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A Crossroad in Investment: Why Investing in REITs can be Good for Your Portfolio
By
C K Wong
June 10, 2021
Key Takeaways:
While the S&P 500 and Nasdaq Composite are repeatedly hitting the news headlines of 2021 by closing at their all-time highs, REITs, a less popular asset class, is recovering at a higher speed from their poor performance in 2020 due to the COVID-19 pandemic. The price ratio (excluding dividend) of S&P US REIT vs S&P 500 is on the verge of an upward trend starting this year. In short, it translates to increased growth in the price of US REITs compared to US equities for this year as US equities are getting pricey. Thus, this fuels the discussion to talk about REITs and presents a deeper analysis of REITs as an asset class in your investment portfolio.
What are REITs? How does its investment nature and structural form make it so competitive?A Real Estate Investment Trust (REIT) is a company that manages, operates, owns and/or finances a wide range of properties in order to earn sustainable rental income and long-term capital growth via property development, merger & acquisition, asset management in the real estate market. The main source of revenue of REITs usually comes from the rental income generated by investing income-producing real estate properties like residential buildings, hotels, warehouses, offices, retail centres, healthcare facilities and the recent booming data centres due to IT advancement, etc. Most listed REITs are subject to certain conditions, like maximum leverage (“Gearing”) ratios and mandatory dividend payouts of distributable income. Therefore, REITs usually deliver a relatively predictable, recurring and higher dividend payout compared to ordinary equities. The contractual nature of rental income provides a relatively stable and conservative income stream for REITs’ investors. At the corporate/trust level, REITs have some tax exemption benefits and thus, deliver most of the profit to shareholders in the form of dividends periodically. Most REITs are publicly traded companies listed at major stock exchanges, for example, NASDAQ, NYSE, SGX, London Stock Exchange, Australian Securities Exchange, HKEX, etc. In term of investment opportunities, there are 3 major reasons to invest in REITs:
REITs have performed steadily in the last 10 years under this prolonged low-interest-rate environment with the support from generous monetary easing and expansionary fiscal policies around the world. Despite the COVID-19 pandemic that has caused the deepest global economic crisis in nearly a century, REITs have had a decent rebound and net positive returns since the pandemic outbreak. Based on the data collected from S&P Dow Jones Indices, S&P Global REIT is leading in YTD performance compared to global equities and fixed income. The average net total return for S&P Global REIT, S&P Asia Pacific REIT and S&P Singapore REIT is 6% to 9% p.a. for the past 3 to 5 years. Although investment in equities generates higher returns in the long run, we did observe that during certain years like 2012 and 2014, REITs had greatly outperformed the broad equity market.Although REITs had a poor year in 2020 due to the pandemic, it is important to note that REITs have had a great leap and recovery in the year thus far where we are expecting to see a larger scale of reopenings and global economic recovery.Adding REITs to Your Portfolio to Enhance Broader Diversification and Increase the Yield
In addition, REITs have had a low correlation in returns compared to equities (0.42) and bonds (-0.0063). It is good to consider adding REITs to your portfolio for diversification purposes to lower the overall volatility within the portfolio. A diversified portfolio also inherently brings the advantage from the volatility of returns among the asset classes by allowing investors to take profit when necessary, especially when REITs have outperformed the rest.
For yield-seeking investors, it is worth noting that the dividend yield from REITs (3.6% - 7%p.a.) are generally much higher and more consistent than the dividend yield from value stocks (~1.5%p.a.) and the yield from investment-grade bonds (1.3%-3.5%p.a.) in the past 10 years. Additionally, in terms of performance, REITs tend to generate higher total returns compared to global high yield bonds which usually offer investors a high coupon payout (5%-12% p.a.) but underperform in capital growth over time.
The Fundamental Analysis of Investing in REITs: The Impact of Inflation vs Economic GrowthAs the COVID-19 situation continues to improve around the globe, economists, central banks and investors are expecting inflation to rise this year (>2%p.a. target). However, it is still not known if the Federal Reverse will start tapering and increase the interest rates in the 2nd half of 2021 or 2022. A higher interest rate will increase the discount rates used to derive and value the NAV of REITs. Similar to fixed income, the value of REITs moves inversely to the interest rates. At this point in time, investors may not worry about the hike in interest rates (especially when interest rates increase from zero) that would affect the NAV of prices as investors can always cost-dollar-average their investment in REITs when the prices become lower and attractive. The inflation we have seen in 1Q2021 and 2Q2021 is probably transitory due to the rapid economy reopening from the COVID-19 situation, recovery from supply chain disruptions and commodity prices rebound which are one-time factors. In the intermediate-term, we also believe that the booming digitalization and automation that advanced greatly as a result of the COVID-19 pandemic will help in reducing long term inflation by applying downward pressures on the labor wages, which remains one of the critical factors that influence the Consumer-Price Index (CPI) that measures inflation. Although REITs are sensitive to interest rates, they do have a certain degree of inflation cover. Generally, contractual leases in REITs have a pre-set periodic increase in rent (flat or linked to inflation/interest rate) throughout the lease term, thus providing some inflation ‘protection’ for investors. Rental income will usually go up during an inflationary environment or remain locked up by contracts during a recession. In the long run, capital appreciation in the real estate market may turn out from general price inflation, limited land supply, inelastic real estate supply, GDP growth and increase in population which further add value to REIT investments. For investors who look for inflation protection in short to medium terms, REITs may not be as good a hedge as gold and TIPS as we still rely on the pace of upward revision for the rental income, which is usually lagged behind inflation data or interest rates.
For broad-market REITs investment like ETFs/Mutual funds, we can observe and access the development of some macroeconomic factors. GDP growth, job creation (unemployment rate) and population growth are the 3 common factors that contribute to the growth of the real value of properties over time. The International Monetary Fund (IMF) has projected that the global GDP growth this year will be 6% and moderate to 4.4% in 2022, which is relatively strong in the past decades. With regards to job creation, the Federal Reserve forecasts that unemployment rates will fall to 4.5% by the end of 2021, trickling down closer to pre-pandemic levels — 3.9 percent in 2022 and 3.5 percent in 2023. All these improving fundamental factors will definitely help in REITs investment as the world is recovering strongly from the COVID-19 pandemic. There are many different types of REITs in the market. Each type of REIT has its own upsides and risks depending on the economic cycles. Presently, we are probably close to the end of the bottoming market or start of a rising market. Cyclical real estate like hotels, malls and offices that were adversely hit in 2020, may see the biggest rebound in places that are reopening and loosening the travel restrictions. In Singapore, investors can consider picking up REITs in sectors such as retail, industrial, warehouse, business park, and hotels while waiting for the economy to fully recover, especially on those distressed REITs due to the COVID-19 pandemic. To evaluate a single REIT, analysts normally use Net Asset Value Per Share (which is superior to book value per share), Price/Funds From Operation, and Discounted Cash Flow approach to compare among the REITs and the industry average. However, we would not discuss this here as we would recommend investing in REITs via exchange-traded funds (ETF), especially for first-time REIT investors. Investing in a single REIT can involve a lot of analysis and need insights of the REIT company, especially the quality of the management team. Bottom lineWith the uncertainties of global inflation and interest rate policies by the Fed, we are seeing a rebound of REITs from extremely low valuations but are cognizant that the rising rates may pose a threat to future outperformance of REITs compared to the broad markets. We would like to recommend investors gain exposure to REIT via ETFs (REIT exchange-traded funds) which are already well-diversified with REITs at a low cost in the real estate market. Investors may do cost-dollar averaging from time to time in REITs especially if it is affected by any unanticipated hike of interest rate or tapering of quantitative easing. The speedy recovery of the global economy may encounter some short-term challenges like new variants of Covid-19 and subsequent lockdowns/travel restrictions. These create some opportunities to buy lower prices of REITs and hold for long-term competitive dividends and capital gain. Interested investors may refer to our REIT ETF/Unit Trust List below for investment opportunities and ideas:
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