Valuing a REIT: As an equity bond–First REIT | Investment Moats Skip to Content

Valuing a REIT: As an equity bond–First REIT

Introduction

Many folks have asked me how to compare REITs. In general, I don’t have a certain fixed formula but use the usual PE, EV/EBITDA and Discounted cash flow.

For assets that have predictable cash flows, I tend to compare asset A’s yield versus asset B’s yield.

End of the day, we want to evaluate returns of x number of cash flows over a period, per unit risk.

We will use First REIT, which I notice have came down a bit, and that I am invested at 77 cents versus Ascendas REIT, some LTA bonds and SGS bonds.

 

First Real Estate Investment Trust (First REIT) is a trust investing in a portfolio of Indonesian hospitals.

The appeal is a defensive sector, rental that is paid in Singapore dollars, long term tenant lease (15 years + 15 years), cheap renewal of land lease.

The price of this REIT like most REIT have climbed substantially. A look at the price chart shows that an opportunity may be upon us. Technically speaking, the RSI looks oversold and MACD looks to be heading below zero.

The next few days can be a good test of resilience of this stock. Not turning higher could see attractive targets at $0.92 or $0.84, both still higher than my purchase price.

Equity Bond Analogy

A REIT like this with predictable cash flow, susceptible to interest rate movements is similar to bonds or preference shares with fixed maturity or callable dates.

Think your OCBC non cumulative preference shares, LTA bonds that was listed not long ago.

If you take a look at these bonds and preference shares’ yield to maturity they are yielding around 3.8%. That amount looks low compared to the REITs but it only tells you part of the story.

Potential of capital loss

Speaking for Bonds alone, they have the characteristics that if you hold the bond to maturity, you will not lose your capital, provided the company issuing do not default.

The same cannot be say about First REIT or preference shares.

A sum of future cash flow at present value

A healthcare REIT like First REIT have stability due to long lease tenure with a predictable growth rate.

In the case of First REIT we can use a 1.5% growth rate which is roughly their annual rent escalation

I worked out the Internal Rate of Return using a custom spreadsheet to find out roughly how much are future cash flows valued at.

Assuming my purchase price of 77 cents and an annual dividend payout of 6.3 cents, the XIRR works out to be 6.25%.

Since I am using 20 years of cash flow, it is a rather fair estimate  that I am drawing parallels to a bond with 20 year maturity. The upside is that this bond grows 1.5%.

Even at that purchase price, which is 28% below current prices, that looks a shade higher than prevailing corporate bond yields.

It will take you 13 years to earn back your capital.

If we assume First REIT is able to survive longer, say 10 more years, the XIRR becomes much higher at 8.49% versus 6.25%.

What about at current price of $1.02? the XIRR will be 3.02% for 20 years.

Now that looks rather unattractive isn’t it versus a LTA bond you can buy for 10k yield to maturity of 3.8% for less than 10 years.

The LTA bond yields higher for a shorter duration. if it’s a longer duration corporate bond the yield would likely be higher than that.

Compare against Ascendas REIT

When investing, you not only look at it valuation versus historical but also against another REIT, or another asset class.

Here we compare it against Ascendas REIT, which is Singapore oldest and probably one of the biggest REIT in the region.

Because of its strong management, sponsors and wide portfolio, it provides you with a benchmark how attractive it is versus such a big boy.

A look at the 20 year projected cash flow shows that the XIRR is around 2.93%, which is slightly lower than First REIT.

First REIT is leveraged while a bond is not

Remember that, First REIT at this point, is leverage at 15% debt to asset, while if you buy the LTA bond outright, it  is not.

This means that technically, the properties in the REIT returned probably less than the 6.25%, 8.49% and 3.02% projected.

This will mean that if no capital is injected to this REIT, they don’t make much changes to this REIT, it is a worse of investment at this price than a bond or preference shares.

If you compare First REIT against Ascendas REIT in the previous segment, First REIT is lower in leverage versus Ascendas, which means the attractive spread is actually larger, but probably not by much.

Compare against a low risk AAA rated government bond

Why do we invest? It is likely we want a higher return per unit risk.

So when we evaluate First REIT versus Ascendas, we are trying also to pit the returns we get over the same period of time for the same amount of risk.

Obviously returns, risk and time are variable across different assets. But for predictable cash flow assets like REITs you can do that.

The best way is to compare against Singapore government bonds over the same tenure. Since the government bonds are backed by government, they represent the highest quality and lowest risk instruments.

You can get this yield to maturity table off Fundsupermart.com.

A scan shows that a 17.8 years bond currently yields 2.06%.

Your First REIT and Ascendas REIT, at 3%, doesn’t offer much of a diff versus a safe government bond you can purchase for $1000.

The spread is almost 1%. My preference, if solely based on yield return will be a safe bond rather than the REITs.

Other considerations that make REIT valuation a bit more complex

On top of that pitting A against B becomes difficult due to different factors

  1. Management competency. Good management will improve that 1.5% growth rate. Bad management will kill that or even deflate it. How good is First REIT’s management versus Ascendas?
  2. Cash call or rights issue. Since REITs pay out greater than 90% of cash flow, they cannot grow organically without addition capital injection through debts or rights issue, the latter being asking for more money from the share holders. You ask yourself sometimes the rational of paying you 2 years of 7% yield and then the third year they take back from you 20% of the yield and funnel back into the company.
  3. Heavy leverage. REITs are leveraged and heavily leverage companies show good XIRR but that is financial engineering and in the first place we should calculate by removing that layer
  4. Prospect of higher growth. Yield is one factor of the equation and growth in yield is another. Good management have a tendency to managed that better. It also makes your job harder because growth is in the future and hard to estimate
  5. Risk. There are 3 kinds of risk in my dictionary. Since we value based on returns per unit risk over a period of time, risk are hard to quantify in numerical terms and therefore make comparison difficult.
    1. Known Risk – with your research you are able to find out and factor into your evaluation.
    2. Known Unknown Risk – things that may or may not happen but still something you can find out.
    3. Unknown Unknown Risk – risks that is beyond your competency, research capability or known to experts.

Conclusion

Valuing a REIT follows the concept of valuing any other companies. The upside is that REIT has predictable cash flows that novice investors like me can see clearer compare to a Keppel Corp whose cash flow is lumpy and hard to estimate.

You value the returns per unit risk over a fixed period of time. The challenge for retail investors are that different REITs have different tenures and risks are not easily quantifiable by figures or made transparent.

Nevertheless, I have show you roughly how to compare assets with predictable cash flows and growth rate against each other.

You can better evaluate what is a better price for First REIT, versus older First REIT share prices, versus other REITs, versus other instruments.

I run a free Singapore Dividend Stock Tracker . It  contains Singapore’s top dividend stocks both blue chip and high yield stock that are great for high yield investing. Do follow my Dividend Stock Tracker which is updated nightly  here.

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    lewis

    Thursday 31st of October 2013

    Hi, was there an article on xirr? I tried to search online and I couldn't find a very good explanation. Was hoping I could find one here.

    Daniel

    Thursday 23rd of May 2013

    Similar thoughts. I think you should re-access the way you value REITs.

    Kyith

    Friday 24th of May 2013

    hmm.....

    swinger

    Monday 12th of November 2012

    I've the same question as Marti. It is akin to someone buying a property for rental income and getting zero terminal value say after 20 yrs. Wouldn't it be save to assume the terminal value equal to the starting value. The safety factor would be the inflation rate.

    Marti

    Sunday 11th of November 2012

    It is not quite clear to me why you would assume that the REIT only survives so many years before valuing it to 0. That sounds overly pessimistic - in fact it is more likely a REIT would increase in value over time simply because of inflation. Why would the building that a REIT own loose all their value (save for those who only own leasehold properties)

    Drizzt

    Sunday 18th of November 2012

    hi Marti and swinger, sorry for the late replies. Something was on my mind thus i don't really feel like replying.

    The reason i use 20 years is because usually we don't expect to pay for an investment for super long duration. When you go into a business, you project a certain finite payback period. Usually for discounted cash flow they use somewhat around 20 years.

    Now i know not all REITs are lease hold, but the land lease tenure does make a difference. It is a reason why Sabana's manager are worried about the shorten lease tenure to 30 years by the government. It is likely that they will only buy new buildings. The buildings < 20 years old will see investment value drop instead of rise.

    I have projected First REIT at what i believe is an achievable land lease tenure which is 60 years (30 yr +20 yr +30 yr with 20 yrs already elapse)

    the XIRR for 60 years at price bought $1.02 and 1.5% growth rate: 7.66% versus 3.02%

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