The "Original Sin" of REITs

Business Times featured an interesting article by Ben Paul that is highly relevant to REIT investors titled “Kore’s distribution halt reflects Reits’ ‘original sin’ of needing constant access to capital to exist”.

The article exists behind a paywall, but readers can access it through the National Library App.

While the focus is on Keppel Pacific Oak REIT, the points raised are relevant to other REITs. I’ve summarised the main points at the end.

We can understand the pressures facing REITs today by looking at previous crisis

The 2008 Great Financial Crisis showed how vulnerable REITs can be when liquidity dries up.

REIT valuations dropped significantly and gearing rose sharply, forcing even prominent REITs to conduct equity placements and rights issues at inopportune times to shore up their finances.

The 2020 crisis was far less severe, mitigated by government intervention and coordinated monetary easing that kept borrowing costs low.

However, the current situation is different, with tight monetary policy looking to stay on.

Investors should be wary as many REITs now have weakened financial positions.

Two key ratios to watch are gearing and interest coverage ratios.

Gearing may increase as asset values drop due to higher capitalisation rates.

REIT gearing ratios today may not fully reflect potential declines in asset valuations.

Interest coverage ratios are also dropping significantly, which may push more REITs into “distressed territory” where they will be forced to either sell assets, or engaging in dilute equity offerings.

Suntec REIT is a prominent example where projected interest coverage ratios has fallen below the recommended 2.5x threshold set by MAS.

Even prominent REITs like Mapletree Pan Asia Commercial Trust face risks as interest coverage ratios weaken significantly.

In short - investors must be cautious and prepare accordingly.

Key Points of Kore’s distribution halt reflects Reits’ ‘original sin’ of needing constant access to capital to exist”

1. KORE distribution halt highlights an inherent risk for REITs - their dependence on continual access to capital markets to fund acquisitions and growth.

REITs need to regularly raise equity or debt to expand their asset base, which is their "original sin." If markets tighten, they may struggle to raise funds.

2. KORE was forced to conserve cash and halt distributions after a planned equity fundraising fell through amidst market volatility.

This underscores the risks REITs face if they over-leverage or overextend themselves during good times when capital is readily available.

3. REITs have benefited from low interest rates, allowing them to raise debt cheaply to juice up returns through leveraged growth.

But higher interest rates could significantly impact their ability to raise debt to fund acquisitions. Costs may also increase for refinancing existing loans.

4. REITs also face uncertainty over future demand for their assets, especially sector-specific REITs like industrial, office and retail REITs.

With potential economic slowdown, tenant demand may weaken, impacting occupancy rates and rental reversions.

5. Overall, REITs need prudent capital management and visibility on funding access to mitigate inherent liquidity risks.

Building defensive buffers during good times will allow them to better weather crises when access to capital is constrained. Moderating leverage, managing debt maturity profiles and diversifying funding sources will be critical.