Do You Like REITs with High Debt Ratio?

When we are searching for good quality REIT, there is one key metric that we must pay close attention to, namely the DEBT RATIO.

Debt ratio = Total debts of the REIT divide by the REIT's total assets. 

The higher is the ratio, the higher is the debt level and vice versa. 

Higher debts do not necessarily mean the REIT is in trouble, if the REIT incurs higher amount of debts to acquire new property that is yielding positive return in excess of borrowing cost, the higher debt loads is not 100% bad. 

As REIT needs to pay at least 90% of its distributable profits to unitholders, hence there is lesser profits retained at REIT level as bulk of the money has gone into unitholders' bank accounts as distribution. As a result, REIT may need to borrow money in order to pay some of its property upgrading expenses, refinancing of existing obligations or acquiring new properties.

Currently, Malaysia-REITs (M-REITs) are allowed to incur up to 50% debt ratio, which may be increased if REIT obtained approval from unitholders by way of ordinary resolutions. However, under the latest proposed measures by Securities Commission (SC), M-REITs are likely to have a fixed debt limit not more than 50% without the option to increase this limit. I view this measure as positive as it ensures that borrowings of REIT are kept at reasonable level.

REIT	Debt Ratio
YTL Hospitality REIT	46%
Hektar REIT	44%
Al-Aqar Healthcare REIT	41%
Axis REIT	35%
Sunway REIT	33%
CMMT REIT	31%
Pavilion REIT	26%
IGB REIT	24%

The table above shows the debt ratio comparison of selected REITs. You could compute the ratio by taking the total debts and divide by its total assets ( these numbers could be found from the REIT's financial statement).

What are some possible drawbacks of having high debt ratio?

1) If the REIT wants to incur more debts to buy new property, it might be constrained to do so. For example, in view of high gearing of Hektar REIT, it plans to raise capital (a.k.a rights issue) from shareholders to funds its proposed acquisition of 1Segamat Shopping Centre. Unitholders might need to invest more capital into Hektar REIT, nonetheless, it is not an obligation, but rather a rights. 

2) When the debts fall due, the REIT might not have enough money left to pay the loans as 90% of its distributable profits would have been paid out. It is normal for a REIT to refinance its obligations. Hence, the REIT could be at the mercy of lenders in the extreme scenario.  Avoid bad quality REIT.

3) Debts that were incurred by REIT to buy bad quality property, may eventually result in lesser net income to the REIT as rental income generated from bad quality property might not be enough to cover the interest incurred on the debts if the occupancy rate of the bad quality property declines and compounded further by decline in rental rates.

Usually i will only invest into REITs that have debt ratio of not more than 40%.  

For Retail REITs such as Sunway REIT, CMMT REIT, Pavilion REIT and IGB REIT, they are likely to incur more debts to fund the purchase of new malls or new properties since the REITs still have a lot of room for debts before it hit the 50% limit.

This is the key concept of leveraging using Other People Money (OPM), if it is leveraged well, the newly acquired property will eventually contribute net positive return to the REIT and this is what we eventually hope for.