The real estate industry cycle has been around for many years.
Traditionally, it has several built-in advantages that make it natural for property owners to receive rental income while awaiting for their property to appreciate in value over time. This is due to the higher affluent population group and the higher GDP for the nation as well as decent inflation rise that will all but contribute to an eventual higher property price.
While traditional real estate usually requires high amount of funds to start with and is out of reach by many retail investors, Reits on the other hand are not. They are investment vehicles that is structured to exhibit the same attributes as traditional real estate but more importantly it allows retail investors like you and me with minimal funds to invest in them.
When investors like us buy Reits, the properties owned are generally incorporating a steady income and cashflow predictability into our income-oriented portfolio. Because of this, most of the returns we are getting should be in the form of the dividends that are being paid out. Capital appreciation is a secondary bonus factor, if any due to the nature that they have to pay out more than 90% of their cashflow income as dividends, leaving only a small amount of retained cashflow for any growth opportunities.
How Managers Are Optimizing Their Cost of Capital
Since a REIT is always raising money to grow, its cost of that capital is one of the most important things to help determine a REIT’s long-term investment potential.
There are three sources of capital: undistributed cash flow, equity, and debt.
The cost of capital is the weighted average of all three sources of capital. Undistributed or retained cash flow is by design (and tax law) the smallest but cheapest (free) source of capital.
The next cheapest is debt,measured by the total interest expense it pays out of the total debt, especially in today’s low interest rate environment.
The most expensive source of capital is equity. This makes sense intuitively because each additional share sold is a future claim on a REIT’s cash flow and increases the dividend cost.
Reits Are No Longer Just An Income Play
Gone are the days that Reits are just an income play.
Kep DC Reit – Effective Debt Structure & Accretive Acquisitions
Thanks to the sluggish global economy that encourages lower funds rate and cheap borrowings, managers are looking to tap into the credit liquidity to leverage their portfolio in this era of lower borrowings.
They would tap for as much leverage the company could take before considering for more access to funds via the equity route.
That is because the cost of equity is usually more expensive than the cost of debt and it would make more sense for them to consider debt first then equity as their main cost of capital to structure the most effective leverage for growth opportunities.
To the managers, they would look for pipeline opportunities and maintain a cost of capital that is lower than the cash yield on new acquisitions in order for AFFO and dividend to grow sustainably over time.
REIT’s leverage ratio, measured by key metrics Debt/Asset or Debt/EBITDA, is important because this is one of the major factor that credit rating agencies use to determine how risky a REIT’s profile is. A lower credit rating increases a Reit’s cost of debt capital, which could spiral into lower return on investment for any growth opportunities.
So REITS can grow over time and quickly for as long as they find good opportunities aided by cheap cost of borrowings and a rising share price, which compresses the cost of equity lower when they are issuing shares for funding.
Investors are generally afraid that they will be diluted when REITS increase their share counts over time so this leads to active participation from investors who will but contribute to this gracious cycle that will allow more funds for management to grow and seek accretive acquisition that will allow the cash yield from acquisition to be higher than the cost of capital on the equity.
Growing cash flow and a well diversified portfolio would then lead to a rising share price and capital appreciation for the investors.
In fact, the likely they remain at the top, the easier it is for management to look for external opportunities because the growth play is likely to remain a big part for a rising capital opportunities.
The only likely swan that could break this cycle is a liquidity crunch as well as a black swan event which eventually leads to a credit crunch which typically leads to increase in the cost of capital. But by then, REITS are not alone. All of the companies in all sectors around the world are likely to be impacted as well.
Thanks for reading.
Once again, this article is a guest post and was originally posted on Brian‘s profile on InvestingNote.
Also, we recently did an interview with Brian, to understand how he invested and traded during the SG Active Trading Tournament here.
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