Saturday, December 15, 2018

Should you buy REITs based on a "Good" Sponsor ?

This started because a student felt uncomfortable with the portfolio of REITs selected by one of my better REIT screeners. He examined the list of REITs proposed by the stock screener and said that my portfolio contained REITs with "weak" sponsors. Separately I've been told on other occasions that investors should simply invest in REITs with good sponsors. Of course, these conversations seldom delve into how to actually determine what a good REIT sponsor is.

I've always felt uneasy about investment strategies like this - an intellectually dishonest investor can simply define a REIT sponsor as a good one if the REIT has performed well historically, otherwise the REIT sponsor cannot possibly be a good one. This is tautological reasoning and useless to serious investors.

So yesterday, I went back to the library during my break to get this out of my chest once and for all.

For the purposes of the rest of the experiment, my baseline is an equal weighted portfolio of Singapore REITs. Buying this and rebalancing every year would have resulted in 10.51% annual returns. The downside risk or semi-variance is a modest 13.09%. Experiment was performed 14 Dec 2018.

I made a decision that my proxy for "good" REIT sponsor is larger market capitalisation. I admit that this may not be the best way to conduct the experiment because my backtesting tools do not have a filter for sponsor.

So bear with me for this, for I have reason to believe that my proxy be valid.

Suppose you filter out the top 10 REITs in terms of market capitalisation would get a list that looks like this:

I can only convince you that the list of largest ten REITs should generally have what most retail investors would subjectively consider as "good" sponsors. They do seem to have more prestigious names.

But let us also look instead at the smallest ten REITs :

This list very likely contains REITS that have sponsors which may be less prestigious ( at least based on the subjective opinions of most retail investors ).

So, I backtested two strategies : The first strategy invests in the top 10 largest REITS on SGX for 12 years rebalancing every year. The second strategy invests in the top 10 smallest REITS on SGX for 12 years rebalancing every year.

Investing in the largest ten REITS would result in superior returns compared to the baseline. Returns are 11.42% and a semi-variance of 14.30%. Perhaps a smaller subset of stocks resulted in a higher volatility.  This modestly superior performance may be the reason why so many people believe that a superior strategy can be had by picking superior sponsors.

But investing in the smallest ten REITs also resulted in superior performance. In fact it was tad higher than the first strategy at 11.43%. The counter-intuitive result comes from a lower downside risk - semi-variance was 12.77%. Investing in smaller REITs would have resulted in higher returns and lower downside risk compared to buying all REITs in the stock market.

I think these results cast doubt on the hypothesis that investors should choose "better" REIT sponsors.

Instead I propose the following hypothesis about the REITs market in Singapore - most investors gravitate towards REITs with better sponsors so much so that they become more expensive, resulting in performance that is actually sub par compared to REITs with sponsor who are less prestigious.

Investors who actually follow the crowd and pick the "better-run" REITs are not just handicapped based on returns, they end up with a more volatile portfolio.

As always I am open-minded to any counter-arguments because I am constantly second guessing my own approach towards investing in REITs.

Let me know what you think.


ghchua said...

Hi Chris,

I guess there are many reasons for most investors to choose bigger REITs with better sponsors not only because of returns, but rather other reasons which might not have been captured in your backtest.

1. The frequency of rights issues. Smaller REITs with "weaker" sponsors tends to raise funds via bigger rights issues (for example, 1 for 1) if they wish to grow and buy more assets. Bigger REITs could do so with a small placement or preferential offers. What is means is that investors of smaller REITs must be prepared to fork out cash every now and then for these corporate actions, or risk being diluted big time.

2. Access to multiple sources of funding. Bigger REITs normally have better crediting rating from agencies and they have multiple access to sources of funding, be it from banks, bond markets etc. Therefore, when all hell broke loose, with a strong sponsor, they can still gain access to funds when needed. The strong sponsor could also be the last source of "support" if they couldn't gain access to any funding. Having multiple options will also mean that you can manage the term of your debt well, as in the case of CMT whereby they can lock in some loans at more than 5 years thereby decreasing re-financing risk at a lower cost.

3. Better disclosure, more analyst coverage. Most investors like bigger REITs because it is widely covered by analysts and therefore have more access to information and updates. Although this might not translate into better performance for the REIT, they might seek comfort from the safety of more frequent updates and price targets from analysts.

4. More pipeline of assets from sponsor. Stronger sponsors of REITs are normally bigger developers and they do have a ready pipeline of assets to be injected into the REIT. A smaller REIT with weaker sponsor may not have access to all these assets and they might have to source them from the market, which might not be available even if they wish to pay for it.

All in, I have both good and bad experiences when investing in REITs managed by strong and also weaker sponsors. I have to say that the above are just my general views and one have to look at each REITs individually to ascertain its own merits.

INTJ said...

Hi chris,

I am not competent in REITs investing. But possible points to explore.

Traditionally, sponsors use REITs as an avenue to spin off properties that may have questionable qualities. In a favourable view they may use REITs to unlock liquidity and cash flow from the underlying buildings. If the location and demographics / tenants are favourable, it will benefit all the unit holders and the sponsor may even hold onto significant units.

There is no certainty that sponsors will necessary help out the REITs when it goes into crisis / burdened down by debt / asset write offs/ rights issues. Unless the interests of REITs and sponsor are aligned.

Insider holding and balance sheet strength of the sponsor may be a good proxy to gauge whether the sponsor is good.

Christopher Ng Wai Chung said...

Thanks for the feedback.

I think this post challenges the orthodoxy a little more than I intended to do.

Just adding two points :

a) Right issues create downward pressure on REIT prices and I doubt backtesting algorithms are smart enough to adjust itself to assume that rights becomes exercise, so it can be argued that backtesting result for less prestigious REITs may be biased downwards because of these rights issues.

b) My hypothesis is compatible with all the good things people say about REITs with great sponsors. These REITs are so good that they are expensive even prior to an IPO and thus leads to fairly uninspiring returns over time.

During the holiday week, I will see if I can present another different experiment to support this hypothesis.