REITs: What determines their performance?

June 27, 2018 15:46
Within the sector, however, individual REITs typically have rather different growth rates. Photo: Reuters

When REITs were first introduced to the Asia-Pacific markets, they were described as fixed-income like products because of their dividend distribution rules. Because the law usually requires REITs to distribute substantially all of their net income as dividends, REITs have a dividend yield that is typically higher than other stocks and is directly correlated to the rental yield of the underlying real estate markets.

Additionally, REIT valuation is typically based on its net asset value, which references the price of a REIT’s underlying asset portfolio. These defining characteristics mean that investors can approximate the return of commercial real estate by holding a portfolio of REITs.

Within the REIT sector, however, individual REITs typically have rather different growth rates. According to a study in an upcoming book to be published by the HKEJ, since their IPOs, the annualized total return of HK REITs ranged from a negative 0.6 percent to a positive 20 percent. Moreover, the per share dividend growth also differs amongst Hong Kong REITs. Between 2012 and 2017, on average, Hong Kong REITs saw their per-share dividend grew by 6.5 percent per year.

But the top HK REIT saw a 11 percent per year growth over the same time period, outperforming the runner up by over 2 percent per year. As a result, through five years, the top REIT saw an additional dividend growth of 15 percent.

The difference of performance is directly attributable to the strategies adopted by each REIT. Corporate strategies can largely be grouped into three aspects: operating, investing, and financing. REITs with a sustainable outperformance track record typically excel on at least one of these aspects.

Operating strategies include all aspects of the operation to promote a sustainable growth in rental income. Granted, the general health of the overall real estate market, especially its supply-demand dynamics, will determine the market-wide rental growth. However, on top of this market rent, good operators can drive additional growth by improving the offering at its assets.

For example, a mall landlord can promote retail spending by managing the trade mix and brand mix. A mall targeting a young clientele, for example, will likely have different brands and product types than a mall targeting successful professionals. Additional activities, from mall-wide celebrations of Christmas and Valentine’s Day to weekly shows with local celebrities and singers, can drive additional footfall and thus spending. While the specifics differ for each property type, a thoughtful operating strategy can at least maintain the competitiveness of an asset.

However, having good operations is only the first step of generating sustainable per share growth. As the management team determines what a REIT owns in its portfolio, investment strategies will also impact the per share growth rate of a REIT. A REIT may choose to buy new assets, develop assets, and when the timing is appropriate, sell assets to recover cash. In more active markets, merger and acquisition between REITs can also bring value to investors. In short, a REIT should be conscious of its investment options and follow a strategy that will bring the most sustainable growth to the REIT.

Most REIT investors are what is known as OPMI - outside, passive, minority investors - who do not directly benefit from a REIT’s overall expansion. Instead, REIT investors benefit only from the per share growth of a REIT. This is why financing strategies are relevant to REITs as well. Whether it is equity retained from dividend reinvestment plans, debt funding from banks or the bond markets, or secondary issuance, investors only benefit when the cost of capital a REIT faces is at or below the expected return of the REIT’s asset base. If it does not, a REIT will eventually trade at a discount to its NAV, and potentially create a value trap.

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Chief Investment Officer, Admiral Investment Ltd.