d.o.g. On REITs & Shipping Trusts

Following my own thoughts on 'Investing in REITS', here's a post by D.o.g. on investing in REITs & Shipping Trusts.

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d.o.g.
posted on 19-12-2007 at 03:57

Actually, in ANY sort of investment climate, dividends and distributions are important. Many studies have concluded that dividends form a significant portion of the investor's total return.

For the S&P 500, from 1926 to 2004, dividends provided 42% of the the total return. Put another way, $1,000 in the S&P 500 would have grown to $90,000 during this time. But if the dividends were reinvested, the sum would be $2.3m. A rather significant difference.

Over a more recent period, 1970 to 2000, dividend payers in the US also outperformed non-payers, and suffered less volatility. In other words, dividend-paying companies were not only better for the wallet, they were also better for the heart. You got to eat well AND sleep well. Can't beat that.

However, in any investment, there should be a margin of safety, and high-dividend securities in Singapore are not exempt.

REITs are compelled to pay out at least 90% of rentals. This means that in a recession, distributions must fall since the REIT has at most 10% excess income to absorb the loss in rentals. Since rental agreements are seldom for longer than 3 years, it follows that REIT distributions will track the economic cycle, albeit with a time lag i.e. it takes about 3 years to fully adjust up (down) to good (bad) economic conditions.

Singapore's economic is clearly near its cyclical peak by any measure - full employment, high but static housing prices, construction boom, etc. So the REITs may be able to continue to grow distributions for a while more, but eventually the distributions will peak, just like the economy, and then they must fall, just like the economy. Have REIT distributions peaked? Only the REIT CFOs will know.

Investors in REITs would be wise to poke around their REITs' properties and see just how much more lettable space they can create, and see just how much higher they can push rentals. The REITs have come a long way, especially the retail REITs, but they are approaching (if not already at) a fully optimized state i.e. it can't get any better, so it can only get worse.

Shipping trusts are also compelled to pay out at least 90% of lease income. This means that their income on existing ships follows the shipping cycle, but the income per ship is set only once every 5-7 years when the leases expire. As many trusts try to stagger the leases, the net effect is that over time, the trust will renew a few leases every year, thus it ends up following the cycle, albeit with a longer time lag than REITs.

Something that is not obvious is that the trusts often carry a residual value risk i.e. they may be stuck with a ship if it comes off-lease during a poor market.

Some trusts have signed lease agreements that give the lessee the option to buy the ship during or after the lease. This is disadvantageous because if the market is good, the lessee buys the ship cheap, and can make extra profits. If the market is bad, the option lapses, and the trust is forced to recharter the ship at a low lease rate.

Investors in shipping trusts should do a detailed DCF model and assume the worst case i.e. unit prices do not rise enough for the trust to grow by issuing new units. In such a case, all the return to the investor must come from lease income and the eventual disposal/recharter of the ships.

Don't forget that the shipping trusts are carrying debt that must be paid off, too. After paying off the debt, and discounting the net cashflows back at an appropriate rate of return, they may be in for an unpleasant surprise.

The shipping trust officers frequently argue that such pessimistic analyses do not take into account the potential for growth by acquisition i.e. if the trust price goes up, it can issue units to buy ships, just like REITs.

I would point out that first, this method of growth depends on market sentiment, which is thoroughly undependable, so it should not be a factor. If it happens, it's a bonus, that's all. It should not be taken as a given.

Second, this method of growth is not unique to trusts or REITs. Any listed company can take advantage of favourable market conditions to sell expensive stock and buy cheap(er) assets, whether ships, buildings, machinery or entire companies.

The conglomerate boom in 70s USA was fueled by exactly such a mechanism. If your stock was trading at 20x PE, you could sell stock at 20x PE and buy another company trading at 10x PE. This would ALWAYS be "earnings accretive" so it drove your stock price higher, allowing for more acquisitions, ad infinitum. In theory. In practice, once other companies got into the act, they collectively ran out of things to buy. They bought assets of worse and worse quality, and eventually their earnings - and their stock prices - collapsed.

The 3 shipping trusts (PST, FSLT, RMT) are all very different in how they operate. The fees paid, debt carried, ships bought, lease profile, customer profile, distribution policy etc are all different. Investors should read the prospectuses carefully to make sure they know exactly what they have bought.

Also, here is a useful (but long) primer on ship finance, courtesy of a student at the National Technical University of Athens' Laboratory for Maritime Transport:


http://www.martrans.org/documents/extra/diplomatheses/Orfanidis%20Alexis/ShipFinance.pdf

The first 100 pages cover both historical and current practices in ship finance. I personally found it invaluable when I was studying the shipping trusts. Anyone who is not au fait with shipping trusts should read it.

If you happen to read Greek, you can check out more papers here:


http://www.martrans.org/resources/render1.asp?doc=/documents/extra/diploma.xml

Finally, as a common sense check, remember that REITs, shipping trusts and business trusts were not created for the benefit of investors. They were created for the benefit of asset owners who were unable to finance their assets by conventional means i.e. banks, investment funds and rich private investors.

In other words, the assets being injected into the listed entities are of poor quality, highly priced, or both. Things that the "smart money" won't touch. Deep into a bear market, asset prices come down, and certainly REITs and shipping trusts can be good investments then. Are we deep into a bear market?

As usual, YMMV.