Real Estate Investment Trusts (or REITs) are a very large part of the unlisted asset class. They can provide solid returns, offer opportunities for diversification and reduce your portfolio’s exposure to volatility. There are a few things that you should know before exploring this asset class and we’ll take you through them here.
REITs are structured much like any fund. The trust pools together money from investors and uses that to invest directly or indirectly in properties. Rental income from those properties is then used for their maintenance and development while the profit left over goes into distributions made to unit holders. REITs may be geared for the purpose of developing or purchasing further properties for investment.
REITs come in different varieties. They can be sectorally focused, such as office REITs, healthcare REITs, industrial REITS and so on; or they can be diversified. This article discusses some of the different kinds of REITs available. REITs can hold one or more properties directly, or a collection of them through intermediary trusts and funds. Some REITs can be geographically diversified with holdings in different cities or countries. Others focus on a core portfolio in a confined location. Some REITs are involved in development, others are not. We are going to focus on unlisted REITs and unlisted funds investing in this sector.
If you’re new to REITs, a good place to start is this guide by the ASX and this introduction by ASIC. Some interesting discussions about REITs in the Australian context are here and here. Like any investment, REITs are exposed to all the same macroeconomic impacts that any other asset class is.
The advantages of REITs can include more certainty over distributions in general compared to some other asset classes, good credit ratings and acceptable gearing levels. The weighted average lease expiry (WALE) of a REIT measures the average expiry of tenancy contracts held by the trust. Some WALEs can be quite long term, offering good levels of certainty about future yields. The current low interest rate environment means that debt financing can be obtained at an attractive price promoting future capacity for capital growth.
REITs can be structured in many ways. Some REITs are a single-asset portfolio. The Blue Sky student accommodation fund is an example of this. Other REITs have a portfolio of multiple properties. The Australian Unity Diversified Property fund is an example of this. Some REITs exist as a vehicle to invest in other REITs. The UBS Properties and Securities fund is an example of this. Each of these have different structures, advantages and pitfalls.
A single asset REIT is not a diversified investment and depends on the profitability of a single enterprise. On the other hand, administration costs may be minimal, the team dedicated to a niche area of the market and the offering may be unique. In this case, be aware of tenancy arrangements. In the case of purpose built student accommodation, although the WALE may be very short, the tenancy agreements total in the order of hundreds: this aspect of the investment may be well diversified. On the other hand, if the asset is a single-use, single tenancy property, then you will want to assess the stability of the tenancy as well as the property’s utility on a more general market.
A multi-asset REIT may be diversified over a series of investments at different stages of development and profitability. However, this type of investment structure needs a dedicated and specialist team to manage it. This may increase costs, but these costs and skills will be spread over a number of assets. The yield generated from these properties goes directly to unit holders in the trust without extra layers of management (and fees) to contend with.
A REIT that exists as a vehicle to invest in a diversified portfolio of REITs and related securities is the third alternative structure. These types of REITs hold securities rather than properties directly. It may have small interests in hundreds of properties spread over a number of sectors and a wide geography. However, it sits above other trusts in the management (and therefore the fee) structure. You may effectively be paying the management fees to your specific fund who are paying management fees to all the funds they invest in. On the other hand, your investment may have a lean management structure while at the same time being diversified across sectors and geographies. This type of REIT is less dependent on any single property, sector or area.
There are a few things to be aware of with REITs. While different REITs can be exposed to varying risks, they have some in common. This class of investment is often seen as a substitute for bonds. Rises in bond yields will likely see people substituting out of REITs and into bonds to some degree. So falling bond prices (should the bond bubble unwind) may result in falling REIT prices, too. As always, investing in a product or company because of its fundamentals and not the hype is essential. Different REIT types and sectors have different yields and exposures. Office yields (in Sydney at least) are currently quite strong.
REITs are subject to economic downturn and shocks, just like every other asset class. The chart below shows the ASX 300 A-REIT index before, during and after the global financial crisis until the present. Eight years after the GFC, the index has still not recovered to the level it was prior to the crisis. There are a few reasons for this, including an over reliance on debt funding among some REITs during that period. For an interesting international perspective on debt leverage in REITs and the consequences during the GFC, see here.
Data: S&P Indices. Chart: The Constant Investor.
Unlisted REITs are often evaluated less often than listed property funds. Rather than using the market as a touchstone for value at any given point, these REITs are valued internally by the management team and by independent valuations. This means that over a single period the volatility of the REIT’s valuation may be lower, but the true value of the asset may be assessed at a lag. This is unlikely to be an issue in most cases, but enquiring about the independent valuation schedule of any REIT you are considering will help you assess whether the valuation of the trust is reasonable.
There are some questions you should ask about any REIT you consider investing in.
- What is the current state of the REIT? Is this a REIT with a substantial development portfolio? What are the timeframes around the development? What stage is the development at? How is it being funded – equity, debt or both? How likely is it that development will be delayed? Does your financial plan allow for tolerance in this area?
- What’s the long term plan? Find out what the WALE is, but don’t stop there. What’s the distribution of leases? Does this REIT have a plan for measured, continuous income and growth?
- What is the portfolio? Single asset, multi asset or securities rather than property? What suits your purpose and risk profile? In the case of a REIT specializing in properties directly, what’s the use case of the properties? Are they specialist or generalist? Will tenancies be affected by an economic downturn?
- What are the fees? There is a broad variety of fees and charges in this field, not all of which are easily comparable. Do these fees seem fair and reasonable? Are you comfortable with them?
- What are the objectives and benchmarks of the fund? Remember that benchmarks vary and can do so quite substantially. Research the benchmark, compare it with the fund objective. Then, compare it with the fund’s returns over the medium and long term. Are they very different? What’s a reasonable expectation in this case? How do you think the benchmark will be effected by an economic downturn or an interest rate increase/decrease?
- How and to what extent is the fund geared? What’s the interest cover ratio? Are you comfortable with this?
- What are your withdrawal rights? In securities-based funds, these can be much more free than in properties-based funds. Does this suit your purposes?
Who did we research and why?
In this part of the project, we are presenting profiles on a number of different REITs with varying structures so that you have a good overview of what’s possible in this class of asset as well as a good starting point for your own research. So far we’ve covered the Blue Sky Student Accommodation Fund and we are profiling the UBS Properties and Securities fund as well as the Australian Unity Diversified property fund with more to come.