What are REITs?
REITs stands for Real Estate Investment Trusts.
Investors invest in REITs directly or indirectly through mutual funds. REITs are very popular amongst investors looking to kick start their “dividend investing journey” due to the high levels of distributable income.
Simply put, a REIT is a trust that invests in commercial properties (hotels, offices, retail spaces etc), which are then rented to tenants. Rental collected will then become cash flow to the REIT. A sizeable amount of that cash flow will then be distributed to the REIT’s unitholders.
In an ideal scenario, investors should wish for:
- the REIT you have invested in grows steadily
- underlying properties of the REIT becomes valuable to the tenants, and over time, your dividend payout increases as rental increases
3 Things your REIT might be hiding from you
In reality, when it comes to business and investing, things are usually not what they appear to be.
Misaligned interest among different shareholders, headwinds from changing trends in the industry are some of the reason motivating REIT to manufacture artificial dividends. This is so that they can maintain or increase yields.
And here are the 3 ways REITs manufacture artificial dividends that investors should take note of:
1) Through sponsors and income support
The sponsor can be a company, an investment firm, or a property developer.
- It is an entity that provides support to the REIT by injecting its own properties into the initial portfolio upon listing.
- The sponsor is usually the major shareholder of the REIT and provides credit and equity.
- Income support happens when the sponsor assists by making up the difference between the desired rental income and the actual rental income for the REIT.
- This artificially supports the dividend payouts.
- The initial portfolio of the REIT can only distribute $5million to 10 million shares for the next 3 years.
- Assuming the price of REIT IPO is priced at $5, the expected annualized yield for the coming years for each shareholder will be less than 3.4%.
- This is an unattractive yield that turns investors off.
However, if the sponsor contributes another $5million to the amount, it increases the expected annualized yields for the coming years to be more than 6%.
While income support helps keep new investment venture attractive to investors, on the other hand, many investors are not aware that income support only temporary. The extra $5million that is being supported by the sponsor comes with an expiry date.
Sponsors can also deliberately jack up the yield through income support to make it more attractive to invest in. These sponsors are merely using the REIT as a platform to lighten their balance sheet, albeit at a high price.
Income support is bad if the story painted by the REIT managers does not pan out or the intention of the sponsor was simply to ‘dump’ their properties into the REIT.
Be aware of any income or rental support that contributes significantly to the new REIT’s yield.
Income support cannot go on indefinitely, and the new property will eventually have to must step up and bring enough rental income in order to maintain the overall portfolio yield.
Should it be unsuccessful in doing so, a cut in dividend will be unavoidable.
*Note: When it comes to exceptional REITs, most of their sponsors do not implement income support. They buy properties that have real potential to be yield accretive and will refuse their sponsor if the introduced property doesn’t fit their criteria.
2) Excluding Major Shareholders from receiving cash dividends
Another way of manufacturing artificial dividends is simply not having the sponsor or other big investors receive dividends during the first few years of the new acquisition or new REIT IPO.
By doing so, it helps maintain the impression of a sustainable high yield. Many REIT Investors are usually unaware of such arrangements.
Simply be aware of these exclusion arrangements. It would be troubling if the REIT practices both income supporting and excluding certain major shareholders from receiving a dividend. It reflects the level of confidence they have with the supposedly ‘promising’ new building or REIT.
Exceptional REITs may or may not exclude major shareholders from receiving dividends initially. It very much depends on the project at hand. But if they do, usually, both major and small shareholders are encouraged to receive units instead of cash dividends. They have an all-inclusive policy
3) Paying the Management in Shares/Units than Cash
Managing properties, sourcing for capital, and conducting risk management strategies are expensive duties under of the purview of the Management.
In order to conserve more cash and maintain current yields, some REIT management resort to paying themselves shares/units instead of cash. Should the manager continue to do so, share in the REIT gets diluted.
This means that investors earn lesser dividends, while the manager’s ownership becomes larger. Managers can sell their shares/units in the open market, while the effects of dilutions remain permanent.
While it can be argued it is always good to align the management’s interest with that of other investors via shares/units, doing it excessively and at great amounts is definitely not a good sign to long-term REIT investors.
Here’s how can investors can quickly find the number of units that REIT managers are getting?
- Simply download the annual report or quarterly report
- Press “Ctrl + F”, and a search bar will appear.
- Type in these few keywords:
“payable in units” or “in units”
Should the REIT be paying its management in units, one will see these figures in the cash flow statement under operating activities or under the distribution statement at the end of the report.
Ask yourself this after comparing the overall management fees with the total return for that period
(Total Management fees/net property income)
- Is the management taking a huge chunk of the property income?
- Are they being excessively paid in units/shares?
If the answers to the above questions are both yes. Be careful!
One way to learn more about REITs and how to select to best of them will be to attend “Dividend Investing Specialised Topic: REITs MasterClass” on Udemy.
Seedly readers can enjoy a special discount rate by clicking here.
Seedly Community Contributor: Ivan Ho
Ivan graduated from one of Asia’s top business schools and trained as a lead trainer in various industries. Ivan is an avid value investor since 2007 and is considered by many as an up and coming leading authority on Dividend Yielding Investments.
With his second published book: Winning with REITs, Ivan looks to help everyday, average investors significantly improve their investment returns and manage their portfolio risks properly.
Editor’s note: The above is a really insightful article by Ivan who is a part of our Seedly community. For readers who are interested in REITs investing, Seedly recently did a Review of all 39 REITs in Singapore!