This is one of many in a series of articles where I reveal the nuts and bolts of investing in unique industries like REITs, etc.
I will elaborate on certain factors I look out for, when I select the right REITs to invest in.
Single Sector REIT
REITs may own properties in different sub-sectors, e.g. office properties, retail malls, hotels, etc. I prefer REITs which own only one type of property, instead of well-diversified REITs. As academic studies have shown, investors are much better off diversifying risks (at a lower cost as well) on their own, then relying on the management of companies to do so. Furthermore, owning REITs which own a mixture of properties in different sub-sectors, makes it difficult for investors to estimate the underlying sector risk that the particular REIT is exposed to.
Low Financial Risk
REITs have to borrow money (debt) to meet their operating expenses, working capital and capital expenditure needs, as they pay out more than 90% of their distributable income to unit holders, they are unable to utilize retained earnings like non-REITs. A longer debt maturity reduces refinancing risks and allows REIT managers to focus on operating decisions instead of financing issues. Also, the higher the proportion of fixed rate debt, the lower the volatility in interest rate expense.
Longer Lease Terms
REITs which have longer lease terms, have higher earnings visibility as a significant portion of the future rental incomehence dividend income) is essentially “locked-in.” For example, MNCs will vacate offices in the event of an prolonged economic recession. In the case of retail malls, retailers will not be able to pay rents to the landlord if they are not earning enough to cover their operating expenses.
Conservative Fee Structures
Fees are a double-edged sword for REIT investors. High fees eat into the distribution paid out to unitholders, while low fees discourage REIT managers from performing in the best interests of unitholders. REIT investors should choose REITs with reasonable fees compared to peers and performance fee structures aligned with unitholder interests.