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What is REIT?

REIT stands for “Real Estate Investment Trust”. REITs are companies that own, operate, manage and finance income-producing real estates. REITs are publicly traded on stock market, just like listed stock counters. Here I will explain why REIT is developed from investor point of view, and also from business point of view.

From investor point of view

The concept of REIT was developed to enable participation of small investors in large income-producing real estates. Examples of large scale real estate are shopping mall, factory, office building, hotel, hospital. Without REITs, it is almost impossible for small retail investors to take part in this kind of capital intensive investment.

By paying a small percentage of profit to professional management company, REIT investors do not need to worry about all the hassles on the property business. Income from REIT is distributed to investors as dividend, normally on quarterly or half-yearly basis.

From business point of view

It is important to know that REITs generally do not develop properties from scratch. Real estates owned by REITS are initially developed by other companies.

Why developers do not want to own and operate properties themselves? Normally after a company has developed a real estate and operated it for a period of time, it makes a lot of sense to company to dispose the property for capital gain. Why? Because development of large-scale real estates often involves a huge amount of debt. The debt will set a ceiling for the said company to borrow more money to fund new projects. In addition, after operation of a real estate has been well established, return and growth potential of that property will slow down.

Therefore, by selling established property to REIT, company who originally developed the property can use the money to pursue business opportunities with higher return potential. On the other hand, REIT who acquires the properties obtain an low-risk asset that has already been well established. It is a win-win situation for both.

A typical example is Sunway Group and Sunreit in Malaysia. When income-generating real estates has been developed and established by Sunway Group, it will be injected into Sunreit.

Type of REIT

Based on type of real estates owned, listed REITs in Malaysia can be categorized into six types below.

1. Retail (Shopping mall)
2. Industrial (Factory, warehouse)
3. Hospitality (Hotel, resort)
4. Commercial (Office building)
5. Healthcare (Hospital)
6. Diversified (Mix of property types above)

It is expected that more types of real estates will be injected into REIT market in the future. In Singapore, there is REIT owning high technology property such as data center. In Malaysia, there was once a discussion about setting up an airport REIT.

Business structure of REIT

1. Unitholder – When you buy REIT from open market, you become unit holder.
2. Trustee – Trustee company acts on behalf of unitholder to safeguard their interest
3. Manager – Management company that establishes, operates and manages the REIT.
4. Real estates – Income-generating assets owned by REIT

REIT investing terms and metrics

“unit” vs “share”

Because REIT is an investment trust, similar to other unit trust, investor’s holding is described as “unit” rather than “share”. For stock analysis, we always want to derive earning or asset value on “per share” basis. Similarly for REIT, it is common to describe many terms on ”per unit” basis.

Similarly, when you buy REIT from open market, you become “unitholder” instead of “shareholder”. These two terms differs from each other mainly on two points below

1. Voting right is different. In general, unitholder has a much limited voting right compared to shareholder.
2. Tax scheme is different. Tax scheme for REITs will be elaborated in separate section below.

Net asset value (NAV)

Net asset value (NAV) = Total Assets – Liabilities.

When NAV is divided by number of units in circulation, it represents value of net asset per unit. Many investors like to compare NAV per unit with share price as a quick and preliminary evaluation.

Nature of REIT is to generate recurring income from real estates holdings for unitholders. Unlike asset of other companies that are commonly recorded in financial report as book value (i.e. original cost of asset minus depreciation), market value of real estates hold by REIT is calculated based on net income can be generated by that particular property in future.

In addition, guidelines of listed real estate investment trusts issued by Securities Commission (SC) set up a rule that all real estates in REIT’s portfolio must be re-valued at least once a year.

Therefore theoretically, share price of REIT should not be for away from its NAV per unit.

Earning per unit (EPU)

Earning per unit (EPU) = Total profit of the year / number of units in circulation

Similar to earning per share for normal stocks. This term tells how much profit a REIT company is making per number of unit hold by investor.

Distributable income

Also called “income available for distribution”.

Profit of REIT can be categorized as “realized income” and “unrealized income”. Realized income is rental income from real estates minus all associated expenses and cost, while unrealized is associated with changes in fair value of real estates, typically happen during annual valuation of properties.

Only realized portion of income has been converted to real cash and can be distributed to unitholders, hence the term “distributable income”.

Distribution per unit (DPU)

Distribution per unit (DPU) = Distributable income / number of units in circulation.

It is very similar to the concept of dividend per share (EPS) for regular stocks, which basically tell you how much cash a REIT has returned to unitholders per unit (typically expressed over 12-months period). DPU is much more important than distributable income, because in case of REIT issuing new equity (new shares) to acquire a property, new property can increase distributable income but not necessarily distribution per unit.

Net property income (NPI)

Net property income (NPI) = Gross revenue – property operating expense.

This tells you how well the properties generate profit, taking account of direct cost associated with properties such as maintenance and operating expense.

This term should not be confused with net income. Net income is net property income minus other expenses not directly associated with properties, such as management fee, trustee fee, finance cost, admin expense etc.

Management expense ratio (MER)

Management expense ratio (in %) = Indirect cost / net asset value (NAV)

Indirect cost are expenses not directly associated with properties, such as management fee, trustee fee, finance cost, admin expense, auditor fee etc. MER is an important metric because it tells you how much money is spent on managing the fund itself, so the lower is better from investor’s perspective. MER typically falls in the range of 0.5% to 2%.

Fund from operations (FFO)

Fund from operations (FFO) = Operating cash flow from business activities.

Fund from operations (FFO) shares a lot of similarities with operating cash flow in cash flow statement of financial report, except that it excludes one-time income from sales of asset. So compared to operating cash flow, FFO is a much better metric to measure operating performance. If one-time income does not exist with the period of time reported, then FFO is the same as cash flow from operation in cash flow statement.

Adjusted fund from operations (AFFO) = fund from operations – capital expenditure. AFFO is very similar to the concept of free cash flow (FCC) when evaluating a stock. AFFO tells how much cash flow remains from operation after deducting required capital expenditure to maintain the properties.

When evaluating REIT, price-to-FFO ratio should be used to replace P/E ratio. When investing in REIT, what’s important is how much rental income can be generated from properties because that determines how much dividend you can receive on regular basis. Price-to-FFO ratio excludes fair value gain from property valuation and one-time income from sales of property, therefore it provides a much better insight than P/E ratio.

Gearing ratio

Gearing ratio = total borrowings / total assets

Gearing ratio is an extremely important metric for REIT. This is because regulation enforce a limit on maximum gearing ratio a REIT can have. If a REIT has gearing ratio close to the limit, acquisition of new properties will need to be funded by increasing equity base (i.e. issue new shares).

Gearing ratio imposed for REITs in Malaysia and Singapore used to be 50% and 45% respectively. This limit has been increased to 60% (Malaysia) and 50% (Singapore) due to difficult economic condition as a result of COVID-19 pandemic.

Asset enhancement initiative (AEI)

Asset enhance initiative (AEI), in layman terms, means renovation and improvement of the properties. There are two types of CAPEX associated with REIT, one is acquisition of new properties and the other one is asset enhancement of existing properties.

Whatever the real estate type is, the property will get old or cannot keep up with the latest demand from market. Therefore it is very important for fund manager to always look into AEI so that the properties will stay competitive, this will bring better contract renewal rate, better occupancy rate and better rental rate in return.

Some AEI can be very major that complete or partial portion of the properties cannot be rent out during this period. For unitholders, it is necessary to understand what kind of AEI is being performed and planned.

Occupancy rate

Occupancy rate = proportion of lettable occupied by tenant.

High occupancy rate is an indication that the property is desired by the market. As unitholder, you would want all the properties to be fully rented out for maximum return. For property with low occupancy rate, it is still possible for management to upgrade it through asset enhancement initiative (AEI) to improve occupancy rate.

REIT dividend taxation

In order to promote REITs, government tends to have a very friendly tax policy on REITs. In the case of REITs in Malaysia, as long as REIT distributes at least 90% of taxable income to unitholders, it will not be subject to any corporate tax. However, 10% withholding tax will be deducted from dividend before distributing to unitholders.

Income tax rate for corporate stands at 24% in Malaysia. Even with 10% withholding tax, REIT investors still get 24% – 10% = 14% of tax saving. This is a huge incentive for investing in REIT.

Note that withholding tax is final tax, therefore investors do not declare dividend income from REIT in tax filing. Similarly, there is no tax credit can be claimed based on dividend income for REIT, this statement holds even if you do not have income (e.g. retiree) or you are subject to income tax lower than 10%.

What if a REIT does not distribute 90% or more of its taxable income? Theoretically, this means REIT will subject to corporate income tax. However this scenario has not ever happened in the past as far as I know, but it is very unlikely to happen in future. Waiver of 24% corporate income tax is a big deal, it does not make sense for REIT company to not take advantage of this.

In addition, when a Malaysian REIT acquires or disposes property, the transaction is exempted for stamp duty and real property gain tax (RPGT). This is another huge tax benefit for REIT.

Note: Tax on dividend received from REIT is based on withholding tax system. On the other hand, dividend received from other stock counters are under single tier system (i.e. corporate tax is final and no extra tax will be deducted from dividend paid to shareholders). I’ve written another article about dividend investing, feel free to check it out if you are interested).

REIT investing pros

Here are benefits of investing in REIT instead of actual properties

1. Tax benefits
2. High liquidity
3. Diversification
4. Low barrier of entry
5. Stable passive income source
6. Professional management

Tax benefit – As explained to previous section, income from REIT is only subject to 10% withholding tax. On the contrary, if you are holding a property, your rental income will be subject to income tax, and the tax rate depends on your total taxable income. Waiver of corporate tax, stamp duty and real property gain tax (RPGT) makes further advantage in REIT investment compared to investing in a physical property.

High liquidity – Liquidity is always an issue while investing in physical property. In comparison, by holding a portion pf property through REIT, your holding can be sold in stock market whenever you want. Not to mention in order to dispose a physical property, you need to go through all the hassles of finding a buyer, dealing with agent, liaising with lawyer etc.

Diversification – REIT typically owns multiple properties. There are also diversified type of REIT that owns mixed type of properties (industrial, retail, commercial etc.). So by investing in REIT, your investment gets certain extent of risk diversification by nature. This is something that is very hard to achieve by owning a physical property.

Low barrier of entry – There is no minimum investment capital to invest in REIT, it can be as low as few hundreds to own a small portion of famous shopping mall, hotel, hospital etc. For physical property, 1K is not even enough to pay for transaction fee (stamp duty, MOT, lawyer charge etc.)

Stable passive income source – In order to have the corporate tax waived, REIT has to distribute at least 90% of taxable income as dividend to unitholders. So for investors who seek to build a passive income portfolio from stock market, REIT is a very viable choice.

Professional management – How many of us possess knowledge how manage a office building, warehouse, shopping mall, hospital etc.? By leaving it to the professionals, the investment will have much lower chance to go wrong.

REIT investing cons

Everything has two sides, there is no exception to REIT.

Here are three cons of REIT investing.

1. Sensitive to interest rate
2. Sensitive to change in tax policy
3. Limited growth potential

Sensitive to interest rate – There is no such thing as “net cash REIT”. REIT has to distribute almost all of the realized profit to unitholders. As a result, all REITs must leverage on borrowing to fund the properties. Drop of interest rate will translate into lower interest expenses and therefore beneficial for REIT, and vice-versa.

Sensitive to change in tax policy – A huge advantage of REIT comes from friendly tax policy imposed by government. While it is not foreseen to have any significant change in tax policy, investors must keep this point in mind.

Limited growth potential – Noted that limited growth potential does not mean REIT cannot grow. But if comparing to stocks that could double (or much more) its share price in few years, this is not likely to happen to REIT. There are two factors imposed by securities commission (SC) that limit growth of REIT, which are maximum gearing ratio and maximum allowable property development. These will be further discussed in the following section.

REIT growth

REIT can grow in three ways.

1. Increase rent charged to tenants
2. Implement asset enhancement initiative (AEI)
3. Grow its portfolio by acquiring new property

Increase its rent charged to tenants. The increment can be based on a rate that is already agreed in the tenancy agreement, or it can also be negotiated during tenancy renewal. Of course, how much REIT can increase its rent depending on how much demand is there for that property.

Implement asset enhancement initiative (AEI). With AEI, REIT can maintain or improve its competitiveness, therefore in a better position to negotiate for a better rent with tenants. In addition, it is also possible to increase net lettable area thought AEI.

Increase its portfolio by acquiring new property. With more properties owned, total income of REIT will increase accordingly. However, it is a different story whether can be translated into growth in earning per unit (EPU).

Funding property acquisition

There are two ways REIT can fund property acquistition.

1. Equity financing, i.e. through issuing new units to raise fund
2. Debt financing. i.e. through borrowing

In case of use of equity financing, acquisition only makes sense if it can result in improvement in earning per unit (EPU) despite increase in total number of units in circulation. In technical term, this kind of acquisition is described as “accretive acquisition”. In contrast, acquisition that will dilute earning per unit is called “dilutive acquisition”.

On the other hand for acquisition funded by pure debt financing, it should result in improved earning per unit as long at the property acquired is making profit. However in order to avoid REIT companies to excessively leverage on debt, regulatory body imposes 50% gearing ratio limit for REIT in Malaysia (45% in case of REIT in Singapore).

It is also common for REIT to raise fund through combination of equity and debt financing. When REIT raises fun through equity financing, the enlarged equity base will lower gearing ratio, therefore creating more room for debt financing (borrowing).

Note: Gearing ratio limit has been increased to 60% (Malaysia) and 50% (Singapore) due to difficult economic condition as a result of COVID-19 pandemic.

Growth limiting factors

Growth of REIT is limited due to the following two factors

1. Gearing ratio limit imposed by regulatory body
2. Property development activity limit imposed by regulatory body

Gearing ratio limit. As mentioned above, regulatory body imposes limit on how much REIT can borrow money based on size of equity base. Therefore when evaluating a REIT, make sure to check how much room still available before reaching the limit, i.e. how much room available for new borrowing in case of acquisition of new property

Property development activity limit. REIT is not meant to be developer, instead REIT shall generate stable rental income for unitholders. To ensure that REIT serves its purpose for investors, securities commission has set up a rule saying “The aggregate investments in property development activities (Property Development Costs) and real estate under construction must not exceed 15% of the REIT’s total asset value”. While the intention is good, this rule also place a limit on REIT to carry out aggressive value-added activity on existing properties.

REIT vs property stock

Bursa website has provided a good summary on difference between REIT and property stock. I’ve copied the table from Bursa website in my article, feel free to follow the link for original content.

	REITs	Property Companies
Earning Profile	A REIT is driven by recurring rental income	A property company seeks a combination of property sales, development profits, rental income and property investments
Capital Structure and Cash Flow	A REIT has low and defined level of retained earnings, low debt level defined by the regulators and strong cash flow from operations	A property stock has a high gearing ratio due to high capital expenditure required for property development and sometimes negative cash flow; and low dividend payouts
Dividend Distribution Policy	A REIT will distribute 90% – 100%of its retained earnings before tax	A property stock has no certainty of a dividend payout
Risk Profile	A REIT is a low risk, passive investment vehicle with a high certainty of cash flow from rentals derived from lease agreements with tenants	A property stock has a high development and financial risk
Corporate Governance	REITs are governed by multiple layers of stakeholders – unitholders, manger, trustees, regulating authorities ensuring that interest of minority unitholders are protected	A property stock is often dominated by a controlling shareholder which raises conflict of interest issues with minority shareholders

Can REIT suspend or cut dividend?

The short answer is “Yes”. Below is what stated in Bursa website.

A management company for a REIT is permitted to deduct distribution paid to its shareholders from its corporate taxable income. However, to enjoy this tax-free status, the REIT must have most of its assets and income tied to the real estate and distribute at least 90% of its total income to investors/unit holders annually.

If REIT makes less profit than previous year, of course its dividend will be less. However while it is technically possible for REIT to suspend dividend, it is not likely to happen otherwise the tax-free status will be gone.

Checklist for REIT evaluation

Here I am providing a simplified checklist to find a good REIT stock.

• Dividend yield >5%
• Gearing ratio < 40%
• Share price < NAV
• Growing earning per unit (EPU) & distribution per unit (DPU)

Whether it is for REIT investing or other stock investing, magic formula never exist. As an investor, you have to dig into the details to understand what each metric actually implies. For instance, an asset enhancement initiative might cause REIT to lose portion of its income because operation of property is affected, but it might result in better income once completed. How much you can make profit from an investment is proportional to how much homework you are willing to do.

Official resources

In case you want to read full document issued by Securities Commission (SC) Malaysia to regulate REIT, please follow the link below that will bring you to official website of SC Malaysia.

Guideline on Listed Real Estate Investment Trust

Bursa Malaysia has also a page on common FAQs on REIT investment, click on the following link will bring to you to the Bursa page.

FAQs on Real Estate Investment Trust (REITs)

End

While my main stock investing strategy is on dividend stocks, I do own small portion of REITs in my portfolio. In my opinion, compared to other stock counters, reading financial reports of REITs is a simpler task. Business of REITs is also easier to understand. So REIT investing is a perfect starting point for newbie investors or investors that are lack of time resource.

If you are interested in dividend investing, please read my other article on dividend investing also, the link is provided below.

Ultimate guide For dividend investing