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3 Things that Your REIT may be hiding from you. And Why You Should be Aware of Them.
REITs stands for Real Estate Investment Trusts. Investors of all
ages, in the U.S. and worldwide, invest in REITs directly or indirectly through
mutual funds.
Investors looking to start their so-called ‘dividend investing
journey’ inevitably look towards REITs because of their relatively high levels
of distributable income a.k.a dividend yields.
The business of REITs, to put it simply, is a trust that invests
in commercial properties (hotels, offices, retail spaces etc), which are then
rented to tenants.
The tenants will pay for the rental, which then becomes cash flow
to the REIT; of which a sizeable amount of that cash flow will be distributed
to the REIT’s unitholders.
In an ideal scenario, the REIT you have invested in grows
steadily, their underlying properties becomes valuable to the tenants, and over
time, rental fees increase, as does your dividend pay-out.
But as we know, in reality, especially for business and investing,
things are usually not what they seem.
The misaligned interest between different shareholders;
The headwinds from changing trends in the industry that cause
rental fees to dwindle,
are some of the many reasons why the certain important entities behind
the REIT manufacture artificial dividends, just to maintain or increase yields.
And here are the 3 ways they do so:
No.1 Via Sponsors and their income support
The sponsor can be a company, an investment firm, or a property
developer.
An entity that provides support to the REIT by injecting its own
properties into the initial portfolio of the REIT upon listing. The sponsor is
usually the major shareholder of the REIT, the provider or supporter of
continued credit and equity.
Income support is when the sponsor helps the REIT make up the
difference between the desired rental income and the actual rental income a
REIT gets, artificially supporting the dividend pay-outs.
For example, 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%. An underwhelming, unattractive yield
that turns investors off.
That is when income support comes in. The sponsor contributes
another $5M into the distributable amount.
All else being constant, the expected annualized yields for the
coming years will be no less than 6%.
Now, you might think, well this is good news to the other small
investors, isn’t it?
So what is the problem here?
Well, it is not that straightforward.
On one hand, Income support has its merits, as it keeps a new
investment venture interesting and more viable for investors to give the new
REIT or new property ‘a chance’.
On the other hand, many investors do not know or are not aware
that income support is all but temporary. The extra $5million that is being
supported by the sponsor has an expiry date.
What’s worse is that some sponsors purposely jack up the yield through
income support to make it look like the acquiring the property is “accretive”
to other shareholders. These sponsors do not have the interest of the other
long term investors at heart; they use the REIT as a platform for them to lighten
their balance sheet, albeit at a high price.
The implications:
Income support is bad if the story painted by the REIT managers does
not pan out or the intention of the sponsor was just to ‘dump’ their properties
into the REIT from the very start.
Be aware of any income or rental support that contributes
significantly to the new REIT’s yield ‘accretive-ness’. The two keywords here
are ‘contributes significantly’
Understand that income support cannot go on indefinitely;
eventually, the new property must step up and bring enough rental income to
maintain the overall portfolio yield.
If it can’t deliver, the REIT will be forced to cut its
distribution pay-out.
Don’t be fooled by income support; read through the details of
every property acquisition plans.
Note that, for exceptional REITs, most of their sponsors do not
implement income support. In fact when it comes to exceptional REITs, they are
independent from their sponsors. 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.
No.2
Excluding Major Shareholders from receiving cash dividends
Similar to the notion of income support, 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; doing so helps greatly in maintaining that
illusion of a sustainable high yield. Many REIT Investors are usually unaware
of such arrangements, and I do not blame them, as there is just too much
information to absorb from reading the prospectus or acquisition reports.
The implications:
Simply be aware of these exclusion arrangements. It would be troubling
if the REIT you are holding practices both income supporting and excluding
certain major shareholders from receiving dividend. It goes to show how little
faith they have with the supposedly ‘promising’ new building or REIT.
Exceptional REITs may or may not exclude major shareholders from
receiving dividends initially; 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
No.3
Pay the Management in Shares/Units than Cash
Managing properties, sourcing out for capital, and conducting risk
management strategies are expensive duties under of the purview of the Management.
To conserve more cash and maintain current yields, some REIT
management will resort to paying themselves shares/units instead of cash.
As with income support, there is no free lunch in paying others
with more shares/units instead of cash. If the manager continues to do this,
your share in the REIT will get diluted (you earn less dividends), while the
manager’s ownership becomes larger.
The managers can sell their shares/units in the open market, while
the effects of dilutions remain permanent.
Implication
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.
So, how can you 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’
If the REIT pays its management in units, you will see these
figures in the cash flow statement under operating activities or under the
distribution statement at the end of the report.
Implication:
Compare the overall management fees with the total return for that
period.
Etc: 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!
Summary
So, there you have it! The 3 things you have to look out for when
buying into a REIT or a REIT IPO. Do not assume REIT investing is simple and
easy. Be smart and be aware of the things that go on behind the scenes.
If you are interested to learn how to pick up exceptional REITs,
REITs that do not have all the above financial engineering nonsense (click here)
