5 Key Factors to Choose the Best REIT Stock Today

5 Key Factors to Choose the Best REIT Stock Today

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How to Choose the Best REIT in Malaysia

In the previous article, I explained about everything you need to about REITs in Malaysia before getting started in stock investing. REIT is commonly known as the best choice for those who are new to stock investing in Malaysia. But most would find it difficult to choose their very first REIT stock.

Don’t you feel the same? Well, you are certainly not alone…

The fact is, choosing a winning REIT might not be as difficult as you have always thought.

And, today I’m going to show you how to choose a winning REIT in Malaysia by looking at 5 important factors.

Let’s dive right in.

1. Quality of Management

Imagine you own the best horse breed for racing, which is also well-trained and well-fed. But if an amateur jockey rides it, do you think the horse could win the race easily?

Horse Racing

Similarly, you may own a REIT that has a portfolio of AAA-grade real estates with strategic locations and great potential. 

What if the management who manages the REIT is incompetent or only prioritises its interest rather than yours?

Not only you would not earn any positive investment returns, but most likely you would suffer losses in the long run.

Therefore, management’s quality is a key factor to consider when choosing a REIT stock. The management plays a vital role to ensure the long-term success of a REIT. 

It’s not surprising after looking at the responsibilities that they shoulder:

  • Maintaining high occupancy rates; 
  • Maximising rental rates;
  • Making decisions on acquisitions or divestment of real estate;
  • Making financing decisions such as the issuance of equity or obtain loan borrowings for expansion;
  • Carrying out asset enhancement initiatives to preserve or enhance the value of real estate;
  • Developing a long-term strategic plan to maximise investors’ value.

Competent management will always make operational and financing decisions that are in the best interest of the investors.

The question is, “How do we evaluate the competency of the REIT’s management?”

It’s fairly straightforward.

How do we evaluate the competency of the REIT’s management?

Every decision that the management makes would have a direct impact on the long-term success of a REIT. Therefore, the easiest way to evaluate the management’s competency is to look at the REIT’s performance track record. 

Distribution per unit (DPU) measures how much investors get for each unit they own in the REIT. 

Below are the examples of two REITs in Malaysia with growing and declining DPU respectively.

Reit Malaysia - IGB REIT Distribution per unit from 2014 - 2018
IGB REIT DPU from 2014 – 2018 (Source: IGB REIT Annual Report FY2018)
Reit Malaysia - CMMT Distribution per unit from 2014 - 2018
CMMT DPU from 2014 – 2018 (Source: CMMT Annual Report FY2018)

Net Property Income (NPI) measures the operating profitability of a REIT. It’s the residual income after subtracting the operating expenses (e.g. repair and maintenance, taxes, insurance, etc) from the gross rental income.

Choose Best REIT in Malaysia - Net Property Income Formula

Below are the examples of two REITs in Malaysia with growing and declining NPI respectively.

Reit Malaysia - IGB REIT net property income from 2014 - 2018
IGB REIT NPI from 2014 – 2018 (Source: IGB REIT Annual Report FY2018)
Reit Malaysia - CMMT net property income from 2014 - 2018
CMMT NPI from 2014 – 2018 (Source: CMMT Annual Report FY2018)

Sustainable growth in NPI and DPU over time often proves the management’s ability to improve earnings.

Some investors form their judgment based on the decisions that the management make especially during the challenging times. A REIT with resilience to an economic downturn tends to outperform its peers at all times.

Key takeaway: 

When you choose a REIT stock, always choose the one with growing DPU and NPI. Whether the management is competent or not is somewhat subjective, but numbers will never lie.

2. Types of Real Estate

REITs have different categories depending on their underlying types of real estate.

Choose Best REIT Malaysia - Concrete Buildings

Different factors affect the economic value of each type of REIT. And of course, its suitability as an investment at different times.

You might think that a REIT is still a REIT. Why does it matter?

Just think about it. 

During a recession, you might not take vacation travel to save costs. But you would still need to visit the doctor when you are sick. At such times, does it make more sense to invest in the health care industry which is non-cyclical?

Likewise, each type of REIT performs differently under different economic circumstances. Besides, changes in demographic factors also affect the valuations of REITs.

Let’s now look into the different categories of REITs as well as the primary factors that affect their economic value.

a) Retail

Characteristics:

Invest in shopping malls. The anchor tenants normally have very long fixed-rate leases. Smaller tenants pay a minimum rental and a % of sales after hitting the minimum threshold. 

Key consideration factors:

  • Growth in retail sales
  • Job growth
  • Rental rates (per square foot)

b) Office

Characteristics:

Owns office buildings. The lease term is usually long (5 – 25 years). 

Key consideration factors:

  • Office space supply vs demand
  • Job growth
  • Quality of office space (location, age and condition of the building)

c) Residential

Characteristics:

Invests in rental apartments/condominiums. The lease term is usually short (1 year). Rental income is volatile.

Key consideration factors:

  • Population growth
  • Job growth
  • Cost of homeownership
  • Demographics and income trends

d) Health Care

Characteristics:

Rent properties to health care providers. 

Key consideration factors:

  • Population growth
  • New space supply vs demand
  • Insurance cost
  • Government funding

e) Industrial

Characteristics:

Own properties used in manufacturing, warehousing and distribution. The lease term is usually long (5 – 25 years). 

Key consideration factors:

  • Growth in retail sales
  • Population growth
  • Proximity to transportation (airports, roads and ports)
  • Trends in tenants’ requirements

f) Hotel

Characteristics:

Rent properties to hotel management companies. Rental income is highly volatile.

Key consideration factors:

  • New space supply vs demand
  • Job growth
  • Occupancy, room rates, operating profit margins vs industry averages
  • Maintenance expenditure
  • Financial leverage

Key takeaway:

The growth in the overall economy drives the value of REITs. First off, good economy results in more job opportunities which increase demand for office space. Secondly, it also boosts consumer spending that increases retail sales and demand for hotel rooms.

But each type of REIT has different risks and sensitivity to economic and demographic factors. Therefore, you should always look at the underlying types of real estate before choosing a REIT that fits your investment criteria.

3. Quality of Real Estate

The quality of real estate has a significant impact on a REIT’s rental and occupancy rates. 

Choose Best REIT Malaysia - Old Buildings

Below are the three primary factors that determine the quality of real estate.

a) Age

An aged property tends to have more structural and functional problems than the new one. The depreciation of the property would in turn results in lower occupancy and rental rates.

Sungei Wang Plaza, a shopping mall held by CapitaLand Malaysia Mall Trust is a great example.

Sungei Wang Plaza was once the most popular shopping destination for both locals and tourists in Malaysia. It’s located at Kuala Lumpur’s central business district, also known as the “Golden Triangle”.

However, the glorious days are long gone. 

Sungei Wang Plaza Interior
Sungei Wang Plaza Interior

There goes my childhood memory…

So, the older the properties, the poorer the quality? 

Not necessarily. It hinges upon the ability of the REIT management to maintain and preserve the property. 

Competent management would carry out asset enhancement initiatives (AEI) strategically to maintain the competitiveness of the aged properties. Not limited to only refurbishing the property’s premises, but also continuously improving its functional characteristics and appearance.

b) Physical Condition 

The physical condition could be vastly different between new properties. 

Other than the property’s aesthetical characteristics, the net lettable area (NLA), building systems and amenities also make a huge difference in quality between different properties.

Undoubtedly, the physical condition of property would also deteriorate over time if the management does not maintain it properly. 

c) Location

The last criterion is no-brainer. 

It’s indisputable that a property with a strategic location commands a much higher value.

Would you prefer visiting a shopping mall which is located at the doorstep of a train station? Or, a shopping mall that requires you to take a train, then a bus and finally a 30-minute walking distance before reaching it?

However, a strategic location means differently for each type of REIT. 

For example, the proximity to transportation such as airports and ports is critical for an industrial REIT. In contrast, the proximity to tourist attractions for a hotel REIT is more important.

Key takeaway:

The quality of real estate affects the earnings power and performance of a REIT significantly. 

Before choosing a REIT stock, always ask yourself this question.

“Do I like the properties that the REIT is holding?” And, “WHY?”

4. Financial Strength of a REIT

Choose Best REIT Malaysia - Bank Notes

A REIT has to distribute at least 90% of its income to enjoy corporate tax exemption. 

Since REITs distribute most of its income, the residual income available for reinvestment is limited. 

Therefore, REITs can only finance real estate acquisitions for expansion either through loan borrowings or issuance of additional shares. And the former option is more favorable to the investors as the cost of debt is generally cheaper than the cost of equity.

That’s when the financial strength of a REIT comes into play.

A REIT with less debt burden has a higher capacity to take on more borrowings and service its interest cost. The debt-to-assets ratio is the common metric used to measure the financial strength of a REIT.

Debt to Assets Ratio Formula

A lower ratio shows that a REIT has greater opportunities to acquire real estate and grow its earnings without causing an excessive financial burden.

The leverage ratio is more meaningful when you compare it against the industry average. This is because the optimal debt level differs for different industries depending on the nature of the business. 

Key takeaway:

A highly leveraged REIT has a higher risk of insolvency and would impair your investment in the event of bankruptcy. In contrast, not only a REIT with good financial strength is less risky, but also has better opportunities to grow its assets with debt capital.

5. The Valuation of a REIT

The valuation of a REIT is definitely the deal-breaker for me. 

5 Key Factors to Choose the Best REIT Stock Today

You might come across a REIT that meets all the criteria of a fantastic REIT. A REIT that owns AAA-grade real estate, outstanding performance track record with high earnings growth and distribution yield.

Sounds very appealing, isn’t it?

But the key rule of investing in stocks is, never buy a stock at a price higher than its worth. The cheaper the stock, the higher the potential upside you might earn when the stock price converges to its intrinsic value. 

Price to Net Asset Value (NAV) ratio is commonly used to determine whether a REIT stock is under or overvalued. 

NAV simply refers to total assets minus total liabilities. Worry not, the information is always available on the annual reports of the REITs.

Choose Best REIT Malaysia - Price to NAV ratio formula

Again, looking at the ratio in isolation does not give meaningful information. Always compare it against other comparable REITs to see if it’s under or overvalued.

What if you have finally found a hidden gem after spending day and night but it seems more expensive than what it should be.

The chances are you might face a dilemma…

You might also think, “It’s just a bit more expensive. It’s the best performing REIT at all times. Let’s give it a try!”

My advice is, hold your thoughts. Patience is the key to success in investing in stocks.

Key takeaway:

Never buy an overvalued stock no matter how great it is. Keep it in your watchlist and wait for the best timing. 

Final Thoughts

Investing in REITs Malaysia is always a great choice for stock investors to build long-term wealth due to low price volatility and high dividend yield.

Choosing a good REIT stock is like looking for a hidden gem. It requires you to devote time and effort to do some research work. But it’s not as daunting as it seems if you have a proper framework to follow.

Do you also look at other factors when looking for the best REIT stock in Malaysia? 

Share your thoughts below.

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