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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)

Also known as (AREIT) for Australia Real Estate Investment Trusts. AREITs make up one of the largest sectors on the Australian Stock Exchange. 

REITs allows individual investors to gain exposure to direct real estate assets in their portfolio, which were previously close to impossible to gain access into. 

While Australian investors love invest in property. REITs is one of the most accessible means for individual investors to gain exposure to Commercial Real Estate. It is also tax efficient. REIT Distributions does not have franking credits because the income is not taxed if its paid out to investors.