Despite the seemingly endless US-China trade war, the market prices of REITs have increased sharply since the beginning of the year. If you have substantial holdings of Real Estate Investment Trusts, you need to be careful.
This may sound counter-intuitive, but if you are investing in REIT as an Income Generating Asset for retirement income, you don’t want your share price to go up too fast.
Here are several reasons why:
- Your capital outlay needed to generate the same level of passive income will be much higher.
- The volatility of your investment portfolio will increase and thus reduce your willingness to hold the asset for the long term.
- Your net worth may drop substantially in the near term, which will affect your overall financial health.
The recent euphoria over Singapore REIT investments is a testament of Singapore’s stability in the uncertain time like now, but it may not end well.
Let me explain…
A REIT (a.k.a. Real Estate Investment Trust) is a popular income instrument nowadays. But it wasn’t always the case.
(Additional reading: How a Real Estate Investment Trust generates passive income for retirement.)
When I first talked about REITs as an investment many years ago, a lot of people were skeptical.
I advised my clients that in many developed countries, the rich people had already moved their wealth from physical property investments to securitized property investments such as Real Estate Investment Trusts. But as the Singapore property market was still hot at that time, not all took my recommendation.
When we fast forward to today, REIT investing has become synonymous with income investing. Why? Because REITs were doing very well and Singapore’s stock market was sluggish. Now people are rushing in to buy REITs, and the same phenomena of any asset bubble has started to surface:
- A person who has never invested in stocks before starts to talk about putting money into REITs.
- Financial bloggers start to brag about their REIT portfolios.
- REIT courses mushroom. Even “value investing” course providers switch gears to jump on the bandwagon.
- New REITs-related unit trusts and ETFs launch.
- A parabolic price movement occurs in the price of REITs.
I have no problem using REITs as an asset class in a retirement portfolio. However, I am concerned that investors are putting too much faith in REITs.
(Additional Reading: Investing for Retirement: Why you should not over-rely on REIT investments.)
When I looked at my clients’ stock portfolios this year, I noticed a lot of investors have 80% to 90% of their holdings in REITs. That is not a healthy sign.
Similar to investing in a condominium, most people started investing in REITs as an income instrument. But when the price kept on going up, they became greedy, “Oh, I can also invest for capital appreciation”.
This is known as the herding mentality and it is quite powerful in driving up the share price of REITs.
You see, if you are investing for income, you want to buy the asset at the lowest possible price. But when you think the asset price will appreciate in the future, you will pay whatever price the market asks for.
Singapore REITs are simply overpriced.
Although you can find much information about REIT investing, an unbiased opinion is hard to come by.
No matter what other people tell you, REITs are overpriced now. It is a fact (I will explain later) and all financial professionals know this. The problem is that most people hesitate to admit it. Charlie Munger’s quip, “Show me the incentive, I’ll show you the outcome,” explains it all. Let’s analyze some incentives.
- If you are the bank who lends the money to REITs, can you issue a “SELL” recommendation to a client?
- If you are a REIT fund manager, how do you tell people that their fund is on the verge of correction?
- If you sell a course to teach people how to buy the best REITs, how do you tell people that this asset class is no longer attractive?
- If you, an individual investor, just realize that you have missed the boat in REIT investing, would you give up so easily? (think about bitcoin)
Some people may say, “You are a financial adviser, that is why you don’t recommend REITs because you can’t earn a commission”.
This is a common misperception.
As an independent adviser, I do allocate REITs in my clients’ income portfolio. The reason I can do this is that I am fee-based so I can be unbiased when it comes to advising my clients.
Since June I am already getting very cautious over this asset class. Below are comments extracted from my monthly investor’s letter.
June 10, 2019 Investors letter
As you can see from the earlier performance chart, the GMC (Global Momentum Compass) Income portfolio has done well. This is thanks to our allocations of fixed income and REITs which took the fund outflow from riskier assets.
My concern is that Real Estate Income Trusts (REITs) as an asset class could be overvalued for now. I am prepared to exit or reduce the holdings.
July 8, 2019 Investors letter
20% of our Income portfolio was allocated to Real Estate Investment Trusts, which has done really well. Our REIT positions have made around 18% this year.
But since last month, I have already expressed my concern about the REITs valuation, especially for Singapore REITs. Singapore REITs have outperformed the STI by too much and deviated from its fundamentals.
Moreover, I hear more and more retail investors are rushing into REITs as if it is heaven sent. I will be taking the profit from this position and rotating it into a global multi-asset income strategy.
The chart below shows how my GMC Income portfolio positioned REITs in the past year.
I can’t say that Singapore REITs can’t go up higher this year. But I sold the positions with conviction.
Because a REIT is a relatively easy investment to understand. You own an asset (the property) and that asset generates rental income (your dividend). Therefore, in an overly simplified manner, your asset value should be proportionate to the dividends you receive.
One easy way to calculate this is to compare the difference between a REIT’s yield with the 10 year Singapore government bond yield (the so-called risk-free rate), which is called ‘the yield spread’ in financial terms.
From a layman’s perspective, because a REIT is riskier than a government bond, you need a higher return (the yield spread) to compensate for the risks that you are taking. As you can tell from the chart below, the yield spread of the FTSE Singapore Real Estate Investment Trust Index has reached a historic low.
This is not a good thing.
Because eventually, the spread has to revert to the norm.
The price correction of REITs may be much more than you think.
You may say, “Nah, I won’t bother since I am holding for the long term”. I understand where you are coming from, but there are two problems:
- You missed the opportunity to lock in a solid double-digit return within a short period, which is, by the way, hard to come by in today’s environment.
- You may not be mentally prepared for the degree of loss and the length of the downturn period.
Let’s do some math. Over the past 9 years, the average yield spread of Singapore REITs has been 6.72%. As of July 5th, 2019, the yield spread is 5.12%. The difference may not seem like a lot to you, but it has a huge impact on the future REIT price.
In a not so precise manner, here is how you can look at it. If you buy a REIT at $100 today and your yield is 5.12%, you receive a dividend of $5.12 a year. If you want to receive the same dividend, and the yield goes back to the historical average of 6.72%, your share price needs to be at $76.19 ($5.12 / 6.72%).
It means a whopping 24% potential downside for your REITs!
I know many retirees or pre-retirees bought REITs believing it was a safe asset class. But it is not. You may never have prepared for such a drawdown.
If you have fully invested in REITs, what can you do when the price is more attractive?
Did this happen before? Of course. In one of my earlier articles, I showed you that during the 2008 Global Financial Crisis, the FTSE ST Real Estate Investment Trusts Index dropped 70%. Even during uneventful times, the Singapore REITs dropped 19% in 2015 and 12% in 2017!
Should you sell all your REITs?
Let me tell you a story first.
June was a fantastic month for durian lovers like me. The durian this year was good and not so expensive. I was recommended to try this “Combat Durian” store because they “don’t cheat”.
When the uncle opened the second durian, there was an empty compartment with no flesh inside. So I asked the uncle to change it.
The uncle asked, “Young man, is this durian good?”
“Yes,” I replied.
He looked at me and said, “东西好就可以，不要太贪心”. (If you get a good thing, appreciate it and don’t be greedy.)
While that uncle may (or may not) have wanted to just push the durian on me, I did find some wisdom in his comment.
Our different sources of retirement passive income are just like the compartments in durian fruit. We all want to have a durian that has the most “flesh” inside. The thing is when you give up “good” for “more”, the next durian may not be as tasty as you hope it could be.
REITs are indeed good investment instruments. But this doesn’t mean they are the only asset class you should rely on for income investing.
On 3 July 2019, the Monetary Authority of Singapore (MAS) published a consultation paper in consideration of
- Raising the current leverage limit of 45%.
- Removing the requirement for REITs to submit a notification to MAS to obtain a “Restricted Scheme” status when they make an offer of units to accredited and other investors.
If implemented, this is an “easing policy”, which seems to be a pre-emptive policy to prevent a liquidity crunch in the REITs sector.
Selling REITs doesn’t mean giving up income
I have helped many people build their income-generating portfolios, and I still get the same questions every time.
If you think you have a fabulous investment portfolio and you want to hold on to your positions, that is cool.
But if you have substantial REITs holdings and you are not sure what to do, or you are tired of monitoring the stocks and want to spend more time to enjoy your life, I offer a fee-based consultation for
- An independent review of your existing investment portfolio, which may consist of stocks, bonds, ETFs, REITs and unit trusts.
- Recommendation to diversify your source of passive income to a global multi-asset income portfolio.
If this is what you are looking for, simply leave your contact below for a complimentary non-obligatory investment discovery meeting.