3 key concerns REIT investors should take note of
As the world experiences an uneven recovery from the Covid-19 virus, investors continued to pile into markets driving the S&P and NASDAQ indices to all-time highs. The divergence between reality and stock markets have been explained by some as the lack of any viable alternatives for return as interest rates have plummeted.
On the S-REITs front, industrial REITs have continued their outperformance while hospitality and retail continue to lag. In this article, I will explore some general concerns investors have regarding REITs in order to provide readers with more tools to evaluate REITs.
1. Have equity valuations fully accounted for real estate valuations?
In my opinion, the short answer is 'No' as most valuations would have been done at the last year-end, generally being Dec 2019. In Dec 2019, Covid-19 was still in its nascent stages and valuers were unlikely to have factored in the profound changes that the pandemic has brought about. As cashflow and growth are inputs of certain valuation methods, I think the decline in both would lead to lower valuations when assets get revalued soon.
An example of this valuation decline from book value would be OUE Limited's sale of US Bank Tower for US$430m vs its book value of US$650m (~1/3 lower!). Additionally, I do believe that asset owners are holding back on conducting asset revaluations as this could have a negative impact on loan covenants (Ie. fall in asset value leading to higher LTVs).
2. Could leverage limits be breached?
Leading on from my previous point, this is certainly true as valuations decline. The key concern about breaching leverage limits would be the implications on capital structure. If a REIT is close to breaching the limits, it is more likely to embark on equity fundraising (possibly dilutive). This could be why we are seeing smaller premiums (or larger discounts) attributed to REITs with >40% gearing like ESR REIT and ARA Logos Trust. From a pure property investment standpoint, a 40% LTV is not actually something to be very worried about as private funds do not have such limits and tend to go over 50% LTV. However, being a REIT comes with this trade-off of extra regulations.
For investors with a longer memory, S-REITs undertook extremely dilutive equity fundraisings during the GFC period headlined by blue-chip names like Mapletree Logistics Trust and Capitaland Commercial Trust. That exercise caused a crash in REIT stock prices; the crash was a short-term one and REITs subsequently had a strong run until 2019.
3. When will things go back to normal?
Due to the difficulty in quickly testing for Covid-19, I believe that a return to the old norm will come only when a fast test and a vaccine are found. As earlier mentioned, different REIT subsectors have had different impacts from Covid-19. Subsectors like data centres and logistics are strong beneficiaries from the shift to a virtual economy and stay-at-home nature that comes with Covid-19. Others like hotels have been decimated while the future of retail and office are still up in the air.
For both office and retail, I believe that the longer the pandemic lasts, the more people would be accustomed to flexible working and online shopping respectively. Covid-19 has accelerated nascent trends and this may not be reversible. On the flip side, we have also been seeing office workers pining to return to office as work-from-home arrangements have caused additional stress. Shoppers have also been craving the full sensory engagement that comes with seeing and touching items.
As for hospitality, while it is a short term mega loser, I do think that in the long run, it will recover more than office and retail, especially leisure travel. Corporate travel could be somewhat hampered by greater adoption of virtual conferencing but leisure travel is something I believe society is itching to go back to. Of the top 5 oldest business that have been around since before 1300, 4 of them are hotels. This further emphasizes the intrinsic need that humans have for exploration and discovery.
Conclusion
While the market continues to power on, I do think that the Covid-19 situation has shown the importance of having a strong balance sheet and survivability. These are characteristics that are present in most REITs as they have strict gearing limits and have cashflows backed by assets. When the time comes, I believe REITs will come back in favour.
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