November 22, 2019
REITs are something I’ve mentioned in passing many times on the blog.
But today is the day I finally put pen to paper (or is it words to screen?) and delve right into this topic.
Real estate investment trusts come in all sorts of shapes and sizes (literally). We’ll look at the types of REITs available, the pros and cons, as well as the risks involved. We’ll even look at some individual REITs and I’ll share my thoughts on whether they’re worth investing in today.
Real estate investment trusts (REITs) are exactly as they sound – investment trusts that invest in real estate. You’ll also see them called ‘listed property trusts’. Again, they’re simply property investment trusts which are listed on the sharemarket.
A REIT’s purpose is to own and manage a portfolio of real estate for the benefit of shareholders (also referred to as unitholders). This typically means investing in good quality properties with strong tenants and favourable lease terms, then passing the rental income stream on to shareholders.
As is common with property investing and business in general, REITs usually take on a certain amount of debt to grow their portfolio and/or enhance returns. How a REIT manages its debt level is important and a risk which can bring them unstuck (more on this later).
So far, so good. But why would somebody invest in REITs versus a regular company or an index fund?
Most of the time, an investor would invest in REITs as part of their portfolio – not all of it! There are a few reasons why they might do this…
— An investor finds REITs interesting and they feel it’s something they understand. So they may simply be more comfortable with real estate than other investments.
— REITs typically pay a higher yield (often 5-7%) which appeals to some investors. And this rental income is generally more stable than the profits of a traditional business. Also, this cash yield is unaffected by any changes to franking credits.
— REIT income can be tax-efficient. Distributions often come with a ‘tax-deferred’ component, which means an investor will only pay tax on some of the income (this also reduces their cost base for tax purposes, resulting in higher capital gains tax later).
— REITs own essential, tangible assets that many of us use or work in every day.
— Almost all REITs structure their leases to include mandatory rent increases each year. This is either a fixed rate like 3% per annum, or it could be CPI inflation +1-2%. This offers higher certainty around future earnings and income for the REIT and the investor.
— REITs are relatively low effort investments. Not much changes from year to year, so there is generally less to worry about than shares in a typical business.
— Commercial real estate has huge economic value, and much of it is not available for investment on the stockmarket.
Like most things, this last point is debatable. Currently, around 8% of the value of the ASX300 is made up of REITs. An investor may want a higher weighting than this, as they view investing further into REITs is a more accurate reflection of real estate’s value relative to other asset classes.
Or, they may simply want a different balance across asset types. I don’t feel there’s a right or wrong allocation, so everyone has to make up their own mind. Now let’s look at the types of REITs that exist.
The most common commercial property we’re all familiar with is Retail. This includes your neighbourhood shops, large shopping centres such as Westfield and also ‘large-format’ (big-item) retailers like furniture stores, Bunnings Warehouse etc.
Here are a few specific examples of Retail REITs listed on the ASX…
Owns a large portfolio of neighbourhood and regional shopping centres, with 95 properties in total across Australia and New Zealand. Most of the portfolio is in the Eastern states.
They focus heavily on non-discretionary retail, meaning things people have to buy like groceries etc. Given this approach, their main anchor tenants are the big supermarkets Coles and Woolies. At the time of writing, Shopping Centres Australasia is trading on a dividend yield of 5.5%.
Owns and operates the Westfield branded shopping centres across Australia and New Zealand. Given the size, location and value of Westfield centres, this REIT is currently the 17th biggest listed company in Australia!
These tend to be created as ‘destinations’ with lots of entertainment and dining options, in addition to regular retail shops. Scentre Group has an eye-watering 11,000 tenants across its portfolio, offering a diverse pool of rental income. At the time of writing, Scentre Group is trading on a dividend yield of 5.7%.
Aventus owns 20 ‘large-format’ retail centres, mostly in eastern-states metro areas. They have a decent spread of tenants including Nick Scali, Harvey Norman, Bunnings Warehouse, Baby Bunting and many more.
Like most REITs, Aventus looks to add value through sensible acquisitions and re-positioning its current portfolio to its highest use. They have a high occupancy rate of 98.4%, meaning very little space is currently empty. Right now, Aventus trades on a dividend yield of 6.1%. (full disclosure: I own shares in AVN)
If you work in an office, there’s a chance the building is owned by a real estate investment trust. It could be a listed REIT, a private fund or simply owned by a private investor. But most businesses these days tend to lease their premises. Here’s an example of a listed REIT that invests purely in office buildings.
Centuria owns 20 high-quality office buildings worth over $1 billion, located in metro locations around Australia. Over 70% of their rental income comes from multi-national, ASX listed and government tenants.
Centuria invests mostly in well-located fringes of cities, to avoid areas which can be saturated with office space, like the CBD. They also have a reasonably high occupancy rate of over 98%. Currently, Centuria trades on a dividend yield of 5.7%.
An unusual but relatively simple investment proposition. Self-storage REITs develop storage spaces of various shapes and sizes and then rent them out to collect an income.
These are used by people to store possessions and/or valuables, those moving house and increasingly, by small businesses to store goods.
National Storage owns over 160 self-storage facilities across Australia and New Zealand worth around $2 billion. Their properties offer self-storage to individuals and businesses, vehicle storage, as well as climate-controlled wine storage.
National Storage has been expanding its portfolio in recent years with over 35 centres either built or acquired throughout FY 2019. Occupancy rates are typically lower in this type of REIT at around 80%, though they are targeting occupancy of 85-90% over time. National Storage currently trades on a dividend yield of 5.2%.
This category includes production plants, distribution centres and factories. These are large and important pieces of real estate, but can also be riskier compared to an office building for example. That’s because it’s less common for two different manufacturers to need the same style and size of industrial property, for example.
Owns a portfolio of 45 industrial properties around Australia worth in excess of $1 billion. Key tenants include Woolworths distribution centres, Visy packaging, Australia Post and Toll logistics.
As with Centuria’s office REIT, this is the largest purely industrial rent-collecting REIT on the ASX. Centuria Industrial REIT has an occupancy rate of 96% and their portfolio value has grown strongly in recent years. It currently trades on a dividend yield of 5.2%
By now you’ll recognise there are REITs for every possible category of property!
Another one is those which own hotels or pubs and then rent those buildings back to the operators of those businesses.
HPI is the owner of 43 pub and accommodation assets, which are almost exclusively located in Queensland. These properties used to be owned by Coles Group, who are now the major tenant in a joint-venture between Coles and another party.
The occupancy rate is 100% and the average rental increase across the portfolio is currently 3% per annum. HPI is looking to increase its accommodation offer and look to create further income from underutilised land on its properties. Currently trading on a dividend yield of 6.2%.
Another property-type that we use and drive past without thinking much about.
Someone owns those well-located income-producing properties, where people fill up with petrol and grab some food or coffee!
AQR owns a portfolio of around 80 properties which are petrol stations and adjoining convenience food outlets. These are predominantly in metro areas with 57% based in Queensland and the rest spread across the rest of Australia.
Major tenants include Puma, Caltex Woolworths and 7-Eleven. The portfolio has a 100% occupancy rate and very long leases, with 78% of leases locked in until 2030 or later. In addition, nearly all leases contain 3% annual rent increases. AQR is currently trading on a dividend yield of 6.3%. (full disclosure: I own shares in AQR)
By the way, none of these individual REITs are recommendations, okay!? I’m simply providing some examples. And that brings up another point, if you want to buy REITs but have no interest in choosing your own, you can always buy a REIT index fund.
VAP holds a portfolio of the 30 biggest REITs from the ASX300, weighted by market cap. The index has a spread across different REITs such as retail, industrial, office, diversified and others. VAP is managed by Vanguard for a fee of 0.23% per year, at the time of writing.
As tends to be typical of all things in Aussie markets, the REIT index is heavily weighted towards a few big names. The top 10 holdings make up 84% of the fund. As a set-and-forget way to invest in REITs, it’s a decent choice. But I wouldn’t personally invest in VAP (as it currently exists) for two reasons:
— The fund owns property developers and property fund managers, as well as traditional REITs. These firms are more business-like with often wildly fluctuating profits, rather than simply rent-collecting REITs with reliable income streams. If I want to invest in REITs specifically, I want them to invest in buildings and collect rent – nothing fancy.
— With a current yield of 4.3%, this seems low (implying expensive assets) for what is generally a higher yielding asset class. A simple Aussie index fund has a similar yield (and greater when franking credits are included), which comes with far greater diversification and arguably better growth prospects.
This is an interesting idea for Aussie investors. Especially those who want some diversification but also like getting a decent income from investments.
DJRE is an index fund managed by State Street for a fee of 0.50% per year. The fund has over 200 holdings, spread across many developed countries like the US, Japan, UK, Singapore and Australia. Like VAP, it’s also diverse by category with industrial/office, retail and residential being the largest three sectors.
Importantly, to make it into this index, a REIT must ‘have at least 75% of the company’s total revenue derived from the ownership and operation of real estate assets’. In plain English, most of their earnings have to be rental income – not funds management fees or development profits. I really like this criteria.
That’s good for investors who want to invest in broadly diversified real estate and simply collect the rental income. DJRE currently trades on a dividend yield of 3.7% (or it appears 3.2% after fees).
Believe it or not, there are other forms of property trusts too. Those which invest in childcare centres, healthcare centres and some which invest across different property types. There are also unlisted REITs.
Many big real estate investment firms offer direct investment into in their unlisted funds, which are typically much smaller and invest in a couple of holdings or sometimes a single large property. Such companies include Charter Hall, APN Property Group and Centuria.
So, you get the idea by now – there is no shortage of options out there! Which brings us to the next important area to cover.
The first risk to consider is that of single company risk. Even though most REITs own a diverse portfolio of real estate, it’s still run by one management team. Like any management team, they are human and will make errors from time to time.
As you were reading, many of you were probably thinking, “but isn’t this just like picking stocks?” And the answer is, more or less, yes. We discussed REIT index funds being an option to solve this issue.
But as I see it, investing in a couple of REITs is unlikely to be as hit-and-miss as choosing individual businesses looking for the next big growth idea. Because even if the real estate is poorly selected or managed, those assets will always have genuine value in the marketplace. The land and buildings can be re-purposed by a property developer, for example.
Let’s be clear, there are real risks. But the value of real estate helps reduce the risk of a REIT investment being a complete disaster. So what should we consider when looking at individual REITs?
Unlike residential, commercial property tends to have much longer leases. Businesses sign up to leases for multi-year periods – 5 years, 10 years, and even longer in some cases.
As a lease expires, if the tenant doesn’t renew, that leaves the REIT with no income from that property. And these vacancies tend to take a lot longer to fill than your average suburban house!
If multiple properties fall vacant at once, this can be a big hit to a REIT’s income. So carefully managing leases is a top priority. They monitor this by tracking what’s known as the ‘weighted average lease expiry’, or WALE. It’s a bit of a mouthful but it’s very important! The WALE tells us, how long the current portfolio’s leases/rental streams are locked in for.
Obviously, these will vary between different REITs, and a longer WALE is much desired. For example, Centuria Industrial REIT (ASX:CIP) currently has a WALE of 4.3 years. In contrast, Convenience Retail REIT (ASX:AQR) has a WALE of 11.4 years. Big difference!
Another important aspect of leases is contracted rental increases. Most REITs will have a good portion of their leases with built-in rent increases of 2-4% per annum. Either that, or rent increases will be based on CPI inflation +1-2%. It’s important to check this out to get a feel for the likely rate of earnings/dividend growth.
REITs are a cashflow play. So it’s critical to have good quality tenants who can continue paying their rent rain, hail or shine. Clearly, financially strong tenants are a lower risk proposition than Bob’s Budget Botox who is just starting out with a loan from his Uncle.
Government departments and large ASX-listed companies are generally good tenants to have. And you’ll see many REITs proudly mentioning their largest tenants to show off the quality of their portfolio. This info can be found in presentations on their websites.
REITs around the world got caught up in the debt binge of the mid 2000s. Many were highly leveraged with loans which they couldn’t refinance when credit seized up during the GFC. As a result, a number had to offload properties at substantial discounts and cancel dividend payments for a period of time.
This destroyed confidence and shareholders were badly burned. In fact, the Aussie REIT index fell by over 80% during the GFC! The mess was eventually cleared up and these days REITs are typically much more conservative with debt than before.
Currently, most REITs have debt levels in a range of 20-40% of the value of their portfolio. This debt is easily serviced by rental income, and in this environment, taking on debt to grow the portfolio increases their earnings as rental yields are comfortably higher than interest rates.
Thanks to low and falling interest rates, REITs have had a tailwind for a number of years. Interest costs have fallen considerably which has boosted earnings and fuelled higher dividends.
When rates rise again someday, this will act as a drag on earnings growth. So, even REITs with good leases may struggle to grow their dividend at the rate you expect, if rates were to begin rising.
After all this, you’re probably wondering whether I think they’re a good investment in the current environment. Well, to be honest, at current prices I wouldn’t invest in most of the REITs here.
In case you haven’t noticed, REITs have been on a huge run. Many are up 40% or more in the last 18 months! Given their earnings are growing by 2-5% per annum, that type of growth is not sustainable.
Many REITs are trading at a large premium to the value of their assets. For example, some are trading at 20-30% premiums, so we’d be paying $1.30 for $1.00 of assets. Not a great idea. And because of this run-up, yields are now much lower than before.
Why is this happening? Probably a couple of reasons. The uncertainty around the future earnings of regular businesses, given there is lots of disruption these days. This makes predictable earnings like rental income more desirable.
Also, very low interest rates are forcing people to take risk to achieve a decent yield on their money. So perhaps it’s no surprise REITs are trading at a premium.
Regular readers will know we own a couple of REITs in our portfolio. Interestingly, I’ve just sold one because of I don’t think the price made sense anymore. It had grown so much and was trading 28% above the value of its assets, and a yield in line with what I’d get with an Aussie index fund (around 5.6% gross).
Given I expect the ASX300 to achieve higher earnings growth over time than a REIT, the switch made sense to me. I have no clue what’s around the corner, but most REITs don’t look like an attractive risk/return choice right now. So I’d be cautious and selective in this area moving forward.
By the way, there’s absolutely no requirement to venture into the land of REITs. If you own shares in an Aussie index fund, you already have a decent level of exposure.
REITs currently make up 8% of the ASX300. So buying shares in VAS, for example, means around 8% of your savings are going into various real estate investment trusts.
And if you’re an LIC investor, you don’t miss out either. While they all differ, the old LICs each own at least a few REITs in their portfolio. For example, Whitefield has around 10% of its portfolio in REITs.
REITs can provide a solid and tax-effective income stream. They’re underpinned by valuable real estate and have built-in rent increases. But they’re certainly not without risk.
For most of us, REITs are relatively easy to understand and can provide a high yield in a low interest rate environment. For retirees or those paying very little tax, that’s pretty desirable. As a side note, REIT income would soak up excess franking credits if the tax rules on franking refunds changes in the future.
At the end of the day, it’s a personal choice whether to invest directly into REITs or not. If they genuinely interest you, start researching. If you prefer to keep it simple and focus on your main investments, that’s cool too! Either way, it’s probably best that REITs don’t make up a huge part of your portfolio.
We may not own our REITs forever, but right now we’re happy owning some as they’re relatively predictable and provide an attractive level of growing income. And that helps keep the lights on around here, as we enjoy early retirement 😉
What are your thoughts on REITs? Let me know in the comments… and thanks for reading!