5 Criteria I Use To Pick Outstanding REIT

Ever since I have written the article on why I love to invest in REITs, I have been getting a lot of questions on how to pick a REIT to invest.

To tell you the truth, I did plan to squeeze those points into the last article I wrote. But I found that it took me longer to write a comprehensive article (like the Dividend Comprehensive Guide), compared to writing two short articles. Hence I decided to break my contents into small pieces and focus on writing short and informative articles.

Okay, enough with my personal stuff. Before we jump straight into the 5 criteria, let us take a look at the Malaysian REIT data that I obtained from Fifth Person. They provide really useful REIT data which updated in real-time. You may bookmark it if you like.

For the whole article, we will be using this data as an example so you guys can “catch the ball”. Besides, I love providing practical ways for my readers. Okay, let’s get going.

Gearing Ratio

The first thing I always use in REIT screening is the gearing ratio. Gearing ratio is a financial ratio that gauges the borrowings by the REIT with its shareholder’s equity. For me, the gearing ratio is just another term for the debt-equity ratio, which I also use on stock valuation as well.

To be safe, we only invest in REITs with a gearing ratio lower than 40%. This is to ensure that their business can withstand borrowings and afford to pay off them slowly, or at least the interest from their borrowings. If a REIT couldn’t earn enough profits to pay its debt interests, the gearing ratio will be slowly increasing to an alarming state.

Price to Book Ratio

The price to book ratio compares the cost of stocks to the company value if it was broken up and sold today.

Investopedia

To simplify it even further, we compare the stock price to the underlying asset value from the REIT. We can find the Net Asset Value (also known as Book Value) of a REIT from its financial report.

In essence, we would prefer a P/B ratio of less than 1. It means we are paying a share price that lower than the REIT’s asset value. Here is the example of Malaysian REIT data after applying the benchmark for P/B ratio:

Though this ratio only shows us if the REIT is undervalued (when it is less than 1). A lower P/B ratio might also indicate that the REIT is fundamentally wrong. So it is wise to look at more metrics instead of just relying on the P/B ratio.

Distribution Yield

Distribution yield is a metric to measure how much dividends (In REIT, we called it DPU, distribution per unit) we will get from the share price we bought. For your information, the average return of Malaysian REITs is around 4% to 5% in 2019. Not sure if that is the precise data, but I usually take 5.5% as my benchmark. (I will explain later why I use 5.5%)

Here is the example of Malaysian REIT data after applying distribution yield benchmark:

You might be saying, this criteria is a no-brainer right? Just choose the highest yield to get the best result!

Nope. It doesn’t work like that.

From the formula, the distribution yield will change when the share price changes. Hence we should be cautious about REITs with unreasonable high distribution yield i.e. more than 8%. Those REITs share prices may already drop a lot to have such high distribution yield. You can understand how distribution (dividend) yield works in my dividend article.

In another case, we can see some REITs such as Axis REIT and IGB REIT have a low distribution yield. This might be indicating that they have good fundamentals and hence their share prices are high.

In short, I usually use distribution yield as a metric to determine my own intrinsic value of a REIT I am interested in. For example, I will buy Axis REIT when its price is below a point where its DY is higher than 5.5%. (This is not a buy recommendation)

Distribution Per Unit (DPU)

DPU is similar to dividends per share for stocks. In other words, DPU is a metric to see how much profits are distributed by REITs to investors. By noting down the DPU of each REIT in their past years, we can see how the REIT has performed in the last few years.

Here is an example on how you can see if DPU of a REIT is increasing across years:

We would want to see a REIT company that increases their DPU over the years. It means that the REIT is doing better in business and have more profits to distribute.

But then we also need to give and take for the economic challenges they face such as the Covid-19 pandemic. So it is wise to look at a whole picture of the business rather than purely rely on numbers.

Future Prospect

We always used to check how good is the historic performance. And yet without a good future prospect, we will see our investment dropping in values over time. To check how good is the REIT future prospect, I usually break it down into 3 parts:

New Acquisition

As a REIT business, one of the main goals is to acquire more real estate into its portfolio and expand the business. This is the fastest way to grow the business profit and definitely benefit us, the investors as well.

However, it requires a huge amount of money to make a new acquisition. This usually forces the company to borrow money for making that acquisition. Naturally, this will increase the gearing ratio.

We might expect to see the gearing ratio shoot up above our benchmark of 40%, but that doesn’t mean it is a bad thing. In long terms, if the company manages its cash flow well, it will slowly pay off the borrowing and hopefully have the capability to make another new acquisition.

Occupancy Rate

REIT is all about renting out the spaces in properties to others. The ideal case we want to see is every corner and space of its properties are getting rent out. We can measure this by looking at the occupancy rate from the company’s annual report.

Another thing to check is the REIT’s lease expiry profile and renewals. The tenancy contract will have its expiry date and there is a risk that the tenants won’t be renewing their contract. This is known as tenancy risk.

If we look at the example above, there are 47.8% tenancies pending for renewal in 2020. But if the demand for the new spaces is high, the REIT owner can take this chance to raise the rentals during renewal, which increases the profits of the company.

Type of Industry

When we are screening for REIT, it is good to understand the industry for each REIT we are going to invest in. Each industry has its own pros and cons. For instance, you will find retail REITs such as IGB REIT (which own the Megamall Mid Valley) and Pavilion REIT getting hit hard during the pandemic.

By understanding the REIT industry, we will able to be prepared for the potential risk and plan ahead.

Here is a table with asset type (industry) of all Malaysian REITs:

Things to Note

On top of the criteria mentioned above, I would like to top up some info about REITs that worth to know.

Distribution Tax

The government currently imposes a 10% withholding tax on REIT dividends to local and non-resident individual investors. Listed REITs in Malaysia are exempted from annual tax assessment if they distribute 90% of the year’s total income to unitholders.

The Edge Market

Unlike the dividend by individual stocks, income distribution tax from REITs will get taxed before we received it. We will end up having only roughly 90% of the distribution.

Here is an example on how to calculate our net return from REIT:

This is a screenshot of the income distribution declaration (dividend tab) from KIP REIT. From the total income distribution of 1.52 cents, 1.386 cents will be deducted 10% of withholding tax while 0.134 cents are tax exempted. So the net income distribution will be (1.386 x 90%) + 0.134 = 1.3814 cents.

This means we will receive RM138.14 instead of RM152 if we have 100 lot of KIP REIT shares. Initially, I thought it will be direct 10% taxed on every income distribution, but apparently there is some tiny non-taxable distribution there.

There you go, the method to calculate the exact amount of distribution (dividend) you will get from a Malaysian REIT.

Remember why I use 5.5% as my benchmark for REITs? This tax is the main reason. After getting 10% taxed, my distribution return will be roughly 5%, which is my ideal dividend return from my investments.

Conclusion

Just like stock investments, we need to look at both the quantitative and qualitative sides of REIT. Purely relying on the numbers will not make us a good investor. I admit that reading the financial report is tough for new investors, but it will be a skill that worthy to learn.

Here is a summary of the article:

1. To be safe, we only invest in REITs with a gearing ratio lower than 40%.
2. REIT with a P/B ratio of less than 1 means it is undervalued.
3. Personally I prefer REIT with a distribution yield of more than 5.5%, but avoid the one with the highest yield as it might be a value trap.
4. Increasing DPU over the years means the REIT is doing better in business.
5. A good future prospect is crucial to makes our investment increase in values.

After you know how to find a good REIT, all you left is a brokerage account to invest in REITs.

I usually recommend Rakuten Trade as its registration process takes just a few hours compared to direct account brokerage that takes at least 2 weeks.

Here’s an article to guide you through the registration process:

Beginner’s Guide: How to Register a Rakuten Trade Account