Certain industries by virtue of their unique characteristics have proven to be stumbling blocks for investors, who are used to reading the financial statements of a typical goods and/or service business.
This is the first in a series of articles where I reveal the nuts and bolts of investing in unique industries like REITs and banks, etc.
I talk about some of the risks that an investor has to assess before investing in a REIT:
Property Cycle Risk
- During good times, rising rentals and property prices stimulate new development activity and eventually overbuilding. By the time the economy falters, weakening demand coupled with oversupply results in decreased occupancy rates and rents. The property market only recovers when demand finally catches up with supply.
Interest Rate Risk
- High interest rates increase the existing interest rate burden and refinancing risk for REITs, and also increase the attractiveness of competing instruments such as bonds.
Legislation Risk
- During the global financial crisis in 2008 and 2009, there were talks of regulators considering removing the minimum mandatory level of dividend payout ratio of REITs to ease the pressure on REITs.
Tenant Risk
- For an office building, MNCs will vacate offices in the event of an prolonged economic recession. For retail malls, retailers will not be able to pay rents to the landlord if they are not earning enough to cover their operating expenses.
Capital Market Dependency Risk
- REITs, by virtue of their business model, have to pay out 90% of their distributable income to unitholders and are unable to retain earnings for growth. As a result, REITs are heavily dependent on the capital market in the form of either equity or debt financing. That is also the reason why Third Avenue prefers Real Estate Operating Companies (REOCs) to REITs.
In Closing
Notwithstanding the risks mentioned above, REITs provide stock investors with two major advantages: (1) Fixed Dividend Payout Ratio ensures a certain minimum amount of dividend periodically; and (2) stock investors are provided with the opportunity to own a diversified portfolio of real estate (albeit as small minority shareholders). Investors should not fear risks, but understand how to diversify, avoid, reduce, transfer risks associated with any investment including REITs.
