Risks in Reits are not what they once were

WE'RE used to thinking of real estate investment trusts, or Reits, as defensive plays that beat the market during times of uncertainty.

But given that Reits are no longer in bargain territory, it's worth taking stock of some of the reasons behind this perception.

So far, the Reit rally has been driven by a lower-for-longer interest rate outlook, which basically reflects the belief that economic growth will remain weak.

Generally, Reits own real estate that they rent out on long-term leases, which should shield their income streams from the direct impact of a business slowdown.

However, resilience also varies across the different Reit sub-sectors based on the unique structural risks that their industries may face, as well as how their leases are structured.

For instance, hotel trusts have fallen sharply from the slump in tourism caused by the novel coronavirus outbreak.

Hotel trusts are said to be the most cyclical of all Reits due to their less-defensive lease structures.

These usually include a sizeable variable rent component that exposes investors to the actual business of running a hotel, instead of simple rent-collection.

For example, more than 90 per cent of net property income at CDL Hospitality Trusts last year came from hotels with leases. Half of all rental revenue was fixed, the other half was variable.

Another Reit sub-sector that has faced structural headwinds is retail Reits.

Globally, many retail Reits that were once considered defensive now trade substantially below book value as they struggle with the pressures of e-commerce.

Singapore's retail Reits have mostly resisted this trend with their focus on non-discretionary spending at suburban malls and a higher proportion of food and beverage tenancies.

But seeing how frantic future-gazing has driven merger, demerger and acquisition activity for retail Reits in every other market, some say it was only a matter of time before CapitaLand Mall Trust made the move to diversify its asset base while it still had the capital to do so, as it has now done with the proposed merger of CapitaLand Commercial Trust.

Of course, investors have been told that mergers are really driven by the need for scale. Increased scale should drive down the enlarged Reit's cost of debt in the long term. However, one can't help but wonder if the wave of consolidation that we're seeing across the Singapore Reit (S-Reit) universe right now could also be a sign that Reit managers are looking at their property clocks and anticipating greater fluctuations in income in the months ahead.

If so, there is safety to be found in a larger, diversified portfolio and lower tenant concentration.

Lower margin of safety

On a broader level, investors also have a lower margin of safety against capital losses today compared to, say, five years ago, when Reits used to offer a 6-7 per cent dividend yield.

Last year, dividend yields compressed to 6.2 per cent across the 44 listed Reits and 4.3 per cent for the benchmark FTSE ST Reit Index.

Finally, S-Reits may also be more volatile than they used to be, with global funds trading them more furiously as fixed income substitutes in recent times.

Last year, the daily average value of S-Reits traded on the Singapore Exchange rose by 50 per cent to S$250 million, accounting for close to 25 per cent of the day-to-day turnover in the Singapore stock market, even though S-Reits only represent 11 per cent of all stocks here by market value.

In 2018, S-Reits accounted for only 15 per cent of daily turnover.

From the start of 2020 to date, the daily average value of S-Reits traded is closer to S$300 million.

While the path of interest rates and the nature of Reits' assets will continue to be the biggest drivers behind how the Reits trade, the experience of the Australian Reit market shows that offshore fund rotations into or out of the larger Reits is another key driver of short-term volatility.

In many ways, the risks in Reits are not what they once were.