4 Reasons Why REITs Might Not Be A Great Investment

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Back when i first started investing in stocks, i remember the very first counter i decided on, was a REIT.

Even today, when i initiate novices to stock investing, i still fall back on REITs as a starter option. The reason is simple; an easy-to-understand business model, less volatility than other stocks, and rewarding dividend payouts are all positive aspects of REITs.

Over time however, I’ve come to understand that REITs are not as flawless as they seem. Because of their fundamental business model and regulatory frameworks, REITs also suffer from salient shortcomings which shareholders might not know about.

As investors find out more about this asset class, they will be in a better position to make a calculated investment decision. In this article, we’ll go through 4 important reasons why REITs might not be a great investment for you.

An Opportunity Cost

It’s generally accepted that REITs don’t offer much in terms of capital appreciation. Unlike some stock counters which can multiply it’s value by 3 to 6 times in a span of 1 to 2 years, a REIT would be hard-pressed to achieve more than 100% capital gains in a decade.

Therefore, by putting our money in REITs, we are actually giving up the possibility of collecting better returns in other assets. This might not sit well with investors who have a longer investment time-frame, or desire a much higher return on investment.

Because REITs are required to pay out at least 90% of their net property income as dividends to shareholders, they tend to suffer from a lack of capital to conduct further property acquisitions to expand their portfolios.

Furthermore with properties being their main asset class, while the REIT benefits from the holding power of property, it also needs to work with the sluggish growth of property rental rates, and portfolio value as well.

Rising Interest Rates

Interest rate fluctuations tend to affect REITs directly as their main assets are commercial properties which require large sums of money to own.

Most REITs are constantly in the process of optimizing and paying down their debt which was incurred during the purchase of their respective properties, while also setting aside adequate cash to maintain dividends paid to investors.

In the eventual case where interest rates rise, REITs will need to set aside more money for their debt obligations, leaving them with lesser cash flow to pay dividends to shareholders. This is especially so for REITs which utilize floating-rate debt instruments which increase their coupon payouts inline with the global economy.

An increase in interest rates also makes it more difficult for REITs to raise cash for further acquisitions as they begin to compete against other fixed income instruments such as bonds, fixed deposits, and high-yield saving accounts for capital.

This is because REITs normally attract investors who are looking for income payouts, something which other fixed income instruments can offer, without the implied volatility.

Building A Warchest

Because REITs are unable to accumulate capital for acquiring more properties due to their tax structure, their management is forced to resort to certain avenues to raise capital for expansion.

Funds are normally raised either through debt financing (such as bonds), or private placements / rights issues.

Debt financing involves the borrowing of funds through instruments such as credit facilities, term loans, and the issuance of bonds, which can be secured or unsecured. This affects the leverage ratio of the REIT, and the REIT manager must weight the efficiency of these options based on interest rate trends and market liquidity.

Private placements and rights issues on the other hand, entail the issuing of new shares to either institutional investors or retail investors to raise funds for the REIT’s acquisitions and growth strategy.

This allows the manager to raise substantial funding especially when the REIT’s share price is at it’s peak, but has the negative effect of diluting current shareholders unless they op to take up the rights issue by investing more money into the REIT.

Correlation With Stocks

As REITs are commonly traded like stocks on the local exchange, the monetary value of their shares can be heavily affected by market news and recent events. An example would be March 2020 when the Covid-19 pandemic first impacted Singapore.

During this period, share prices for most REITs fell by around 30-40% due to the debilitating effects of the pandemic. An investor who invested in such counters as a form of passive income might find himself in a very bad financial position indeed.

Luckily, most REITs have since embarked on the road to recovery, but are undeniably still facing headwinds in the form of circuit breakers and intermittent restrictions.

To Conclude

Undoubtedly, REITs are a great equity instrument which retail investors can utilize in their portfolios. The combination of good management, solid dividend payouts, and easy/diversified access to prized commercial properties are all commonly recognized advantages of REITs.

However, REITs also suffer from certain in-built deficiencies which affect them in various ways. It’s therefore important that potential investors recognize and evaluate these pointers in their decision making process when choosing to invest in REITs.

Casey H

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