Investing in REITs - Really for the yield?

Business model of typical REIT

People invest in Real Estate Investment Trust (REIT) primarily for the stable dividend yield. REITs are supposed to provide good source of passive income for those with neither the cash nor the leverage capacity to invest in typical properties for passive rental income. Is this really so?

Before answering that question, let's look at the business model of a typical REIT. In layman terms, REIT acquire properties and lease them out for rental income. The funds for acquisition comes either from shareholders (share issue), banks (loans) or both. REIT is supposed to pay out ALL profit from rental income less all other business expenses (including bank loan interest) required to keep the REIT alive.

During Good Times

When the economy is booming, demand for factory, office and retail space pushed up rents and hence the record rental income for REITs, pushing up the dividend per unit (DPU) of these REITs. However, the prices of these REIT surge even higher, and hence the yield is actually very low. For blue chip REIT like the Capitalmall Trust, yield got as low as mere 3 to 4% in 2007. At such yield, I am quite puzzled whether the investor are indeed after the dividend yield.

During such time when demand for practically everything is high, profit is easy to come by and credit is even easier. DPU accretive property acquisitions continue to be made even when property bubbles seem to form. Perhaps the REIT management think no matter how much they pay for the properties, with easy credit, they can always milk much more from the tenants. Perhaps investor think the same way too, and look pass the current depressed yields for brighter future returns.


During Bad Times

Unfortunately, all good things must come to an end one day, especially those built on excesses. The subprime crisis put an end to the easy credit and the ensuing recession saw demand for factory, office and retail space plunge, driving down rents and rental income for REITs. Since REITs pay out all their profit, little is left to repay debts and when the loan are due, some faced problem refinancing their debt. Investor confidence in such REITs sunk like a rock in water. For example, Cambridge Industrial Trust, without a strong sponsor and concern was material that it might not survive, its annualised yield at one point went above 25%!

Inherent to the REIT's business model of growth by debt and paying out every cent less all expenses, continual injection of funds is their sole source of life sustaining blood. Thus capital call in form of debt refinancing (at prevailing interest rate) or equity raising exercise via rights or placement is inevitable.

For debt refinancing, the consequent is dip in DPU if interest rate is much higher than before.

But for equity raising exercise, dilution becomes a significant concern for those who do not have the funds to subscribe to rights entitled to them or left out cold in an event of private placement to new shareholders. The latter is especially unfair to current shareholders and normally met with angry shareholders like the recent case of MacAuthurCook Industrial REIT's dilutive recapitalisation plan.

Whichever route the REIT take, by virtue of their business model, high DPUs or high dividend yields are never sustainable.

Conclusion

If high yields or high DPU is not sustainable, is REIT never a worthwhile investment? I don't think so. Like all businesses, each have their intrinsic business cycles and one can benefit by exploiting the ups and down. For REIT, during recession, rents are low, property valuation are low, credit are difficult to come by and share prices depressed. At this juncture, the moment they can sort out their outstanding debt issues (i.e. refinancing, rights, placements), there is no better time to buy them and await the eventual economic recovery.

Thus in my opinion, REIT is better as a one-off capital appreciation investment than long term passive income generator.