.

There is, however, no assurance that the last government rationalisation exercise will be its last.

Elite's portfolio consists of 97 out of the 800+ properties that the Government currently leases. The previous rationalisation reduced the number of properties by around 20 per cent. If we use a conservative estimate for another round of rationalisation (say, by 2023), it could reduce the Government's real estate footprint by a further 10 per cent to 15 per cent.

Such a move may lead to a direct spill-over to Elite's portfolio and impact 10 per cent or more of its total revenue.

This is a problem related to tenant concentration risk, as Elite has no other tenant to turn to in order to buffer any such decline in rental income as the Government is its sole tenant.

GET SMART: BEING COGNISANT OF PORTFOLIO RISKS

Investors will notice that most, if not all, of the above-mentioned risks, relate to aspects of the lease structure and tenant details.

These risks stand out as red flags and should make investors sit up and take notice. REITs may offer high yields as an enticement for investors to park their money, but the importance of risk management should not be downplayed as it could be a dealbreaker in the future.

This article was first published in The Smart Investor. All content is displayed for general information purposes only and does not constitute professional financial advice.