A perfect storm for REIT investors.

Another point which was keyed off the meeting we had with some fans is the idea of the perfect storm for REITs.

Just to summarise REITs are the perfect instrument for the investor who is gunning for financial independence.

REITs are Collective Investment Schemes so come under moderate scrutiny by the Singapore Government. Issuing REITs require a high level of compliance to prospectus requirements. Investors then get rewarded with be able to diversify their holdings among multiple pieces of property. REITs are also held by back with a gearing limit of 45% and a 25% on development property. The most important feature is that REITs must pay out 90% of their income to retain their benefits.

A combination of these investor friendly restrictions and tax benefits has resulted in a huge growth in the REITs market and many investors who are financially independent today count REITs as a mainstay in their dividend portfolio.

But what can go wrong ?

A perfect storm for REITs investors looks like this :

a) Rising interest rates

One fear is Janet Yellen after achieving a level of comfort in jobs growth in the US, decides to raise interest rates. This will create ripples on SIBOR which would affect interest payments for the highly geared REITs investments.

In this scenario, investors should expect getting less dividends on their investments.

b) Lower rents due to oversupply.

The second fear is oversupply. This is likely to be felt in industrials before the end of the year. I imagine retail property to be hit badly over the next two years because of changes in consumption patterns. Singaporeans have always been buying online for their goods and now I always make it a point to search Carousell if I really want something badly.

In this scenario, tenants are willing to pay less for shop or factory space, hurting investors further.

c) Removal/reduction of tax benefits.

Currently, if REITS pay out at least 90% of the income they receive, they will not be taxed at the corporate level. This was done to promote the asset class and promote the Singapore markets. Since its inception, the government has been slowly scaling back some benefits for REITs. In 2015, REITs no longer have stamp duty concession.

The next time the government will review this tax concession will be in 2020. It's too early to guess whether this will taken away but investors should be aware that these concessions can be taken away once the rationale for them ceases to exist.

Not only will investors be entitled to less dividends, REITs no longer need to provide a 90% payout to obtain tax breaks.

If (a),(b) and (c) occur at the same time, we will have a perfect storm for REITs investors and I expect the damage to be quite significant for most of our portfolios.

The only defence against this is to promote diversification and limit REITs to smaller part of your portfolio.

The problem is that high-yielding equities are quite rare in Singapore markets and you will need to lower your expected yield to around 5% to have a decent non-REIT equity portfolio.