Reit Investing: Leverage gone wrong

Reit Investing: Leverage gone wrong

In learning how to invest your money in Singapore as a beginner, it is important to keep a tab on what can potentially go wrong with an investment. An investment is meant to provide a return while at the same time ensuring a healthy preservation of capital. However, sometimes we do not get the promised returns and other times we even lose our initial principal. Such is the risk of making an investment. Hence it is always important to look beyond Real Estate Investment Trust Singapore Dividend Yield and quantify what can go wrong when you buy into a Real Estate Investment Trust.

Balancing Optimism with Conservatism

There are of course the typical mistakes that we can get ourselves into. That includes being too optimistic about the investment, buying at overly expensive prices. Of course there is also the error of omission where we miss a good opportunity out of our fear. However, these mistakes in executing an investment decision is a topic for another day. Today we will be talking about how the management of a REIT can mess things up for you if they do not handle leverage well.

Why do Reits have to take on debt

Every REIT has to deal in debt. That is quintessential of a REIT’s business model. Why is that so? This is because the REIT is required by law to distribute at least 90% of its net income to its unit holders, leaving very little surplus every quarter to plow back into its operations. Without cash flow from operations to invest in new projects, Reits require alternative sources of financing such as capital recycling ,equity raising. However, debt remains a key tool in a REIT’s toolbox to generate the required return for its unitholders.

Apart from being an important source of financing, debt also helps to increase the return on equity for the REIT unit holders. Assume that the net income for the REIT is 100 dollars and the total equity is 1000. Assuming that no leverage is used, Return on Equity will be 10%. Now assume that the company has 400 in equity and 600 in debt. This will also mean that the company will have an interest expense of say 5% (i.e. 30 dollars). This leaves us with an adjusted net income of 70 dollars and a Return on Equity of 17.5% which is higher than the original ROE of 10%. Hence, debt can help to dramatically increase shareholder equity.

Over Leveraging

The one thing that a REIT manager can do to potentially cause heavy damage to the business is to over leverage. You may think that is not a possibility especially since MAS has legislated that Reits in Singapore can only gear up to 45% of their total assets. While this is indeed a cause of comfort, there are two primary ways where things can go wrong.

  1. Within the gearing limit of 45%, the company can bring it so close to the limit that any downward valuation of their investment property can cause them to breach the limit.
  2. Management can invest in massive projects that creates a huge bullet repayment in any particular one year. If the project falls through, the company may not have sufficient cash flow or cash on hand to pay the bullet repayment.

Apart from the perfectly legitimate way of creating a liquidity crisis due to ineffective debt management, there are also more illicit ways to get above and beyond the 45% debt/asset restriction. This often comes in the form of off balance sheet financing. One good example will the the financing of joint ventures. The reit can participate in many joint ventures which can on their own take on more debt without actually contravening the debt limit at the reit level. The problem with such behaviour is that when debt goes sour, it may or may not have recourse to the Reit. If the debt obligations are due payable by the reit, the latter will suddenly have a sharp increase in debt liabilities on its balance sheet.

Conclusion

A reit is supposed to be a stable investment vehicle will recurring cash flows from its property portfolio. In so far as the degree of leverage threatens the stability of the business model, you can consider the reit to be over leveraged. At this point, it does not matter how high the return on equity is as the risk adjusted return is likely to be very low.

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