REITs Part I: Decomposing Dividend Yields

This is the first part of my series in how to analyse REITs.

In this article, I will be dissecting a REIT’s dividend yield so that an investor will have a better grasp when combing through the sector. This is not a recommendation to buy or sell any REIT in particular, but is intended to broaden your perspective when looking at REITs in general.

As the factors that shape a REIT’s dividend yield appear to be poorly understood by the average investor, I will be sharing my framework of decomposing a REIT’s dividend yields into simpler blocks for investors to understand. REITs, to a large extent, trade like junk (high yield) bonds, as institutional investors approach them as such. Under this paradigm, REITs are usually valued in terms of dividend yields, unlike common stocks. While REITs are also evaluated by their Price to NAV (P/NAV), it is usually a secondary factor that comes after the dividend yield.

My framework for decomposing the dividend yield is a derivative of the model typically used to analyse a corporate bond. Corporate bonds are tradeable loans of companies, and are valued according to their yields. Broadly speaking, a bond issued by a company with stronger financials will have a lower yield as compared to a bond of a weaker company. This is also reflected in the REIT market, with ‘riskier’ REITs generally offering higher dividend yields. The dividend yield can be broken down into the following factors:

Dividend Yield = Risk-Free Rate + Sector Risk + REIT-specific Risk + Other Risks

Risk-Free Rate
This is the rate of return that an investor can get by investing into a risk-free asset. This is typically represented by the yield on a government bond, though if this is not easily accessible for the average investor, using the best-in-town interest rate for a fixed or term deposit is a reasonable substitute. For the purpose of this discussion, this is theoretically the highest annual interest rate that an investor can get without subjecting his savings to any risk of capital losses.

The risk-free rate is the baseline for all bonds and in our case, REITs. To illustrate this point with an extreme example, if one could put his money in the bank at an interest rate of 10%, it is highly unlikely that he would choose to be holding REITs that yield less than 10%. This assumes that the REIT has an operating currency that is the same as the bank deposit and assets are domestic.

What if there is a REIT that yields exactly the same as the bank's interest rate, that is 10%? Would you invest in a 10% yielding REIT or a 10% bank deposit? A rational investor would prefer the bank deposit, as holding the REIT runs the risk of capital losses. The risk-free component is actually a major driver of the REIT sector as a whole, but I will address this in the next analysis of the REIT sector as it deserves a whole piece of its own. For now, we will return back to decomposing a REIT's dividend yield.

How much higher does the REIT need to yield above the risk-free rate, in order to tempt an investor to hold it, over putting it in the bank or perhaps buying a government bond? That is a question that I will be addressing in the next part. Investors need to be compensated for bearing the risk of capital losses, and that reward is known as the risk premium, which basically explains all the other components of the REIT's dividend yield.

Sector Risk
An astute REIT investor would have over time grasped the concept that certain sectors are more 'risky', that is experience greater volatility in terms of rental income and DPU. These sectors are typically more exposed to the business cycle, and include sectors such as industrials and hospitality. In contrast, sectors such as healthcare and retail are less vulnerable to fluctuations in earnings and DPU. By this point, you can probably deduce that sectors which are more resilient and have stronger growth prospects will generally have a lower sector risk premium, and trade at lower dividend yield than 'riskier' sectors. The chart below shows the distinction between the retail REITs and the industrials.

REIT-specific Risk
This component captures the factors that distinguish one REIT from another within the same sector. Although REITs within the same sector tend to have similar dividend yields, specific factors usually drive differentiation. Factors such as sponsor, growth prospects and the quality of assets can lower or raise the yield relative to the sector. Another important factor that leads to differentiation despite two REITs having identical risk profiles is leverage. REITs that leverage up should naturally have a higher dividend yield, though this relationship is clearer in sectors that are perceived to be more risky, such as industrials, hospitality and logistics. On the other hand, Investors do not seem to demand a higher risk premium (and there higher yields) for retail and office REITs.

Other Risks
This factor encapsulates the various risks that are not covered above, and broadly includes a premium for REITs with foreign assets, foreign exchange risk, poor liquidity, among others. Some factors can constitute a fairly large risk premium, and should be allocated a risk factor on its own. One of these is the country factor, which exist due to the equity home bias factor, where investors prefer to hold stocks with assets in their home country over foreign countries, on the basis of familiarity. Also, foreign exchange risk should be priced in accordingly, given MAS' monetary policy stance of gradually appreciating the SGD in the long run.

Case Study - Capitaland Retail China Trust (CRCT)
CRCT, as a retail REIT with operations purely in China, trades at a higher yield than its counterparts with Singaporean assets, particularly those under the CapitaLand umbrella such as CapitaLand Malls Trust (CT) and CapitaLand Commercial Trust (CCT). This is likely due to its operations being in China (Foreign Market-China risk). However, when compared to the other Chinese retail REITs, it trades at a lower yield. This is due to CRCT being part of the Capitaland group, which investors have assigned a risk-reduction premium. We can therefore dice CRCT’s dividend yield up in several different ways.

The first, is to view CRCT’s dividend yield as CT’s dividend yield (CapitaLand’s Singaporean mall assets) plus a Chinese risk factor, which captures the foreign exchange risk (SGD/CNY) and foreign market risk. We then add a CRCT specific risk factor to capture other subtle differences such as different leverage levels.

CRCT = CT Dividend Yield + China Country Risk + Foreign Exchange Risk + CRCT Specific Risk

Or to fully describe it in terms of my model above, we can break down CT's dividend yield as well.

CRCT = (Risk Free Rate + SG Retail REIT Risk + CT Specific Risk) + China Country Risk + Foreign Exchange Risk + CRCT Specific Risk

Alternatively, we can also express CRCT as a Chinese retail REIT, but with a risk reduction due to its backing by CapitaLand, Asia’s largest real estate company and is majority owned by Temasek.

CRCT = Chinese Retail REIT Sector Dividend Yield - CRCT-Specific Risk (CapitaLand-backed)

By understanding how REITs are priced according to their sectors, and to one another within the same peer group, we will be better prepared to take advantage of opportunities as they come by. A high yielding REIT may look attractive on a standalone basis, but what if you could invest into a peer with a slightly lower yield, but for a much lower risk profile or higher growth prospects? The key to investing into a REIT is to know what is being priced in, and more importantly, what is not being priced in, at times. Understanding this is an important source of alpha, not just for REITs, but for all assets in general.

1 comment:

  1. Can't wait to see how you put ur model in practice, looking forward for it.