This article should be read in conjunction with other articles Part 1 to 6 on evaluation of REITs.For those unfamiliar, append below are some key drivers which can impact the capital appreciation of a REIT :-

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.

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