The REIT Metric Everyone Overlooks - But Shouldn’t

Updated: Dec 12

When investing in Real Estate Investment Trusts (REITs), most investors diligently monitor the usual indicators like gearing ratios, interest coverage, and distribution yields.

However, an emerging trend may be slipping under the radar: the increasing use of perpetual securities (bonds) by REITs.

Post-COVID-19, this method of raising capital has become more popular, and it could obscure the true financial health of a REIT if not properly accounted for.

In this article, we’ll explore what perpetual securities are, why their use by REITs can be problematic, and how investors can better assess the real health of a REIT’s balance sheet.

What Are Perpetual Securities?

Perpetual securities are a form of debt-like financial instrument that pays a fixed coupon (similar to bonds), but unlike traditional debt, they do not have a maturity date.

This means that REITs can raise capital by issuing perpetual securities without the obligation to repay the principal. In many ways, perpetual securities act like bonds, but with an indefinite repayment period.

That said, the issuers of such securities would often attach a callable feature that allows the REIT to redeem the bond after a pre-determined amount of time. However, the callable feature comes at the expense of a higher borrowing cost as investors need to be compensated for the additional reinvestment risk from the callable feature.

On the topic of borrowing cost, the interest on the perpetual bond is also fixed for a pre-determined period and would be reset periodically (often 3 or 5 years) to “re-price” the interest based on the prevailing market rate. This means that the cost of borrowing is still subjected to the changes in the interest rate environment and is not fixed indefinitely.

Post-COVID-19, REITs have increasingly turned to perpetual securities as a way to raise capital. The primary reason for their popularity is that they offer REITs greater flexibility in terms of financing operations while reducing the future refinancing risk of the REITs.

However, this flexibility comes with potential risks for investors that are often overlooked.

The Hidden Nature of Perpetual Securities

The issue with perpetual securities lies in their accounting treatment. While perpetual bonds behave similarly to debt, they are accounted for as equity on a REIT’s balance sheet.

This means that even though REITs are taking on obligations to pay coupon payments to the holders of these securities, these obligations do not show up in key financial metrics that investors typically monitor.

Given the classification of perpetual securities, here are some of the commonly used capital management indicators that might be affected:

Gearing Ratio: The gearing ratio, a key metric used by investors to assess a REIT’s debt levels, measures the ratio of a REIT’s debt to its total assets. Because perpetual securities are recorded as equity and not debt, it allows the REIT to report a lower gearing ratio. This can make a REIT seem less leveraged than it is.
Interest Coverage Ratio: As the coupon payments on perpetual securities are not treated as interest expenses, this can result in an inflated interest coverage ratio, making the REIT’s financial health appear stronger than it truly is.
Thankfully, regulators have implemented safeguards requiring SGX-listed REITs to disclose an Adjusted Interest Coverage Ratio (ICR), which includes the impact of perpetual coupon payments and limits the REITs ability to take on more borrowing if the Adjusted ICR is not satisfactory.
Debt Profile: Perpetual securities are also excluded from a REIT's debt maturity profile and their cost of capital is not factored into the weighted average cost of borrowing.

This can obscure the true financing costs and interest rate risks of the REIT. Without accounting for these securities, investors may have an incomplete understanding of the REIT’s financial exposure.

The Problem for Investors: Hidden Leverage

Because perpetual securities don’t show up as debt, they can give a false sense of security to investors evaluating a REIT’s financial health.

A REIT may appear to have a low gearing ratio and strong interest coverage when, in reality, it has taken on significant financial obligations through perpetual bonds.

For example, AIMS APAC REIT has reported an Aggregate Leverage Ratio of 32.6% and an ICR of 4.1x but if we were to consider the use of perpetual securities, the total debt (including perps) to asset ratio is calculated to be around 45.80% and the Adjusted ICR is at 2.4x.

For investors who don’t dig deeper into the balance sheet, this can lead to overestimating the REIT’s ability to weather economic downturns, repay its obligations, or maintain dividend distributions.

In addition, should interest rates rise, the REIT may face even higher coupon payments on existing perpetual issuances when the coupon resets as opposed to traditional debt financing, further straining its cash flow.

Investors who were initially attracted to a REIT based on seemingly healthy financial metrics may find themselves holding an investment that struggles to maintain stable distributions over time.

As of October 2024, here are the REITs that use perpetual securities as part of their capital management strategy:

Conclusion

While perpetual securities offer REITs a flexible way to raise capital, their hidden nature can obscure the true financial health of the REIT.

Investors need to be aware of the potential risks that come with perpetual bonds and take a deeper look into a REIT’s balance sheet before making investment decisions.

By understanding the rising use of perpetual securities and how they can impact a REIT’s financial obligations, investors can avoid being blindsided by seemingly healthy financial metrics that don’t tell the full story.

The next time you evaluate a REIT, make sure you’re not overlooking this important indicator—your investment returns may depend on it.

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