Gandy Gandidzanwa & Itai Mukadira
After years of relentless advocacy by the investment management community for the enactment of required legislation, finally there is now in place the regulatory framework that governs the creation of REITs.
Modeled along fund structures, REITs (Real Estate Investment Trusts) are a special type of professionally managed legal entities that own real estate properties, mortgages or both, and they are generally traded on public exchanges, similar to traditional stocks. These entities have to meet a number of requirements to qualify as REITs, and in turn, they offer a number of huge tax benefits to investors. REITs that own physical properties directly are classified as equity REITs. Mortgage REITs, on the other hand, issue and hold debt tied to real estate. In most cases, REITs invest in a single property type such as office, retail, industrial, distribution centres, warehouses or even unique property types such as data centers or telecom towers.
Income and Capital Growth-Oriented Asset Type
First promulgated in the US in the 1960s to give all investors the opportunity to invest in large-scale diversified portfolios of income-producing real estate, REITs have long become an important asset class in portfolio construction for investors – retail and institutional together.
Today, there are more than 225 REITs in the US that trade on major stock exchanges. Closer to home here, South Africa has a very vibrant REITs sector that has been growing steadily since the introduction of the necessary legislation back in 2007. Kenya also has had the necessary legislation in place since 2015. There has not been such a marked uptake and growth though in that market and there is currently only one registered REIT that is listed on the Nairobi Stock Exchange (NSE).
Although they are called trusts, they can be instituted either as a company with shareholders and legislated under the Companies Act, or as a Trust with unitholders and legislated under a Collective Investment Scheme Act, or some other similar legislation. Either way, they are created with the goal of maximising shareholder/unitholder value. It is required that a significant portion of income they generate be distributed as income to their shareholders in the case of companies, and to unitholders in the case of trusts. Basically, REITs operate along a straightforward and easily understandable business model: by leasing space and collecting rent on its real estate, the entity generates income which is then paid out to shareholders/unitholders in the form of dividends. In the US, REITs must pay out at least 90% of their taxable income to shareholders/unitholders — and most pay out 100%. In South Africa and Kenya the set dividend payout ratios are 75% and 80% respectively. There is no corporate income tax that applies in most jurisdictions for REITs while shareholders/unitholders pay income taxes on the dividends they receive.
In our instance, the regulatory authorities have resolved to legislate REITs under the Collective Investment Scheme Act – thus they can only be set up as Trusts.
Investing in REITs can serve as a source of cash flow for income-oriented investors. However, succeeding with REITs means finding the best REITs for income and understanding the advantages and disadvantages of this investment vehicle.
Direct Property Holding Proving More and More Difficult to Navigate
REITs, where they have been in existence, have historically delivered competitive total returns, based on high, steady dividend income and long-term capital appreciation. Their comparatively low correlation with other assets also makes them an excellent portfolio diversifier that can help reduce overall portfolio risk and increase returns. Their unique characteristics of combining the liquidity and accessibility of investing in the stock market with the stability and tangibility of owning real estate, makes them such an attractive asset class.
For many pension funds, most of which are currently facing the mammoth task of how to proceed with their current direct property exposure in the backdrop of a very non-normalised environment, REITs could certainly be the saviour that could free them away from the current trap to salvation.
With a very long history of dominating the pension fund sector, direct property holding is for the first time facing real, and unprecedented, existential threats. A hyper-inflationary environment, negative real returns, souring costs of real estate management and maintenance, low occupancy rates and high voids are nudging pension funds to take another look at their direct property portfolio exposures. Ageing fund memberships as companies are not recruiting new and younger employees in any significant ways and the consequent need for liquidity that builds up from it are compounding the challenges that funds are currently having to deal with. That direct property holding is itself illiquid and indivisible is only making an already bad situation ugly. Well, maybe not as ugly to many as one may want to portray it until of course one throws into the mix the issue of highly questionable property market values that funds are currently quoting in their valuations. While replacement cost might be a sound valuation approach for insurance policy purposes, it is certainly not a prudent approach for ascertaining what a property is worth on an ongoing basis. In a non-normalised environment though like ours, the discounted cash flow method itself breaks down immediately, thus rendering it unfit for purpose either.
Pension funds are desperate for a way out – but then, they are faced with a dilemma. Property is probably the only asset class that has consistently withstood, in a commanding way, the vagaries of hyper-inflationary periods. For some pension funds, had it not been for the property component in their asset mix, the real value of their assets could have been eroded to near-zero levels during the 2008/2009 hyper-inflationary period. It is thus understandable if trustees are hesitant to offload their properties and replace them with something else. There is also a lot of sentimental and emotional value attached to owning direct property anyway. However, this time around the world has thrown a curve ball at pension funds directly holding property.
REITs, the Saviour?
So are REITs the real deal for the woes pension funds find themselves in with respect to their direct property exposure. Yes, they could be, and they come with a lot more extra benefits too beyond the immediate redresses.
REITs are certainly a much-needed reprieve for pension funds right now. They will help immediately unlock liquidity from the pension funds’ current positions where they are stuck in. REITs address the many challenges of direct property exposure.
For instance, depreciation tends to overstate an investment’s decline in property market value. Reliance on this valuation could have been resulting in the understatement of the true value of the properties. In the listed space, the forces of supply and demand that take into account a battery of valuations based on different valuation methodologies will ultimately determine the true and fair market value.
Also, real estate markets tend to be cyclical and dependent on the overall economic environment and the level of interest rates. However, REITs’ diversification among many types of properties can smooth out the ups and downs of the market.
REITs are professionally managed by experts who need to satisfy the regulator of their competence in real estate management as part of the conditions for qualifying for the licence to establish and operate a REIT. By converting their direct property exposure into units in REITs, pension funds are assured that any future investment decisions on their assets will be made by professionals with the right combination of experience, skill, and talent. In the real estate space, strong management does make such a huge difference. Furthermore, risk is mitigated because legislation requires excellent governance and reporting. REITs trustees are accountable to the SECZim.
By giving up part of their direct property ownership, not only can the pension funds diversify within the asset class, they will also be able to diversify out of the property asset class altogether. At a time when the traditional equity, property, bonds, and cash asset blend has fallen short of investors’ risk-return expectations, diversifying into the alternatives is fast becoming a recommended strategy.
Other benefits are that, with REITs, risk is pooled among many investors, unlike now where funds are largely the sole owners of the properties in their portfolios. This pool of investors would also likely include foreign investors that otherwise have felt all along that they were restricted from owning direct property. Also, potentially to be attracted to this are foreign investors that all along would have felt that direct property portfolio management in a foreign land would be way too demanding.
Additionally, pension funds will no longer be concerned with property taxes, insurance, onerous maintenance and upkeep, and much more, as these become the responsibility of the REIT. In comparison to direct property holding, REITs are really a “passive” investment.
Are They the Almighty Panacea Though?
It should not be forgotten though that REITs are simply a legal structure for investment purposes – the underlying asset remains the same – property. The problems bedeviling the real estate sector do not instantly disappear simply because the investment has been candy-coated as a REIT. While they address the traditional issues that are peculiar to direct property investment, they fall short of what is required to attend to the real challenges facing real estate as an asset class today.
That there is now legislation in place is not in and of itself a sufficient condition – albeit a necessary one. Kenya has had the necessary legislation in place since 2013 and yet to date only one REIT has successfully listed on the NSE. The real appetite for REITs might have been overstated in the hype that motivated the industry to push for the introduction of the relevant legislation. The real interest will only be observable in the coming months and years. A limited supply of competing REITs might be a discouragement for many investors to convert their direct property ownership into REITs units. That hesitancy will in turn cool off any further interest from the industry to roll out REITs – and before anyone realises, everything would have turned into a downward spiral and REITs would be effectively dead at infancy.
It need be remembered also that at the end of the day, REITs are stocks, and their price will vary largely in tandem with the rest of the listed stocks. So, a move being seen by many as an escape route the industry has been requiring effectively piles up more funds’ assets into the listed equities space. That flies against one of the core fundamental principles of investing – “never put all your eggs in one basket”. It also ignores one of the related truisms of investing – diversification is the only free lunch available for investors.
It also turns out, one of the greatest points of attraction for REITs happens to simultaneously be one of their biggest sources of potential pain. That they are liquid means that their prices will fluctuate endlessly and will not reflect the true value of the underlying properties at all times. Members leaving when the market values are below the intrinsic values will lose out and there is just no mechanism of correcting or making any good on losses suffered as a result of market volatility.
As with stock investing, when converting to pooled REITs, not only will the pension funds be relinquishing their total ownership of the properties, they will also be resigning control and all the direct influence they currently have on how their properties are managed. Trustees will be forced to trust that the REIT managers will manage their property investment exposures well. For instance, Trustees will have to rely on the REITs managers for implementing their property portfolio related ESG policies.
The other problem with REITs is that, like with stocks, they are not a physical object that can be used. If the value of a REIT is down, it is essentially worthless until its value picks up again, unlike a real property which can serve other purposes while its value is down. There is a lot of value that a real estate owner can derive from their property for some other uses. For instance, in the past some pension funds have derived a lot of socio-economic value from renting out their apartments as student hostels at below market rates when they could not find their ideal tenants.
Furthermore, whether directly held or housed under a REIT, property is highly cyclical. While the advent of the new norm might be advocating for a focus on only a few sectors that are seen as being aligned to the new norm this increases their sensitivity to trends in the real estate market. So, pension funds need to pay particular attention that in the quest to specialise in promising sectors they also do not over-concentrate their REIT portfolios.
It is worth mentioning here that, while for pension funds already holding property the timing could be very wrong for conversion to REITs as property values are currently subdued and so would be the REIT values. For those that are invested in other asset classes and have been contemplating gaining some exposure into the real estate sector, the introduction of REITs could not have come at any better time. Any REITs coming into the market are likely to be at deep discounts to fair values. Of course, there is also a danger of falling into a value trap with this view – that is, buying an asset that looks cheap but then never recovers from that low value.
Also noteworthy is that conversion to REITs immediately introduces two new layers of fees for most pension funds. First additional line of fees will be with respect to the REIT manager. The second will be as a result that pension funds will most likely not invest directly with just one REIT – instead, they will invest in a portfolio of REITs that is professionally constructed by REITs portfolio managers who will also charge fees for their expertise. These will still be over-and-above the current realtors and property management fees that pension funds are already paying. Hopefully, the expert REITs Trustees and property managers will be able to introduce efficiencies which result in overall reduced costs, even after incorporating the additional layers.
It also needs be highlighted that REITs are just investment vehicles born out of an act of parliament. The underlying asset remains the same, property – an asset class facing its strongest headwinds ever. When the economy is doing great, REITs are a fantastic buy. But if the economy goes through a recession, REIT profits take a heavy hit and income dries up. Not only is our economy down, the prospects of an immediate recovery are also rather remote too. But worse still, changes in societal behaviours seem to be establishing a less friendly relationship with real estate on a more permanent basis. It is still to be seen if introducing RIETs under the current economic conditions is the best timing. A huge risk will be the transfer of property investments from pension fund members to other financially resourced investors at heavy discounts.
Investing in REITs, just like in ordinary stocks, does not in and of itself guarantee immediate liquidity. There are listed stocks whose liquidity is worse than that of some commercial properties in prime areas. So, trustees need to realise that conversion to REITs will not automatically bring them to a fully liquid marketplace. There are some REITs investments that will lack liquidity still.
Furthermore, converting to a REIT can sound exciting at first, as the tax advantages do look attractive. However, the tax breaks on their own will not deliver superior investment returns – properties that have been struggling will not immediately turn profitable because they are now housed under a REIT.
Conclusion
In conclusion, while we celebrate the promulgation of the relevant acts governing REITs, this is certainly no panacea to solving all our direct property holding challenges. Pensions funds will need to seek expert guidance and advice on how to navigate any potential conversion to REITs exposures. Also, a general lack of policy consistency has the threat of keeping investors at bay. Policies that are less friendly to foreign investors will also be such an impediment to the kind of REITs growth that the industry could be anticipating as domestic investors alone may not be enough to fund this anticipated growth. A robust REIT sector will not only require an environment that makes it easy for foreigners to bring their much-needed capital into the market, it also requires that they be able to repatriate their dividends with ease.