Limbering up for REIT
If we wish to use all the benefits of REIT, we need to start planning. It is not only about the formalities connected with going public.
We need to consider how we shall assure investors about stable appreciation in value of our properties as well as what our dividend policy will look like, the lawyer Robert Szczepanek - the founder of Causa Finita Commercial Real Estate Law Firm stated to the Retailnet portal.
A great deal has been said recently about REITs. What do you think about the initiative of introducing this type of investment vehicles in Poland?
REITs will be an effective vehicle for investing in real estate. Only the fact of working on introducing them should be evaluated in a very positive way. In our practice we had a pleasure to work for an American REIT. Therefore, we know very well the reality of functioning of such companies in the USA.
What should investors do to start preparing for obtaining the REIT status?
It is a very complicated issue. Particularly, because of the fact that the final content of the law is not known yet. Some features of REITS, however, have a universal character – REITs function in this way or the other in many countries all over the world. From our perspective, it is certain that REITs will be able to deal with shopping centers, they will be public companies and they will pay out 90 % of net profits as the dividend.
Thinking about what the preparations to REIT should be started from, first of all we need to ponder circumstances in what REITS will debut on the stock exchange. Assuming that the law will enter into force at the beginning of the next year, there will be many companies of the real estate rental market appearing on the stock exchange at the same time. They will compete for the capital not only between each other, but also with REITs dealing with other segments of the real estate market.
Do you, therefore, think that REITs will enter into force in an unfavorable period?
Generally speaking, the economic situation in Poland does not favor business. In the USA, the REITs managements keep observing cycles on the real estate markets. In Poland, shopping centers do not function long enough to be able to show a cycle. Nevertheless, if such facts as: the saturation in retail space in Poland in 2016 at the level of the European Union average, the lowest index of the delivered retail space for 2004 (slightly exceeding 400 thousand square meters), the increase in the vacancy rate to 5 %, withdrawal of such brands as Marks&Spencer, Mothercare or Topshop from Poland, the cases of such projects as Bawełnianka or CH Sosnowiec, bankruptcy of Alma or Marcpol, were to be interpreted appropriately, the conclusion might be that the shopping center market in Poland has just reached an equilibrium.
As a consequence, the REITs will basically have to adopt defensive management strategies focused on maintaining the current lease levels as well as preserving current FFO.
A similar situation has been lasting for some time.
Yes, it has, but additionally the inflation rate has been increasing lately and specialists predict that it is rather a stable tendency. Inflation is not the best information for investors wishing to obtain the REIT status, because real estate traditionally “does not feel” well in the environment of increasing interest rates. The cost of money increases thereby. At the same time, the risk of not being able to roll over the current debt in some time on the present conditions increases. Moreover, we need to remember that REIT shares compete for the capital with corporate bonds, State Treasury bonds or bank deposits. All these instruments become more attractive against REIT shares in the higher interest rates environment. Besides, more expensive capital inflates yields, and consequently, higher yields deflate the prices of real estate.
What would you advise investors who wish to obtain the REIT status in the future?
If we want to use all REIT benefits – that is the possibility to efficiently liquidate funds invested in real estate, to have an access to cheap capital and an unlimited number of investors – we need to get prepared. And it is not only about the formalities connected with going public. We need to think how we will assure investors of a stable appreciation of the value of our properties as well as how our dividend policy will look like.
Investor most often buy REIT shares because their prices tend to increase steadily (on an annual average by 4 % in compliance with the statistics of the American NAREIT organization) and because REITs should pay out dividends regularly.
Thus, the portfolio of real estate held by our company needs to be analyzed and appropriately composed. The American experience shows, for example, that the market does dislikes branch diversification, meaning investments made by REITs in some different segments of real estate ( e.g. investing simultaneously in shopping centers and warehouses). Investors prefer to spread the risk by investing simply in shares of a few REITs specialized vehicles. It looks differently when it comes to geographical diversification. In such case, there is no danger that management will lack experience in managing real estate of various types.
On the basis of such an analysis, our projected net profit from the possessed real estate portfolio should be estimated. It will be best if the amount of the planned dividend per share is announced to public.
Is it necessary to make the amount of the dividend available to public?
Yes, it is. REITs announce the amount of the dividend to be paid to the shareholders. It is supposed to help stock exchange investors estimate the planned return on the investment. It also helps weighing the costs of capital.
Let’s assume that a developer adopted his real estate portfolio to REIT. What further actions need to be taken to prepare for obtaining REIT status?
The next step would be a detailed analysis of the possessed debt and the cost of capital. Such issues will be analyzed in detail by stock exchange investors. The draft law on REIT of October last year allowed a maximum debt-to-gross-asset-value level at 70 per cent. Obviously, such a high debt rate is theoretically possible, but in practice it is expected to be observed only exceptionally. Indebtedness is significantly important in evaluating the investment risks of a given REIT. A too high debt rate puts REIT in danger of problems with its handling in case of an economic downturn. It was perfectly visible in the USA during the Great Recession when several dozens of the most indebted REITs decided not to pay out dividends in order to preserve funds necessary for debt servicing. It obviously resulted in their loss of the REIT status.
In the current economic situation, the higher the debt, the higher the risk. The higher the risk, the more expensive the capital. If a given REIT has a weighted average cost of the capital at the level of 7 %, then it cannot buy real estate at yields being lower than 7 % - it wouldn’t make a greater economic sense for it. REITs which possess a lower cost of capital will have a competitive advantage over it. In the USA the average REIT debt rate in relation to its assets equaled 36 % towards the end of 2015 and it is considered to be safe at such a level (NAREIT data).
You have mentioned that the market has saturated itself. How should REITs react to such situation as far as attracting tenants is concerned?
Let’s look at this matter from the perspective of a stock exchange investor. The rents will be the basic source of income for REITs. Thus, investors will analyse our REIT mainly in light of the stability of the rent income. As an example, if our projects were opened during in 2013- 2014, the basic 5-year rental periods will soon expire. Moreover, our commercialization practice usually looks in such a way that all lease agreements in a given building are concluded for the same period of time, therefore – they will be expiring at the same time. Stock exchange investors – taking into consideration the general situation on the real estate market – may have doubts whether REIT will manage to renew the agreements on the current conditions. All these aspects have to be taken care of now. During the period of market uncertainty, investors should be reassured by rent agreements concluded for longer period of time. The turnover rents have to be also carefully negotiated. If the economic situation improves during the rent period, the turnover rents will be basically the only way of reflecting such improvement in the income from the real estate.
The situation seems to be very complicated indeed.
True, but it is just the beginning. Our future REIT has to be seen through the eyes of a stock exchange investor and not a private owner, as it is today. Stock exchange investors will be also very interested – apart from the aspects mentioned above – in the strategy of the development of our business. Are we going to develop it through organic growth (that is, maximizing the income from the real estate portfolio which is already possessed), through acquisition or perhaps development? (in the last case we do not know how the legislator will treat the matter). This strategy will have to be clearly communicated on the market as it has an impact on the investment risk in the shares of a given REIT. Moreover, a transparent corporation structure needs to be created. Procedures preventing conflicts of interests between REIT management board members and REIT interests need to be developed. There are many aspects to be worked out.
autor: Robert Szczepanek, Attorney at law, founder of CAUSA FINITA Law Firm