The Growth Problem With REITs Investing

Daniel Lee

12 minutes ago4 min read

While Real Estate Investment Trusts (REITs) are one of the better instruments for capital preservation and income generation for one’s financial freedom, it is not a suitable asset class for investors seeking growth and wealth accumulation purposes.

This is because REITs are limited both by the design of the instrument and the nature of the underlying assets (properties). In this article, I will go into detail on how a REIT grows and why the growth of a REIT is limited.

How REITs Grow

To understand why REITs are, by design, limited in terms of their ability to grow, you will have to first understand how a REIT grows. Generally, REITs can increase their value by three methods.

Firstly, a REIT can increase their rentals to increase the total income generated and hence the overall value of the property (a.k.a Rent Reversions).

Secondly, a REIT can conduct asset enhancement and repositioning to increase the total rental income.

This can be achieved by two means, the first is to re-design the floor plan and expand the property (by adding additional floor space) to increase the total leasable area and hence increase the total income generatable.

The second is to redesign the space itself to fit a specific tenant or purpose in an attempt to differentiate it from other similar properties. This will allow the REIT to command a higher rental rate without increasing the leasable area.

Thirdly, a REIT can acquire more properties or conduct capital recycling where they sell their existing property and re-invest the capital back into a more profitable property. Doing so enables the REIT to increase its total income by either having more properties to rent out or having the same number of higher-yielding properties.

Why Is The Growth Of A REIT Limited

Now that you’ve understood how a REIT can grow and achieve a higher intrinsic value, here are two major limiting factors that will impede the sustainable growth of a REIT’s valuation.

The first limiting factor is the commoditized nature of a property.

As REIT (or property) investors are essentially just buying and leasing a space, the ability for us to increase the rental rate is very much limited to the market’s supply and demand due to our inability to differentiate the “space” to command a higher rental rate.

Even if you attempt to differentiate the space via asset enhancement and repositioning efforts, there are hard limits to the additional premiums that tenants are willing to pay for such differentiating factors as it must make economic sense for them as businesses to lease from you as well.

As a result, the growth of a REIT’s intrinsic value via higher rental income per net leasable area is very much limited to the market conditions that are outside of the control of the REIT investors themselves as this is influenced by the economic cycle and government policies.

The second limiting factor is the 90% distribution requirement that all REITs tend to comply with.

Given that REITs are incentivised to distribute the bulk of their earnings, they would usually only retain sufficient earnings for day-to-day working capital. As a result, should a REIT decide to do an acquisition or asset enhancement initiative, it would often have to either borrow from the banks or issue new shares to acquire the capital necessary.

This ends up diluting the existing shareholder base which then brings about not much earning yield benefits apart from further diversification.

For example, if a REIT has 10 properties and 10 investors and they have to bring in another investor to acquire an additional property, the ratio of the number of properties to the number of investors (hence earnings per investor) would not change apart from the fact that collectively, the REIT has 11 properties instead of 10.

That said, there are yield accretive acquisition or asset enhancement projects where the projected increase in rental income outweighs the additional cost of capital or dilution, but those are largely dependent on the REIT manager’s ability to identify and implement yield accretive opportunities.

While it is possible to find a REIT that can sustainably increase shareholders' value in the long run, investors should take note that such REITs are rare and you should not count on REITs if your main investment objective is to accumulate wealth via fundamental growth of the investments.

Ironically, it is easier for investors to achieve a more sustainable capital gain via active management (selling when the REIT is overvalued and buying when it is undervalued) as compared to counting on the fundamental growth as the intrinsic value of a REIT tends to remain stable while the price of a REIT tends to be volatile and easily influenced by market sentiment.

Conclusion

While REITs do have the ability to grow, the design of the instrument coupled with the nature of the underlying asset (properties) makes it a tough endeavour for investors to expect their REITs to grow at the same pace as say a tech company.

That said, the very factors that limit the growth of a REIT are also the factors that provide REITs with their inherent ability to preserve their value and provide investors with a stable income that is much sought after for investors who are investing for their retirement or financial independence.

Long story short, before considering which REITs are worth investing in, I think investors need to first have a good understanding of the different financial instruments available and decide for themselves if REITs are suitable based on their investment objectives.

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