If you’re an investor in Singapore REITs you will no doubt have been hit by the rapid collapse of REIT stock prices over the last few weeks [Full disclosure: I’m not invested in any of the Singapore REITs].
In just a period of two-plus weeks, many counters were down 40-50% from their early March highs. Many REITs lost 50% or more. Sentiment on REITs was badly hurt by the escalating measures due to Covid-19 that will keep more people at home instead of going to work, shopping in the malls, and keeping out tourists that would stay in hotels.
Unsurprisingly, the hospitality REITs have done the worst while the healthcare REITs have outperformed. But even “blue chips” like Capitaland Mall Trust were not spared from the carnage.
Thankfully, there’s been a relief rally in the past few days, but Singapore REITs are still down significantly from their recent highs. For investors who have been relying on the REITs as a stable source of retirement or passive income, this has come as a big shock.
Aren’t REITs supposed to be stable, safe investments?
Do you really understand REITs?
REITs have made property investing more accessible as they allowed investors to benefit from the rental income (mainly of commercial properties such as offices, malls, hotels, and industrial parks) in an easily accessible way with low transaction costs. (You can read The Beginner’s Guide to Investing in REITs to learn more about what REITs are and how they are structured. I’ve also previously written about whether REITs or physical properties make a better investment).
But what many investors don’t realize is that REITs are leveraged vehicles. Just like how an individual investor will take a mortgage when buying a property, REITs borrow money to buy their properties so they can offer shareholders attractive yields.
Lenders to the REITs will place restrictions on them, called covenants, that specify how much they can borrow in total relative to their assets (a gearing cap) and an earnings level relative to their debt they have to maintain.
Entering the vicious cycle
In the current situation caused by Covid-19, the rental income of the REITs are almost certainly going to fall. The most sensitive are the hospitality trusts due to a sharp fall in the tourist numbers globally as almost every country is in lockdown. They will feel the hurt immediately.
Mall REITs with turnover rent agreements will also be hit as the revenue of their tenants will also fall significantly, and they have to provide rent subsidies. Office and Industrial REITs with longer lease lock-ins (or WALEs) will fare better in the short term, but as the economy weakens companies will cut back on their leasing needs and rentals will fall too.
When earnings fall, asset values follow. When valuers look at a property with a reduced earnings ability, they will cut the valuation. This could result in the REIT breaching its gearing covenant or the MAS’ leverage limit (currently at 45% debt-to-asset ratio), and force it to either sell assets or raise equity by doing a rights issue.
In a weak economic environment with poor market sentiment where many asset owners are trying to sell, prices get pushed down further. Valuers also look at similar transactions to peg asset values and have to reduce their valuations in tandem.
All of this creates a vicious cycle which usually results in an extremely dilutive rights issue at a low price to “rescue” the REIT.
As an investor, just when you thought things couldn’t get worse as you are already nursing large paper losses on the REIT’s stock price, you get a capital call that forces you to cough up more money or be massively diluted.
How far can REITs fall?
I don’t know how long the Covid-19 situation will last or how much more REITs have to fall. But if we compare the current situation to the Global Financial Crisis, then there’s still a lot of downside.
During the GFC, many high-quality REITs fell by 60 to 70 percent from top to bottom, in a process that took many months. More importantly, many REITs traded at a 50 to 80 percent discount to their NAV. By this measure, REITs still look “expensive” versus their GFC lows and could have a lot further to fall.
I’m not saying that REITs WILL fall to their GFC lows. Maybe Covid-19 passes quickly and everything goes back to normal in a couple of months. Also, REIT managements have learned from the GFC and financial metrics such as interest coverage and debt tenor have improved since then. The MAS may also relax the leverage limit to stop the downward spiral.
But in some ways, the current situation is worse than the GFC as lockdowns and severe social distancing measures means that the revenue hit to hotel, retail and F&B businesses is even greater.
I would caution bargain hunters to be careful about using current NAV/book value numbers and dividend yields to project into the future, as these could fall significantly if Covid-19 turns out to be an extended crisis.
One thing I would certainly not do is use leverage (like margin financing) to buy REITs. In effect, you are taking leverage on a leveraged vehicle. One likely reason for the sharp drop in REIT stock prices recently could be forced selling due to margin calls by investors who borrowed money using their REIT holdings as collateral.
In this time of great uncertainty, stay safe both physically and in the markets as well.
By Mr. Propwise, the founder of Singapore property blog www.propwise.sg, which aims to help people make better real estate buying, selling, renting and investing decisions.