The Basics and Not-So-Basics in REIT investing

With the listing of IGB REIT, the largest real estate investment trust (REIT) thus far in Malaysia, retail investors are now probably all pumped up to invest in the REITs. It is undeniable that the REIT sector is experiencing phenom- enal growth in the recent years. In fact, investing in M-REIT has never garnered so much attention since the framework set upon by the Securities Commission Malaysia (SC) in 2005. However, before you do so, let’s demystify some of the financial jargons used in REIT investing.

Distribution per unit

Although you could call distribution per unit (DPU) dividend, the Inland Revenue Board prefers to use the term ‘income distribution’ to differentiate between income received from REIT and dividends income from other stocks. This is due to the fact that the tax treatment for REIT is quite unique.
For REIT, the tax deducted at 10% in the cheque you received is the final tax. So the taxpayer is not required to declare the REIT income in his or her Income Tax return form and, thus, not entitled to claim for deducted tax.

Income of a REIT is derived mainly from rents collected from the REIT property assets portfolio. In the Statement of Comprehensive Income, this is known as net property income after deducting property operating expenses. The taxable income is computed after deducting non-operating and trust expenses from its net property income (and invest- ment income, if any). Non-operating and trust expenses may include, but not limited to, manager’s management fee, trustee fee, valuation fees, finance costs and auditor’s fee. This taxable income is the lump sum available for distribution to unitholders.

When a REIT manager disposes of a property in their portfolio, it is likely that the net gain on disposal will be distributed to unitholders. This is not the norm, but certainly a welcomed bonus for unitholders. For example, when Axis REIT announced the proposed disposal of Kayangan Depot, it intends to distribute the RM6 million net capital gain or 1.3 cent per unit to investors.

REIT Return on Investment Formula
Just like any other stocks, your total return comes from the stock dividend and capital gain from the stock price. Passive income stream from dividends is almost guaran- teed; so investors who look for consistent income are keen to invest in REIT. Investors who are looking for long term growth may also be keen to invest in REIT because the dividend provides a safety net should the stock price heads south in short term.

Think of yield as your annual investment return by having just the income distribution, assuming the REIT stock price remains hypothetically constant.
Yield is equivalent to total income distribution divided by the REIT stock price for the financial year in consider- ation. For instance, Axis REIT FY11 DPU was 17.2 cents per share, and taking into account its share price of RM2.70 on 31 December 2011, you will get the gross yield figure of 6.3%.

Record Date and Ex-Date
REIT investing is primarily about getting consistent income distribution – either half yearly or quarterly. Therefore, it is important to know your entitlement to the recently announced income distribution. When income distribution is announced, there will be corresponding record date and ex-date. Record date (aka Book Closure Date) is the date when the REIT share registrar deter- mines the unitholders who are eligible to receive income distribution. Essentially, a date of record ensures the income distribution cheques get sent to the right people.

Ex-date refers to the date on or after which the REIT stock is traded without a previously declared distribution. To be entitled for the most recently announced distribu- tion, investors need to purchase the REIT stock in question before the ex-date. And if an investor is already long in a REIT stock, and plans to dispose, it would be wise to dispose of his holdings only on or after the ex-date so he will be entitled for the recently announced distribution.The ex-date is usually two business days before the record date.

Taxation on REIT
REIT is almost certain to distribute at least 90% of its taxable rental income so that it eligible for exemption from corporate tax rate of 25% under Section 61A of the Income Tax Act 1967.

Net Asset Value
Net asset value (NAV) of a REIT is the market value of its assets portfolio, less any debts which are secured by the property. NAV does not directly affect unitholders’ return. However, its per unit metric is used to determine if a REIT stock is undervalued or overvalued from a fundamental analysis point of view.

This is done by comparing NAV per unit of a REIT to its current stock price. If the NAV per unit is higher than the REIT stock price, then it is said to be undervalued and vice-versa.

In real estate property, capital gain during disposal due to property value appreciation is the norm. However, for REIT, investors do not get the benefit of property value appreciation, reflected by NAV.

However, if a REIT reports that one of its property holdings has risen 20% in value, it will not benefit unitholders until the REIT manager sells that property and realised their 20% gain. As long as they still hold onto that property and collecting rent from it, the 20% in value does not benefit investors directly in income distribution.

Also, the realised gain of capital revaluation on disposal is not the same as operating or rental income. Capital gain is tax-exempted in the first place. Therefore, there is no mandate or requirement that 90% of the realised capital gain must be distributed to obtain the tax-exempt benefit like rental income does.
AEI & Acquisition

A well managed REIT is always making improvements to its existing assets to remain competitive, and is always on the lookout to acquire new properties to boost income from its assets portfolio.

Asset enhancement initiative (AEI) includes, but not limited to, renovation and facility refurbishment to its properties.

Direct AEI can add value by increasing net lettable area (NLA) or converting previously unused area into income- generating spaces. This is especially true for retail REITs. For example, Gurney Plaza, under Capital Malls Malay- sia Trust management, has undergone major AEIs in 2011, which includes conversion of certain car park spaces on two of its floors to retail units.

Indirect AEI for retail REIT may refer to appearance or ambience improvement. For instance, upgraded toilets in a shopping mall could attract higher shopper traffic. This translates to brisk business for tenants, which in turn, helps in tenant retention. A highly popular mall commands a premium in rental rate, which results in increasing income distribution for unitholders.

Asset acquisition for a REIT means it is buying and incorporating new properties into its portfolio to increase income. One example of this is the recent acquisition of three Marriott hotels at Sydney, Melbourne and Brisbane by StarHill REIT.

Weighted average lease expiry (WALE) refers to the average lease term remaining to expiry across the portfolio weighted by rental income.
That is quite a mouthful, but here is a simplified illustra- tion of what it means.

When tenancies is about to expire, it is the REIT manager’s responsibility to actively engage the tenants in early negotiations of tenancy renewal, preferably with positive rental reversions. Rental hike would be corre- lated with increasing income distribution for investors. For example, Sunway REIT registered double digit rental reversion of 14.4% in FY2011 in its asset portfolio.

This is to minimise, if not to prevent, void periods as it directly impacts rental income, which in turn, reduces income distribution to investors.

Usually, in the REIT annual or quarterly report, there will be a table illustrating tenancy expiry profile. Having said that, a high number of tenancy expiries per se should not be a cause of concern – it should only be when there is a negative rental reversion or unsuccessful rental negotia- tions.

Gearing Ratio
The gearing ratio reflects the indebtedness of a REIT. Simplified, it refers to total borrowings over total assets value. Although this financial metric is regulated by the SC to not exceed a 50% threshold, a REIT portfolio with gearing of over 40% would tend to raise some eyebrows.

High gearing is significantly more dangerous at times of high or rising interest rates and also low profitability.

Shariah Compliance
Syariah Compliant REIT is managed in accordance with Shariah investment principles and procedures, which are consistent with principles of Islamic law and general considerations of ethical investments in terms of social responsibility in asset selection and structuring.

Islamic law prohibits investors to derive benefits from interest paid on loans, conventional insurance, sale of pork, firearms, and other sin investments related to pornography, gambling, alcohol or tobacco. Business activities that involve short selling and the use of lever- age are also shunned since borrowing contradicts one of the basic principles of Islamic law.

As determined by the Shariah Advisory Council of the SC, the benchmark for the rental percentage of non-permissible activities out of its total rental turnover of mixed activities REIT is 20%. This can be based on the ratio of NLA occupied for non-permissible activities to the total area occupied.

Shariah compliant REIT is, therefore, able to tap into relatively more diverse sources of equity funding and a larger investor base. In Malaysia, such REITs are Axis, Al-Hadharah and Al-Aqar Healthcare.