1. Interest rates regime
2. Acquisition trails of a Reit to generates profit growth
3. Professionalism of the REITs Managers
4. Changes in the law like improved debt funding and/or lower taxation

(1) Interest rate in relation to Valuation Improvement in REITs

• In simple terms, falling interest rates can make REITS comparatively more attractive. The impact of falling interest rates and valuation improvement is quite prevalent in Singapore REITs – yields are only four to seven percent per year but prices of REITs are higher. Why is this so? Let give an example, say, if a REIT yielding six percent is deemed attractive and gets re-rated to four percent, the corresponding share price appreciation is a strong 50 percent.

Incidentally, in a Reit’s capital management exercise, a top most priority is to look at the means to cap Interest Risk. Some suggestions are as follows:

• To mitigate fluctuations in interest rates, the REIT’s debt should be fixed at various length of maturities and at a certain weighted average interest rate inclusive of margin.
• There should also be a constant awareness of the interest rate trend. This could present opportunities for the REIT to gear up for other yield accretive acquisitions, as well as to lower borrowing costs where appropriate.
• However, Malaysian Reits are not able to respond properly to effective modes like interest sways, converting floating to fixed interest rate,etc as efficiently as its other counterparts due to its less sophiscated financial market.

(2) Acquisition trail

• REITs generally try to buy properties to increase their yields. The increased yields attract more investors and results in share price appreciation. As it is an internal strategy, not surprisingly, we see good REIT managers constantly embark on an aggressive and reasonably valued acquisition to improve the REIT’s value.

However, there is a bit of caution as appended below:

i. As the REIT keeps continuing the acquisition, there will come a time where the base asset is so large that the REIT has to buy much bigger assets than before to have a similar positive effect in percentage terms. Once REITs reach such an acquisition maturity profile, the market should view their valuation less attractively as the potential of similar historical share price appreciation is significantly lessened.

ii. The investors need to understand the acquisition potential. Take for example in Malaysia, most of the REITS are owned by property developers and are seen merely to carve out their investment holding properties to realize existing value. Not many of them seem to have an articulated acquisition strategy. Their key focus remains in carving out the property to enhance the holding company’s value or seek liquidity for other business ventures

iii. The need to understand the gestation period for buying and selling of buildings

3. Professionalism Of Reits Manager:

• In well organized REITs like in Singapore we have professional property fund managers that specialise in buying and enhancing properties. While some of them are similarly listed subsidiaries of property companies, their parent company have a clear strategy to grow and enhance the REIT. A few of them also have holding companies that buy and refurbish properties before injecting it into the REIT, ensuring a steady profit growth.
• Also, read my earlier articles on managing the reits to optimize costs and generate income and income yields

4. Changes in the law/legislation

Two typical examples are:

- changes in taxation incentives to both or either Reit’s company or investor/unit-holder

-changes in permitted gearing level

Changes in taxation:-

Interestingly, to say that Singapore’s REITs are effectively tax-free for individuals and only attract 10 percent tax for corporations, whereas Malaysian REITs are still not able to compare despite the drop in withholding tax rate announced in the earlier Budget 2007. Naturally, if there are further tax incentives, these tax benefits would go to improve the net yield for the investor. And this, in effect, attracts more investors to the REITS instrument and ends up pushing up the price. The end results is further price appreciation. and also in turn encourage the public to invest in REITs which will then create demand for the REITS.

Changes in Gearing level:-

REITs can only borrow up to a certain amount to buy its property assets. Since debt cost is cheaper than equity cost, the ability to borrow more due to regulatory changes will result in better acquisition potential (if there is one).

A good example of changes in gearing level is to compare Singapore & Malaysia. In Singapore, REITs assets are funded by debt that is hovering around three percent and equity that are yielding four to five percent compared to Malaysia where the debt cost is five to seven percent and the equity yield (cost) is five to six percent.

• REITs offer an attractive risk/reward tradeoff
• The correlation of REIT returns with other asset classes has declined over the past 30 years
• REITs may boost return or reduce risk when added to a diversified portfolio
• REITs are worth investigating as an addition to many types of portfolios. The goal of diversification is to lower the risk of a portfolio for a given level of return. Because of their declining correlations with other types of investments
  (Source: NAREIT’s website)

Another critical facor is to review its track record namely its proven acquisition track record, and whats are in the acquisition pipeline

The other two interesting performance metric to measure REIT performance are:

• Funds from operation (FFO)
• Adjusted funds from operation (AFFO)

It is important to note that presently there is no fixed GAAP to make all REITS to comply with certain fixed financial reporting hence making these measures as imperfect, but it is logical to think of FFO as a proxy for operating cash flow and AFFO as a proxy for free cash flow. To judge the success of a REIT’s performance, it is important to look at the rate of change in FFO and AFFO.

Like any type of companies, we need to watch the financial heath of the REIT particularly watch out for its gearing ratio. Refer to my article on management needs to be prudent with its capital management.

Understandly, the founders of many REITS are still in management positions and still own large stakes in the REITS ( when they first diposed off their properties, certain portion of the shareholding are still retain by them). This can be a good or bad situation.

So what should we do?

Check out/investigate the capital structure of the REIT to see whether these founders still have privileged voting rights in these REITS, see from their annual reports whether what plans that they said have been fully executed with efficiently and effectiveness, watch out for any restrictive covenants the REITS might have like for example sale restrictions due to agreements with individual shareholders.

Low quality management whether in REITS or in any type of company will not lead it anywhere!

Firstly, what really is Net Asset Value (NAV)?

Net asset value of a REIT is determined by deducting the value of all the fund’s liabilities from the value of all the fund’s assets at the valuation point. In other words, it is the portion of the fund that is owned by the risk takers, namely the REIT’s unit holders. In accounting, we call it Net Shareholder Funds.

As a reference point, let’s look at the balance sheet of a REIT company below:

What happens every now and then is that the REIT’s properties need to be revalued by professional valuers. Any increases or decreases in property prices will directly increase or decrease the net asset value (e.g. for increases in revaluation of properties, the line on properties $ will increase, hence increasing the net asset value for the fund)

Simply, whenever the prices of properties increases and when properties being revalued, the increases in this net asset value will increase the unit holder’s value. However, as you would expect from the stock market, the listed REIT’s market price might not go up hence, there is a potential attractiveness in investing in that particular REIT ( in the long term)

Incidentally, you can sometimes see REIT managers commenting on their fund’s net asset value. A typical example of such a comment has been directly extracted from a Singapore REIT:

“ With the revaluation of assets, the NAV rose 10.5% from $7.72 per Unit as at 31 December 2005to $8.53 per Unit as at 31 December 2006. Compared to the year-end closing price of $5.90 per Unit, XXX REIT is currently trading at a discount of nearly 31%, making XX REIT an attractive investment for long term investors”

This Part 2 deals with WHERE are REIT’s assets being located.

Generally,REITs tend to follow a strategy of either:

• geographical diversity or
• focus

(a) Geographical diversity is when a REIT owning offices situated all over US, Australia, UK, New Zealand ( or in a country alone)whilst

(b) Focus would mean that the REIT will only FOCUS its properties in one country or one area.

Geographically focused REITS depend heavily on local economic conditions and are therefore riskier REITS compared to the geographically diversified competitors.

Incidentally, REITS would attempt to follow strategy (a) or (b) so as to achieve benefits of scale. Benefits of scale include greater negotiating power with vendors and the ability to offer tenants more choices and lower prices

In this Part 1, this article looks at WHAT the REIT owns.

What the REIT owns falls into two (2) categories namely:

(a) the TYPE of property:

• office,apartment,industrial,regional mall shopping center,hotel and healthcare,
• mixed real estates portfolio ( like Vornado Realty which owns office, industrial and retail property and
• unusual properties like entertainment properties, movie theatres, capital automotive (owns car dealership)

What is it so important to understand this?
Some reasons are:

• It is crucial as average lease lengths vary from property sector to another. For example, regional mall REITs and industrial REITs had leases for 10 years or longer, whilst apartment leases are on annual basis. Lease length important because the longer a REIT’s leases are, the more predictable will be its CASH FLOWS! The more predictable a REIT’s cashf flows are, the easier to estimate its intrinsic value.

• Knowing the type of REIT is also important as all REITs are sensitive to basic economic conditions and the degree of sensitivity varies depending on the property sector. For example, regional mall are very sensitive to changes in consumer spending level whist office REITs are impacted directly by changes in the growth rate of office employment.

(b) Knowing the Quality And Diversity Of the REITs customers/tenants

• The quality and predictability of cash flows will be higher if a REIT has leases with diverse set of well-run tenants -Kentucky Fried Chicken,Subway,DHL etc). Vice versa, if a REIT depends heavily on a small number of tenants, on a single tenant or has tenants sufereing financial distress this will therefore lower the quality of the cash flows.