An Evaluation of Real Estate Investment Trusts Finance Essay

Besides of Equities, Bond, Property, Fix Deposit, Hedge Fund, Unit Trust Fund and etc.A  A new asset class investment option has emerged with potential fair return of investment in Malaysia.A  REIT Also known as Real Estate Investment Trust.A  With the concept like Unit Trust, by gather pool of money from all sizes of investors.A  REIT based companies will invest, manage and distribute rental as dividend back to the investors.A  It is also being trade in Bursa Kuala Lumpur with ease of buy and sells back like a normal equity. REIT is not new to the world, in many other developed countries, REIT has been developed for decades and with steady fix income as oppose to fix deposit as an alternative. It targets long term investor with moderate risk such as insurance companies, pension funds, unit trust funds and even individual investor. As many investors may not be able to invest in a huge property portfolio, REIT gain strength from pool of funds gathered and invests into high profile and high value properties for better return. REIT returns averagely in develop market is around 3-5% depending on its individual performance.A  However, REIT in Malaysia is very attractive because as we are in a so-called last phase of developing nation before developed.A  Our nation’s property’s values are still a gap behind many developed countries in Asia.A  This emerge as an opportunity with an average attractive yields between 6-8% which is higher then other major developed countries. Especially when REITs are in the infant stage in Malaysia, most REIT managers are with option and plan to growth their property portfolio to trade or manage rental in order to achieve even a better yield for investor. As our nation property’s value is undervalued for decades, there will be a high potential of asset revaluation will bring capital growth to the investor.A  Typical a potential of upside will be between 20-30% around a five (5) years period.A  In conjunction with the government effort to liberalize and boost property asset values in Malaysia. An example of an early REITs launched in 2006 – STAREIT.A  It has till date performed a 7% dividend yield based on the NTAB of 97 sen.A  If compare to Fix Deposit of 3-4% and even with government based senior citizen bond that offer 5.5%.A  STAREIT becomes much attractive and excluding the potential of its asset revaluation that includes all its prime location properties located at Bintang Walk, Kuala Lumpur. REIT is not just having the existing property to rent out, manage and collect rental.A  A high performance REIT is like your property fund manager.A  They will develop new opportunities, acquire more properties into their portfolio and to some countries, jointly develop property projects.A  This will provide even a higher potential return compare to those low to moderate risk investment instruments. LEGAL FRAMEWORK GUIDELINES IN REITs HISTORY The Securities Commission of Malaysia released new guidelines on real estate investment trusts (REITs Guidelines) on 3 January 2005. The REITs Guidelines supersede earlier guidelines on property trust funds published in November 2002. The key features of the REITs Guidelines include the liberalisation of borrowing limits as well as the relaxation of restrictions under the old guidelines on the acquisition of leasehold properties and properties encumbered by financial charges. Borrowings of a fund should not exceed 35% of its total asset value at the time the borrowings are incurred.

Leases must be registered and all real estate must be free from encumbrances at the time of acquisition except for charges entered by financial institutions, trustees and management companies in relation to loan facilities extended. The initial minimum size of a real estate investment trust is RM100 million (approximately US$26 million) and the minimum size of subsequent launches is RM25 million (approximately US$6.5 million). Real estate investment trusts may acquire real estate located outside Malaysia subject to the specific approval of the Securities Commission. The management company of a real estate investment trust must be a subsidiary of a Malaysian company involved in the financial services industry in Malaysia or a property development company or a property investment holding company. However, delegation is permitted subject to Securities Commission approval. Permitted investments include real estate, single-purpose companies (i.e. unlisted companies whose principal assets comprise real estate), real estate-related assets, liquid assets, non-real estate-related assets and asset-backed securities.

However, at least 75% of a listed fund’s total assets must be invested in real estate, single-purpose companies, real estate-related assets or liquid assets, with a minimum 50% of total assets invested in real estate or single-purpose companies. For an unlisted fund, a minimum of 70% of its total assets must be invested in real estate, single-purpose companies or real estate-related assets with at least 50% invested in real estate or single-purpose companies. At least 20% of the unlisted fund’s total assets must be invested in liquid assets at all times and the remaining 10% in other permitted assets. NEW AMENDMENT GUIDELINES The recently released Guidelines on Real Estate Investment Trusts (New Guidelines) issued by the Securities Commission of Malaysia (SC) on 3 January 2005 has created waves among the industry players in Malaysia including property owners and developers and promoters of real estate investment trusts (REITs). The New Guidelines replace the Guidelines on Property Trust Funds (Previous Guidelines) dated 13 November 2002 and the highlights are as follows. Re-branding The term real estate investment trusts is adopted in the New Guidelines including in its title, and is consistent with the terminology used in the US, Hong Kong, Singapore, Japan and many other jurisdictions replacing ‘property trust funds’ which was the term used in the Previous Guidelines.

New borrowing limits In the Previous Guidelines, unless otherwise approved by the trustee of the REIT and the SC, the total borrowings of a property trust fund was capped at 30 percent of the net asset value of the fund at the time the borrowings are incurred. The New Guidelines have eased this limit to 35 percent of its total asset value. Acquisitions of leasehold properties Under the Previous Guidelines, a property trust may acquire lease-hold property with at least 60 years remaining on the lease. This requirement has been removed from the New Guidelines to ensure more flexibility in such acquisitions.

The New Guidelines now provide that the consent of the relevant authority to transfer the lease must be obtained before the fund’s prospectus is registered with the SC or prior to the acquisition of the leasehold property; and the lease must also be a registered lease. Acquisition of real estate encumbered by charges The Previous Guidelines provided for a blanket prohibition against the acquisition of encumbered real properties save with the approval of the SC. This requirement has been liberalized under the New Guidelines, which provides an exception where the charges on real estate are entered by financial institutions, trustees and management companies. Acquisition of foreign real estate Unlike the Previous Guidelines that merely mention the possibility of acquiring foreign properties, the New Guidelines specifically provide for the permitted scope of such acquisitions including that the REIT may participate in forward sales and purchases in relation to any foreign real estate in its portfolio, subject to the rules. Eligibility requirements of management companies The New Guidelines have relaxed the limit for foreign equity participation in the management company of a REIT to 49 percent from the previous limit of 30 percent. Further, the previous requirement that the management company shall be a public company has been removed. In addition, the requirements relating to the holding company of the management company have been abridged.

Submission requirements and procedures The submission procedures, dealt with more briefly in the Previous Guidelines are provided for in great detail in the New Guidelines. Specific forms for different types of submissions to the SC are prescribed in the New Guidelines including those for the establishment of a REIT appointment of the trustee, appointment of the Management Company and issuance of new units for an existing REIT Specific forms of declaration of compliance with the guidelines were also introduced in the New Guidelines. It is envisaged that the more detailed rules would mean less time being wasted in clarifying and requesting for further information and therefore result in a speedier decision-making process for REIT related submissions to the SC. The above changes made to the REIT regulatory regime augurs well for the growth of industry in Malaysia considering that several big names such as the Employees’ Provident Fund, YTL Corporation Berhad, Axis Group of Companies, Sunrise Berhad and CIMB Berhad have expressed their interest in setting up REITs. In order to further fuel the enthusiasm of market players, it is suggested that further tax incentives such as tax exemption for dividends received by REIT unit holders including non-resident unit holders should be affected. HOW REITs WORK Investing in income-generating real estate can be a great way to increase your net worth. But for many people, investing in real estate, particularly commercial real estate is simply out of reach financially. But what if you could pool your resources with other small investors and invest in large-scale commercial real estate as a group? REITs (pronounced like “treats”) allow you to do just that. REIT stands for real estate investment trust and is sometimes called “real estate stock.” Essentially, REITs are corporations that own and manage a portfolio of real estate properties and mortgages.

Anyone can buy shares in a publicly traded REIT. They offer the benefits of real estate ownership without the headaches or expense of being a landlord. Investing in some types of REITs also provides the important advantages of liquidity and diversity. Unlike actual real estate property, these shares can be quickly and easily sold. And because you’re investing in a portfolio of properties rather than a single building, you face less financial risk. REITsA­ came about in 1960, when Congress decided that smaller investors should also be able to invest in large-scale, income-producing real estate. It determined that the best way to do this was the follow the model of investing in other industries; the purchase of equity. A company must distribute at least 90 percent of its taxable income to its shareholders each year to qualify as a REIT. Most REITs pay out 100 percent of their taxable income. In order to maintain its status as a pass-through entity, a REIT deducts these dividends from its corporate taxable income. A pass-through entity does not have to pay corporate federal or state income tax — it passes the responsibility of paying these taxes onto its shareholders. REITs cannot pass tax losses through to investors, however. From the 1880s to the 1930s, a similar provision was in place that allowed investors to avoid double taxation which are paying taxes on both the corporate and individual level because trusts were not taxed at the corporate level if income was distributed to beneficiaries.

This was reversed in the 1930s, when passive investments were taxed at both the corporate level and as part of individual income tax. REIT proponents were unable to persuade legislation to overturn this decision for 30 years. Because of the high demand for real estate funds, President Eisenhower signed the 1960 real estate investment trust tax provision qualifying REITs as pass-through entities. A corporation must meet several other requirements to qualify as a REIT and gain pass-through entity status.

They must: Be structured as corporation, business trust, or similar association Be managed by a board of directors or trustees Offer fully transferable shares Have at least 100 shareholders Pay dividends of at least 90 percent of the REIT’s taxable income Have no more than 50 percent of its shares held by five or fewer individuals during the last half of each taxable year Hold at least 75 percent of total investment assets in real estate Have no more than 20 percent of its assets consist of stocks in taxable REIT subsidiaries Derive at least 75 percent of gross income from rents or mortgage interest At least 95 percent of a REIT’s gross income must come from financial investments (in other words, it must pass the 95-percent income test). These include rents, dividends, interest and capital gains. In addition, at least 75 percent of its income must come from certain real estate sources (the 75-percent income test), including rents from real property, gains from the sale or other disposition of real property, and income and gain derived from foreclosure of property. Because REITs are required to distribute 90 percent of their taxable income to investors, they must rely upon external funding as their key source of capital. Just like other stock offerings, publicly traded REITs collect funds via an initial public offering (IPO). Those funds are used to buy, develop and manage real estate assets. The IPO works just like other security offerings except that instead of purchasing stock in a single company, the buyer will own a portion of a managed pool of real estate.

Income is generated through renting, leasing, or selling the properties and is distributed directly to the REIT holder on a regular basis. When a REIT pays out its dividends, they’re equally distributed among shareholders as a percentage of paid-out taxable income. REITs have a board of directors elected by its shareholders. Typically, these directors are real estate professionals who are highly respected in the field. They are responsible for selecting the REIT’s investments and hiring the management team, which then handles day-to-day operations. REITs earn money from rented space or sales of property. The preferred method for measuring REIT earnings is called funds from operations (FFO). The National Association of Real Estate Investment Trusts (NAREIT) defines FFO as: Net income (computed in accordance with generally accepted accounting principles), excluding gains (or losses) from sales of property, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures.

Adjustments for unconsolidated partnerships and joint ventures will be calculated to reflect funds from operations on the same basis. Basically, REITs add or deduct from net income (rent and sales computed according to generally accepted accounting principles [GAAP]) any gains or losses due to depreciation, sale of property and unconsolidated partnerships and joint ventures. Essentially, FFO measures a REIT’s operating cash flow produced by its properties, less administrative and financing costs. Under generally accepted accounting principles, net income typically assumes that the value of assets goes down over time; somewhat predictably.

Real estate generally retains or even increases in value. On the balance sheet under GAAP, however, land remains at its historical cost and buildings gradually depreciate to zero. Since a REIT’s primary business involves real estate, the depreciation charges negatively skewed the company’s true profitability. FFO was adopted to address that problem by excluding depreciation costs from the net income figure. FFO is not a foolproof measure, however. Not all REITs calculate it according to the NAREIT definition and items such as maintenance, repairs and other recurring capital expenses are missing from the formula. In order to get a true FFO, investors must often read a company’s quarterly report, and any supplemental disclosures. MARKET PERFORMANCE OF REITs INTRODUCTION The recent collapse of stock markets around the world has not spared REITs. This unprecedented turmoil has wiped US$160 billion (RM576 billion) off the total market capitalization of global REITs in the year to end-June 2008. That’s a 20 per cent drop as the widespread correction in real estate values collided with extreme volatility in the international equity markets. The United States saw its market cap drop below US$300 billion (RM1, 080 billion) to US$259 billion (RM932 billion) during that period. The Asian REIT market, surprisingly, was the best performer in 2008 in terms of one- and three-year returns and is poised to overtake Europe as the world’s second largest REIT market in market cap.

Among these Asian REITs are Link REIT Hong Kong, Westfield Australia, Parkway Healthcare REIT Singapore, CDL Hospitality Singapore and CMT Singapore which have strong sponsors and good balance sheets. Though Malaysian REITs are small compared to these heavyweights, M-REITs’ performance in 2008 has been much better than the industry average, registering an average drop of 29 per cent versus Singapore’s 56 per cent, and they continue to have simpler structures and low gearing favoured by investors.

What is emerging from the current market turmoil is that shell-shocked equity investors are turning to tax efficient REITs to bolster income returns generated by their bruised stocks portfolio. In its latest Global Property and REIT Report, Standard & Poor’s said its Global REIT index outperformed the broader equity stocks significantly in the third quarter of 2008, falling only 4.4 per cent compared to the 16.6 per cent drop in its Global Broad Market index. It said that in the midst of all the turmoil, REITs and REIT-like companies, typically leveraged around 40 per cent, have done surprisingly well. The global financial crisis started to impact the country’s real economy in the fourth quarter of 2008. The first and second quarters in the current year will be the acid test as to whether the economy will slip into negative growth. At the moment, the situation is one where Malaysian corporates are planning for the slowdown. Results in the third quarter of 2008 had been a mixed bag with some companies showing good results on the back of strong commodity prices and healthy order books. That could change in the fourth quarter where the impact of lower commodity prices and declining order books would mean lower performances.

One strong point is that the balance sheets of banks and companies in the country are healthy thanks to caution exercised since the 1997 Asian financial crisis. Also, the banks have not had any exposure to sub prime structured products or Credit Default Swaps which brought down Lehman Brothers, Bear Stearns and AIG and damaged the balance sheets of many investment banks globally. In Malaysia, liquidity is still strong, banks are still lending and the government is putting in place contingencies for stimulus packages for the economy. A positive note is that inflation is abating, which allows Bank Negara further room to lower the Overnight Policy Rate. MARKET PERFORMANCE IN MALYSIA THE Malaysian real estate investment trusts (MREITs) were launched in 2005 after REITs in general hit the stock markets in Japan, Hong Kong and Singapore. Within a year 10 REITs were launched, one repackaged with another two oldies remaining, making up 11 REITs. Before the global financial turmoil in 2008, the MREITs performed predictably well, yielding 6% to 7% dividend returns with marginal growth in share premium. By end-2008, along with the rest of the equities market, the MREITs took a severe beating from which they have hardly recovered. Menara Axis in Petaling Jaya Some salient points of the MREITs are worth noting. Ac-A  REITS share prices have declined substantially. The MREITs today show a substantial discount to the net asset values (NAV) of the assets underlying the REITs, ranging from 23% to 39% (as shown in Table 1). The property market, in general, has not shown such drastic changes in values over 2007. Although the asset base of the MREITs has increased, much of this is due to the injection of new and additional assets and not because of increases in asset values or appreciation in values.The peculiar nature of this phenomenon is because of the nature of the REITs. Ac-A  on a down market, REITS show equity tendencies, on an up market, REITS show bond tendencies.

Much research has been carried out by academics as to the behaviour of REITs. The research has been inconclusive. It will appear, from the little information and research that can be done in Malaysia, that MREITs have a tendency to behave like an equity in a down market, that is, if the stock market declines the MREITs will also follow suit, irregardless of the stability, or otherwise of the underlying asset. However, in an upswing, the fixed nature of the income and the inability of the underlying asset to react quickly force the MREITs to behave like a fixed-income instrument, like a bond. This phenomenon would explain why the MREITs are now selling at a discount to the NAV. Ac-A  Income to continue at current levels. It is anticipated that the current income of the MREITs will continue at current levels and may not be affected by the general downturn. Almost all the MREITs were launched before 2007; therefore the rents underpinning their income were at 2006 and 2005 levels. It is believed that these rents are sustainable and the majority of MREITs did not increase the rental levels to the high levels reached in 2007. Hence, the income and the dividend flow is expected to continue. Ac-A  Sale and leasebacks will continue to perform better.

Another reason the income will be sustainable is because a number of MREITs has secured guaranteed returns on a sale-and-leaseback basis. Therefore, the downturn in the market is shielded. Ac-A  Yields have increased tremendously. The sustainable income, coupled with the decline in the net asset value, has boosted dividend yields to between 6% and 14%. Table 1 explains the dividend yield position of the MREITs in January 2009. These returns show, on average, an increase of 50% over the previous yields. Ac-A  Singapore yields even higher due to a sharper drop in REITS pricing. The sharper corrections to the equities market and the more prominent impact of the economy has affected the Singapore REITs, pushing prices down and, thus, increasing yields. Some REITs are giving yields in excess of 25% in Singapore. Ac-A  Injection of new assets will face yield disparities.

The yield disparities have affected the injection of new assets into existing REITs. Most real estate pricings and rental incomes fall between 6% and 8% for commercial properties. When current yields are in excess of these returns, REIT sponsors will be unable to inject new assets at below the dividend yields. AcA  Opportunities for acquisition of better quality asset.

However, the current downturn can also provide wonderful opportunities for the acquisition of better quality assets and a more competitive pricing of the real estate. Ac-A  Refinancing. Financing for REITs has been different from normal financing. As the requirement is for the income to be distributed, almost all the MREITs have been servicing only the interest component of the loan; there is no repayment, partially or otherwise of the loan. This, coupled with the lower negotiated interest rates regime, has helped the MREITs to declare a higher dividend than the yields from the underlying asset. In view of the reduced interest rates currently being considered by the financial institutions, it might be easier to get a lower interest rate. The MREITs appear to have weathered the financial storm well as the discounts to the net asset value is manageable and not as severe as in other countries.

Added to that is the sustainable income from the rents. It would appear, therefore, that MREIT yields will be maintained and the downside risks are manageable. RISK AND FUTURE PROPECT FUTURE PROSPECT AND PROBLEM Many countries are currently preparing their own REIT legislation to be introduced. Among the new entries are the Philippines, Indonesia, China, Pakistan and India. REIT legislation is already in place in Malaysia, Singapore, Australia, Japan, Korea, Hong Kong and Thailand. Countries where REIT legislation is not present have encouraged property owners there to consider listings in other bourses where such legislation exists. Examples are Ascendas India and CapitaLand China Mall Trust listed on Singapore Exchange Ltd. Future growth areas will be in high growth markets such as India and China where there is a huge amount of high grade unlisted real estate which could get securitised once their REIT legislation is in place. Asians who likes to own properties will discover that REITs are the best form of a liquid proxy to physical properties. REIT is still an overlook investment by the market because REIT is a conservative investment. REIT didn’t fluctuate much in price over days.

Therefore, investors tend to forget it. Bear in mind that, property will appreciate in times and so the REIT. Now, they are 11 REITs listed on Bursa Malaysia and another 2 more will be added in next year, SunCity and CapitaLand.A A

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