This is Part II of our series on REITs. You can find the first part here.
Apart from a secret passion for owning real estate, what’s drawing many Indian investors to Real Estate Investment Trusts (REITs) is their relatively high ‘yield’ compared to bonds and deposits. The three listed REITs – Embassy Office Parks REIT, Brookfield REIT and Mindspace REIT, offer a yield of 6.4-8.5% at current market prices, based on their expected distributions for FY22.
But is ‘yield’ the only number to look at while investing in a REIT? Not really, as the distribution offered by it is neither fixed nor assured. It is a function of how the REIT manages its portfolio of property assets and generates income from it. Gauging a REIT’s return potential therefore requires you to take a deep dive into its workings. REITs make voluminous (and jargon-filled) quarterly disclosures to investors. Here are the key metrics you should watch out for.
#1 Portfolio size
A REIT derives its value from the portfolio of real estate assets it owns (read more about REIT basics here). In India, REITs are required to invest at least 80% of their portfolio in completed rent-generating commercial property.
This brings us to the first set of five metrics which decide the revenue potential of a REIT.
- The total area of commercial space it owns: More the space, greater the clout the REIT has in negotiating with clients
- Occupancy rate: The proportion of space earning rent. Look for ratios in the nineties.
- Collection Efficiency: The amount of rent due in a period that gets paid. Closer to 100% the better.
- Area under development: Indicates the pipeline of assets and thus future income
- Rent-in-place: The fancy term for the rent per square foot that the REIT presently earns. Higher the rent the better the quality of space rented out
Here’s how the three listed REITs compare on these metrics. The table shows that Embassy is the largest in terms of the office space under its fold and also enjoys the higher in-place rent. Brookfield however scores on high occupancy rates.
#2 Portfolio concentration
Owning large swathes of office space that is rented out to average Joes isn’t going to make a REIT attractive. What’s needed is the assurance that the tenants will cough up their rents on time, are willing to do so for the foreseeable future and have deep pockets to afford increases in rent. This makes the quality of tenants (clients) who make up a REIT’s portfolio very important. Though the Indian commercial property market is made up of office space, retail shopping malls, hotels, multiplexes and warehousing assets, it is the office market – where large companies take prime space for their white-collar employees, which is the most lucrative. Indian REITs are evaluated based on the quality of office clients that they’ve managed to bag.
When it comes to assessing this ‘quality’, REIT investors are quite snobbish. They prefer multinational firms over local ones and non-cyclical sectors such as IT and consulting over cyclical ones such as manufacturing or financial services. Having MNC or tech tenants isn’t enough though. A REIT must also make sure it doesn’t depend too much on a single tenant or geography for a big chunk of its revenues, as this would make its income too vulnerable to upheavals in one company or locality. Concentration risk in a REIT is measured based on its exposure to key geographies, sectors and top ten clients.
The following table shows that Embassy has the lowest client concentration. But it is geographically quite concentrated with nearly 64% of its office space in Bengaluru. Brookfield features fairly high client concentration, but is present in markets where the other two are not.
#3 Growth in Net Operating Income
The growth prospects of REIT are evaluated on the basis of the Net Operating Income (NOI) it earns and the rate at which it is expected to grow. The NOI is a REIT’s total income by way of rents and other receipts (such as income from subsidiaries that own property) minus its expenses. The NOI is calculated before depreciation, interest and taxes. REITs are evaluated on their NOI rather than their net profits, because unlike manufacturing firms which own depreciating assets, REITs own appreciating assets.
The NOI growth of a REIT depends on three metrics:
- Property being developed or acquired: Decides future rentable area
- Contracted rent escalations: Annual rent increases built into contracts for existing clients. Rent escalations for office space in India are typically at 4-5% pa.
- Re-leasing spreads: The difference between the rent on current leases and those on new ones for the same property. A related metric called ‘mark to market opportunity’ captures how much the REIT’s rental income will rise once existing leases run out and prevailing market rates apply.
Embassy REIT for instance reported that it saw NOI growth of 12% in FY21. It leased out 1.2 million square feet of new area during the year and collected escalations of 13% on existing rents on 8.4 million square feet. It managed a 15% re-leasing spread. That is, new clients paid 15% more rent compared to old clients.
The NOI margin of a REIT determines how much of its rental and other revenues it manages to keep for itself, after direct expenses incurred on maintaining and operating its assets. NOI margins of the three Indian REITs range from 77% to 87%.
#3 Growth in Net Distributable Cash Flow
REIT investors have their sights firmly set on the income it pays out. Therefore, the cash flow statement of a REIT is more important than its income statement or balance sheet. The key metric to track here is the Net Distributable Cash Flow or NDCF.
The NDCF is derived from the NOI. Direct expenses incurred in running or maintaining the properties like power, fuel, property taxes and insurance are charged on revenues to arrive at the NOI. From the NOI, indirect expenses such as the property manager’s fees and other costs are deducted to arrive at the EBIDTA. From EBIDTA, working capital increases incurred during the period, capex incurred, debt repaid are further deducted to arrive at the NDCF. Do note that if a REIT holds property through subsidiaries (called SPVs) it may get its income in the form of dividend or interest payments from its SPVs. If it owns assets directly, it will earn rental income which will flow directly into its NOI. For a REIT investor it is the trend in NDCF at the REIT level that is the most relevant metric. Here’s an illustration of how Brookfield REIT arrived at its NDCF.
#4 Portfolio acquisitions and divestments
Just like equity fund managers like to constantly weed out laggards from their portfolio and add outperforming stocks, REIT managers strive to add to prime property with high rental yield while weeding out properties with low rental yield or rising maintenance costs. REIT investors therefore need to keep an eye out for the quality of assets being added and divested by their REIT each quarter as this affects their income as well as capital value.
As REITs are evaluated on the basis of the rental yield they squeeze out, their ability to acquire assets in prime locations at a discount to market prices is a big plus. Given the shortage of prime office space in India, for this, it is useful if a REIT has a sweet deal with its sponsors for acquisition of prime assets before they are sold to others. Brookfield REIT for instance, has signed a contract with its sponsor group to have the ‘right of first offer’ for assets that the sponsor plans to put on the market.
A key metric that REIT investors track to know if their REIT is acquiring new assets at a good price, is the Capitalization Rate or Cap Rate. The Cap Rate is the Net Operating Income likely to be generated by a property divided by its current market price. REITs usually try to acquire new assets with Cap Rates that are higher than that on existing assets. They get rid of properties with dwindling Cap Rates.
#5 Leverage and dilution
When a manufacturing company wants to grow earnings, it usually scrimps on dividends and ploughs back its profits into the business for expansion. REITs are restrained from doing this because regulations require them to compulsorily distribute at least 90% of the cash flows that they receive every year. to their investors. In practise Indian REITs distribute much more – 95-100% of their cash flows after expenses. This usually leaves them with very little retained earnings to invest in expansion or acquisitions.
REITs solve this problem by raising fresh debt or equity to supplement their existing capital. However, as both fresh debt and new equity tend to dilute distributions to their investors (one results in interest outgo and the other cuts distribution per unit by creating new units), REIT managers tend to do a tight-rope walk that balances their fund-raising efforts against keeping up distribution rates.
Many global markets do not cap the leverage that REITs can take on. In India however, a REIT cannot take on leverage more than 49% of its total assets. It is therefore useful for REIT investors in India to keep a watch on how much headroom their REIT has to take on fresh debt before it hits this ceiling. In Q4 FY21, Embassy reported a net debt to Gross Asset Value of 22%. In Q3 FY21 (its latest filing), Mindspace reported a net debt to asset value of 13.8%.
Watching leverage alone may not be enough though, as REIT may raise new equity capital too to fund its projects. Tracking the number of outstanding units of a REIT over the years can tell you the amount of dilution that has ben undertaken to expand the portfolio and NOI.
#6 Distributions and NAV per unit
After all this analysis, two metrics that determine the final returns from a REIT to the investor, are the distributions per unit and the NAV per unit. The distribution per unit is the regular income you receive from a REIT for each unit you own.
REITs are required by law to distribute their cash flows at least twice a year. In practise Indian REITs make quarterly distributions. Given that taxation of your REIT income (we will be writing a separate article on this) is based on the character of that income, REITs usually split their distributions into dividend and interest payouts for your convenience. Most listed REITs provide their distribution history on their website which allows you to gauge the income you can expect from a REIT and calculate the all-important yield. The table below provides distribution and NAV details for the two REITs that have been listed for over a quarter.
To assess the capital value of the assets owned by a REIT, regulations require REITs to get their property assets valued by an independent valuer at least twice a year. This statement is filed with the stock exchanges and is captured as the REIT’s NAV per unit. You can use the trend in this NAV as an indicator of the intrinsic value of the REIT’s portfolio. The deeper the discount at which the REIT’s market price trades to this NAV, the better the bargain. However, as this NAV is provided only at half-yearly intervals, do be aware that the market may be discounted for a fall in market prices of the REIT’s portfolio or recent changes such as divestments that have altered its value.