Why Invest in REITs?
The purchase of any real estate asset is an expensive affair. A two-bedroom apartment in Mlolongo, Athi River costs approximately KES 6Mn. At an interest rate of 13.0% and a mortgage term of 20 years, servicing the loan will require a monthly outlay of KES 70,300. If one were to rent this piece of property, they would charge approximately KES 40,000 — translating into a net outflow of KES 30,300. REITs allow investors with as little as KES 9.34 (market price for a unit of the Fahari I-REIT as at 15th Jan, 2020) to invest in portfolios of real estate assets.
The costs pertaining to the development and construction of a real estate property can ramp up. The REIT vehicle allows for the pooling of capital from different investors to offset these costs. These funds can also be used to fund the marketing, sale, retention, and management of these real estate assets.
Just as shareholders to a company earn dividends from their investments, the participants to a REIT earn a share of the income produced through the real estate investment without actually having to buy or manage the property. This function is usually outsourced to professional managers.
In the same way shares have an income-generating component through dividends earned and a capital-appreciation one through the increase in the share price, REITs are also a total return investment. They typically provide dividends plus the potential for moderate, long-term capital appreciation. Long-term total returns of REIT stocks tend to be similar to those of value stocks and more than the returns of lower-risk bonds.
REITs are a tax-exempt offering. They are exempt from the 30% corporate tax and the 5% capital gains tax imposed within the Kenyan jurisdiction. The only tax chargeable is a 5% withholding tax on interest income and dividends.
Companies are able to raise funds through IPOs or Rights Issues to fund in-house activities such as expansion. In the same breath, REITs allow incremental scalability as property developers and owners can easily raise funds to develop properties or purchase income-producing real estate assets through the capital markets.
Additionally, investing in real estate generally requires significant capital outlay. Stanlib Fahari REIT (I-REIT), the only listed REIT at the Nairobi Securities Exchange (NSE), owns four properties all located in Nairobi: (1) Greenspan Mall in Donholm, (2) Highway House in Industrial Area, (3) Bay Holdings Limited in Industrial Area, and (4) 67 Gitanga Place in Lavington. As at December 2018, these four properties were valued at KES 3.4Bn.
REITs allow an interested real estate investor to buy units (shares) and be a part owner of real estate assets without having to deploy a lot of capital. If one is interested in being a part owner of Greenspan Mall (worth KES 1.5Bn), they can simply buy shares in the listed Stanlib Fahari REIT for say KES 100,000.
This advantage of a listed REIT extends to the owners of real estate as well, since they do not have to sell the entire asset if they are looking for liquidity. The current owner can decide to only sell KES 50,000 worth of shares in the Stanlib Fahari REIT and hold onto the remainder.
A listed REIT also allows underlying owners of the real estate assets to enjoy corporate tax exemption, currently at 30% per annum, as well as the benefits of professional investment management. STREAD will expound on these advantages in later updates.
What Factors Drive REIT Earnings?
As an investor, it is crucial to understand the factors that affect REIT earnings, especially given that 80% of these earnings are supposed to be distributed as dividends to the unit holders.
1. Demand Drivers
- REITs invest in residential property, offices, warehouses, shopping centers, medical facilities, and hotels.
- The key demand drivers for revenue generation are population growth, the rise in economic activities, improvement in the job market, mortgage rates, and commercial and industrial growth, among others.
- Fluctuations in any of these key drivers will have a direct impact on the demand generation of residential, office, warehouse, and shopping center properties, and will affect REIT earnings.
2. Economic Growth
- Economic growth is the major factor that determines REITs' growth.
- An uptick in economic fundamentals positively affects REITs by increasing business growth.
3. Job Market
- The strength of the job market fuels the demand for the housing, office, and hotel industry.
- Strong job growth can drive higher occupancy rates and lead to a rise in unit rental revenue.
- In contrast, high unemployment and slow job growth can result in falling occupancy rates and lower revenue per unit.
4. Demographics
- The rate of population growth in the REIT's operating regions is another key determinant of success.
- Rising population results in greater demand for apartments, hotels, and warehouse units.
5. Occupancy Rates and Rents
- Higher occupancy rates and rising rents are the most immediate sources of revenue growth for REITs.
- The high rates lead to higher income for REITs and vice versa.
- As the economy expands, the demand for space increases, leading to a rise in rents.
6. Mortgage Rates
- If mortgage rates are lower, buying a home becomes more attractive than renting, which diminishes demand for rental properties.
- In contrast, if mortgage rates are higher, renting an apartment becomes more appealing, leading to a rise in occupancy rates and higher rental revenue.
7. Interest Rates
- When interest rates rise, investors demand a higher dividend yield on REITs, which drives down their stock prices.
- Another negative effect of rising interest rates on REITs is that they have to incur a higher interest cost to finance building purchases, putting margins under pressure.