REIT: How does a REIT Grow? Why a Low Dividend Yield REIT Grows Better and More Attractive than High Dividend Yield REIT

When you are prospecting which real estate investment trust (REIT) to purchase, you will choose one REIT with a higher, more acceptable dividend yield isn’t it?

At the same time,

You would want me to recommend you a REIT that has “better prospect”, “more sustainable” that is “for the long term”

There are readers that tell me, they wouldn’t purchase this REIT because the Price to Book ratio is high. That is usually the metric to say asset based investments like REITs are expensive.

Today, I am going to show you that high dividend yielding REITs may not always trumped those low dividend yielding REITs. There are benefits when price to book is high for a REIT.

We also answers the question How does a typical REIT grows over time?

And if you want better prospect and sustainable growth, you have to look at REITs in a different way.

Different Kind of REITs, Different Profile, Different Returns, Different Risks

If you are looking to buy a trust with a manager, managing a group of properties, you have many choices in Singapore. There are currently 37-38 REITs listed on the SGX.

On my Dividend Stock Tracker, you can find majority of them.

You will tend to zoom in to the higher yielding ones, such as Cache Logistics Trust (Dividend Yield 9.2%), Soilbuild Business Space (Dividend Yield 9.3%) or IREIT Global (Dividend Yield 8.4%).

You will tend to shun the lower dividend yielding REITs, such as Parkway Life REIT (Dividend Yield 4.7%), Keppel DC  REIT (Dividend yield 5.5%), Fortune REIT (Dividend Yield 5%).

If you look at these three low yielding REIT’s Price to Book Ratio (PTB), they are respectively 1.4 times book value,  1.3 times book value, 0.7 times book value.

If higher dividend yield and lower price to book ratio are the basic valuation techniques of what is expensive and what is cheap, isn’t the straight forward decision to purchase the high yielding REIT?

Not necessary.

The first thing that you need to be aware of is that dividend yield and price to book are just 2 areas to evaluate. Due to the nature and profile of what is purchased in the REIT, there is a reason some REITs have a higher dividend yield compared to others.

Due to the differences in the demand and land lease of property left, Retail REITs tend to have lower dividend yield then Commercial and then Industrial REITs.

Your Return is Total Return in a Year or Over time Not just Dividend Return

What makes up your return when you invest in a REIT is not just the dividends but also the capital growth.

Suppose you are an investor on the sidelines looking at a particular REIT.

What is going through your head when you are looking at the returns should be:

Total Return in a given year =  Current Dividend Yield + Compounded Capital Growth Per Year

The dividend yield explains itself. It is derived from current dividend cash flow distribution of the REIT divided by current unit price of the REIT.

Compounded Capital Growth can be viewed as the growth of the REIT’s dividend but also the share price.

In a theoretical way, suppose current dividend yield of Capitaland Mall Trust (Dividend yield 5.1%) is 5.1%.

For the next year, if you look at Capitaland Mall again, its dividend per unit should go up from growth, and the dividend yield should be 5%.

For the dividend to stay around 5%, it means the share price has to go up.

For the next year as well.

The opposite is also true, when dividend per share has negative growth. To compensate shareholders, the dividend yield will remain at 5%, but the dividends per unit is smaller. In this case, the share price have to go down.

Your return as a shareholder investor is the dividend yield + capital growth

The Capital Grow or Contract by:

1. Organic – Rental Revision Upwards or Downwards depending on inflation, demand and supply
2. Organic – Filling up vacancies or having more vacancies
3. In-Organic – Purchase of new Property Assets
4. In-Organic – Doing redevelopment or Asset Enhancements on Existing Property

For the benefit of today’s discussion, let us focus on the impact of #3 – In-Organic – Purchase of new Property Assets

How REITs Secure the Capital to Grow

REITs, unlike normal stocks listed on the market are unique in that they are able to pay out their dividend cash flow distributions from their free cash flow.

They are able to pay out higher than net income as they do not have to pay taxes.

This is provided that they pay out at least 90% of their cash flow as dividends.

This is not cast iron and subject to change.

As the REITs payout almost all their cash flow as dividends, they retained very little cash flow to carry out initiatives to grow, such as the purchase of new property assets.

To grow, REITs need to Tap the capital markets.

You need to understand the balance sheet of a typical REIT.

Assets = Equity + Liabilities

In other words, the managers of the REIT can fund new purchase or other capital requirements either by adding to the equity or liabilities.

The following table summarize the common forms the trust manager can sought to finance their new acquisitions:

Different kinds of Capital Raising that you need to be familiar with

1.  Debts to Finance First

#6 is usually the go to option first. This is when cost of debt is cheaper.

However, a REIT cannot be over leveraged and usually when they hit 42% debt to asset, they would have to look for other sources of financing, or wait for the asset value to go up so that the debt to asset ratio will go down.

When the debt to asset goes down, the trust can then fund more acquisitions by debts.

2. Normal Equity to Finance Next

Managers will then turned to #1, #2 and #3.

Placements (#2) are more preferred because existing shareholders are generally not receptive to the idea of having to cough out money from their pocket in Rights Issues to fund the acquisitions. Placements tend to be done when the share price is performing well. When share price is performing well, the cost of equity is cheaper.

The manager might also do a non-renounceable rights issue (#3) when the share price is performing well and the acquisition is accretive. When share price is performing well, the cost of equity is cheaper.

If the share price is not doing well, but due to circumstances, or that the manager wants to force an acquisition, they will call you to put in more money in a renounceable rights issue (#1). This is usually to offer you to put in more equity at more heavily discounted share price (compared to non-renounceable). When they need to discount so much, the cost of equity is comparatively more expensive.

This is usually done when the manager thinks it will not be well received.

3. Hybrid Instruments Next

When both debts and traditional equities are difficult, or that the acquisition is big, then the manager might turned to CPPU, perpetual securities, convertible bonds, perpetual bonds.

These are hybrid between equities and debt, and some do not add on risk to the REIT’s balance sheet (but reduces cash flow to pay the shareholders), while convertible bonds or CPPU can be lower in interest expense, but subject you the shareholder to future dilution.

4. A combination of all the previous

In some complicated situations, or when the deals are too big, a combination of all the previous 3 can be carried out.

When Ascendas REIT wants to purchase an Australian portfolio worth $1 bil or about 20% of their balance sheet AND some Singapore assets purchase, they turned to a combination of:

1. $600 mil in debt
2. Perpetual Securities
3. $200 mil in a 3 for 80 rights issue 5 cents below the last traded price
4. $200 mil placement to institutional investors at $2.29 (last traded price $2.37)

The end result is that they got new assets, and the net debt to asset of Ascendas REIT remains below 40%

OUE Commercial wanted to acquire One Raffles Place so they turned to:

1. $550 mil in CPPU (1% interest rate)
2. $218 mil in renounceable rights issue at $0.555 (9 for 20 shares)
3. $333 mil in debt

Shrewd Managers, who are well connected to good resources, will be in a better position to structure deals to acquire assets.  However, during bad times, resources are tight because most lenders (both finance companies and shareholders) are more apprehensive to provide capital. Then acquisitions will be challenging.

Related: More materials explaining placements and rights issue can be found here, here, here and here

Why High Yield REITs are Constrained by Limited Capital Sources and Accretive Property Asset Prospects

When a REIT like IREIT Global which, have a dividend yield of 9% and a debt to asset of 42%, they do not have much debt headroom to finance a new acquisition when the debt to asset is so close to 45%.

To make it worse, if the asset value plunge they would need to remedy that their debt to asset shooting up.

For a new acquisition to be accretive to you, if you are an existing shareholder, the new property assets net property income yield now, or somewhere in the future have to be greater than the current dividend yield enjoyed by you the existing shareholder, before this proposed acquisition.

In the case of IREIT Global, when they cannot tap by debt, they can go the route of 50% debt, 50% rights issue or placement or a combination of that with preference issues.

If not, IREIT global will have to fund the acquisition by 100% rights issue.

When your current dividend yield is 9%, the trust manager need to find a property asset that yields greater than 9%.

That is a high hurdle.

It is certainly easier if it is the case of Parkway Life REIT, whose dividend yield is 4.7%.

Parkway Life could have an easier time finding an accretive 15 year lease nursing facility that have an net property income yield of 6%.

The difference between IREIT Global and Parkway Life, other than one is a European Centric Commercial REIT and the other a Singapore and Japan Healthcare REIT, is that the market did not recognize the attractiveness of the trust and compress its yield, while the other did.

A Low Yielding REIT and Dividend Growth Case Study – Frasers Centrepoint Trust

When Frasers Centrepoint Trust (FCT) IPO in Sep 2006, the share price was $1.03. 10 years later today it is $2.14.

The share price capital growth is 7.58% per year.

If we talk about total return, FCT have rewarded shareholders well. If you have held it during IPO where they projected a dividend yield of 5.68%.

Your dividend based on cost today is 11.3% yield.

If you are a new shareholder to FCT, the prevailing dividend yield is 5.5%.

FCT’s share price have compressed.

This has benefited the trust manager, but also the shareholders in that there was not a single rights issue carried out.

Much of the financing of acquisitions was done by way of placements and debt. It certainly helps that institutional investors find the projects attractive.

Related: Some past research on FCT

How a Low Yielding REIT Grow its Dividend Per Share, Equity and Share Price in 3 Years

How do we explain this yield compression and acquisition growth in numbers?

Perhaps I can show you by way of an example.

Over 3 years, this REIT will acquire three properties.

We have the following REIT that has the following characteristics:

1. its got a dividend yield of 5%
2. debt to asset ratio of 45%
3. price to book ratio of 1 times

It decides to propose the purchase of a property for $50 mil by way of placing out shares to new institution investors.

This new property comes with a net property income yield of 6%, which is accretive over the current dividend yield you, the existing shareholder enjoy of 5%.

At the bottom section notice the following:

1. Asset base have increase, so is the equity but total debt stayed the same
2. The  number of shares have risen due to the placement
3. The debt to asset is reduced to 42.86% due to a bigger equity base
4. The new dividend yield is 5.06%

Second Year

In the second year, the share price of the REIT rose by 10%.

No more is the share price $0.55 but now it is $0.605. As the share price rose, the prevalent dividend yield is now 4.84% instead of 5.1% previously.

The trust manager decides to propose a new acquisition, this time its bigger at $60 mil.

Again, they decide to do a placement and put out shares to new shareholders at a 5% discount over last traded price of $0.575.

This new property comes with a net property income yield of 5%, which is slightly accretive over the current dividend yield you, the existing shareholder enjoy of 4.84%.

Notice that as the dividend yield is compressed from 5.1% to 4.84%, the hurdle for new acquisition purchase is reduced and more accretive properties come into the picture.

At the bottom section notice the following:

1. Asset base have increase, so is the equity but total debt stayed the same
2. The  number of shares have risen due to the placement
3. The debt to asset is reduced to 40.54% due to a bigger equity base
4. The new dividend yield is 4.83%
5. The price to book is now at 1.1 times

Third Year

In the third year, share price of the REIT goes up another 10% due to its good quality assets, and growing equity base. The trust manager decides to gobble up something bigger at $140 mil.

As the debt to asset have come down, the trust manager have the option of funding the property asset with $80 mil placement and $60 mil from debt. The placement is done at a 5% discount.

This new property comes with a net property income yield of 4.5%, which is accretive over the current dividend yield you, the existing shareholder enjoy of 4.38%.

Notice that as the dividend yield is compressed from 4.83% to 4.38%, the hurdle for new acquisition purchase is reduced and more accretive properties come into the picture.

At the bottom section notice the following:

1. Asset base have increase, so is the equity but total debt stayed the same
2. The  number of shares have risen due to the placement
3. The debt to asset stays almost the same at 40.81%
4. The new dividend yield is 4.68%
5. The price to book is now at 1.2 times

What we can observe

When we line up the three years together we may notice some things:

1. The total equity grew from $550 to $739, 81% in total or 10% per year. When the equity base grows, the share price will be drag along upwards as the asset base becomes more valuable
2. The dividend on cost for you, the shareholder invested at the start of year 1, grew from 5% (0.0275/0.55) to 5.54% (0.0297/0.55) over three years, purely by acquisitions.
3. In this simulation, the price to book ratio remains high at 1.2 times, which makes acquisition easier
4. You the shareholder, did not have to put out a single cent and your DPU and book value per share grew
5. While there are dilution, what matters is that your dividend per unit goes up during this period.
6. The net property income yield of the prospective acquisitions go down and yet it is still accretive

Older Shareholders Benefit While New Shareholders Wonders About the Future

It doesn’t take a genius to figure out, that if you pick a good REIT that is well supported in the market, you stand to make good benefits.

If you are not an existing shareholder, but an investor on the sidelines evaluating this REIT, you will be hoping the management keeps this mandate going.

It means for good REITs, if you sit in them long enough, you will see the benefit compound.

A High Yielding REIT Grows – The First REIT Case Study

Does that mean high yielding REITs are inferior?

Not necessary. Some of these REITs are just neglected and the market have failed to accord them with the right valuations.

One good example is First REIT (Dividend yield 6.5%).

First REIT is a healthcare REIT with majority of the assets in Indonesia.

For a long time, its share price hovered around $0.60 to $0.80. The prevailing dividend yield is 8%.

While 8% seems like a high hurdle to make acquisition, in Indonesia where the risk free rate is much higher, First REIT can still find hospital then that provide a net property income yield of 9%.

They did a rights issue then and after that, the market began to recognize their long 10 years average lease and the share price rose to a high of $1.40 but eventually settled at current $1.30.

At a current prevailing dividend yield of 6.5%, it is much conducive for them to find accretive targets particularly from their parents.

You would hope that your high yielding REIT fall into this picture.

Manager needs to be Well Supported in Various Capital Sources

Another important factor, that needs to be said is that to fund large acquisitions or to consistently fund acquisitions, will require the trust manager to have various funding sources.

The smaller REIT managers lose out when it comes to this aspect.

Trust managers with sponsor backing tends to do this better.

Some complex deals require not just a placement, or debt, but a combination of placement, rights issue, debt and preference issues.

The latest Ascendas REIT (Dividend Yield 6.3%) purchase of Australian assets by way of placement, preferential offering to existing shareholders, perpetual securities and debt. I highly doubt all REITs can do something like this easily.

It will take some time for the dividend yield of a low yielder to catch up to a high yielder

While the majority of the article talks about the virtues of a low yielding REIT, we do require to wait some time before the dividend yield of the low yielder to top that of a high yielder.

In this illustration above, we simulate three different REITs with the same value of $1000. The first REIT is a high yielding REIT with a dividend yield of 9% but its growth in dividend per share is 1%. The second REIT is a balance REIT that yields 7% and its growth in dividend per share is 3%. The last REIT is one where its dividend yield is a low 4.5% but its growth rate is 10%.

The second REIT will take 13 years for the dividend to overtake the first REIT. The third REIT will take 7 years.

However the crux is that it will take some time and it is whether you would want to wait.

One thing of note is that the capital growth of the dividends and the share price might  be very different.

What this means is that while dividend capital growth might be 10%, the share price growth might be a much faster pace, making the low yielder more attractive.

Does this mean that we can buy an Expensive, high price to book, low yielding REIT?

Not so fast.

This article give you an illustration how a REIT grows, why a lower yielding REIT can be attractive.

However, total return is just one selection criteria.

While an expensive REIT can grow, the music have to stop at certain point.

You can load your REIT with numerous assets, but:

1. If the forward economy is not good, with not much jobs and industry, you will have a problem filling up the occupancy of so much assets. Failure to do this will result in a fall in dividend per unit and negative effect on share price
2. If the trust manager is not good at managing their tenants, vacancies, optimizing property assets, the REIT will eventually degenerate

In summary, what is expensive can remain expensive for longer than you anticipate, but the tide or economy will turn such that this growth will have to pause or in the worse case reverse.

You have to respect value always.

How the Manager tackles #1 and #2 to mitigate the impact during down cycles is also a test of quality.

Accretive Acquisitions – Why New Asset NPI Yield versus Dividend Yield?

I need to elaborate a bit here in short.

In general, we evaluate whether an asset should be acquired or not based on its return versus the cost of capital.

Return > Cost of Capital

Cost of Capital could be the various financing methods.

If your cost of capital makes up majority of debts, your cost of capital could be between 2%-4%. If it is preference shares it could be 4.5-5.5%.

For rights issues or placements, the cost of capital, is the opportunity cost of making this acquisitions, or the cost the company, say First REIT need to pay its equity holders. In this case it is the dividend yield of 6.5%.

Hope this helps.

Summary

I hope you have a better understanding of how a REIT could grow via acquisitions.

When I started I always thought that a REIT’s purpose is to distribute the dividend cash flow. It looks like I am not the only one.

George Soros, in his book the Alchemy of Finance, page 61 to 63, wrote about this misinterpretation of common investors:

THE CASE FOR MORTGAGE TRUSTS (February 1970)

THE CONCEPT

Superficially, mortgage trusts seem to resemble mutual funds designed to provide high current yields. But the analogy is misleading. The true attraction of mortgage trusts lies in their ability to generate capital gains for their shareholders by selling additional shares at a premium over book value. If a trust with a book value of $10 and a 12% return on equity doubles its equity by selling additional shares at $20, the book value jumps to $13.33 and per share earnings go from $1.20 to $1.60.

Investors are willing to pay a premium because of the high yield and the expectation of per-share earnings growth. The higher the premium, the easier it is for the trust to fulfill this expectation. The process is a self-reinforcing one. Once it gets under way, the trust can show a steady growth in per-share earnings despite the fact that it distributes practically all its earnings as dividends. Investors who participate in the process early enough can enjoy the compound benefits of a high return on equity, a rising book value, and a rising premium over book value.

You can read more over here.

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