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INVESTORS are spooked by the damage that rising interest rates can do to the prices of real estate investment trusts (Reits). Reits are a hybrid between equities and bonds, providing investors with a stable stream of distribution income.

Investors price Reits at a premium to the risk-free rate, being the 5-year or 10-year government bond yield. Everything being equal, an increase in the risk-free rate should lead Reit prices to fall by an amount which enables the yield to the investors to be preserved.

For a Reit trading at a yield of 6 per cent - which is where some Singapore Reits are trading at - this means that the price will fall by 4 per cent when interest rates increase by 0.25 of a percentage point.

Investors are right to be concerned about the damage that rising interest rates can do to Reits. But in a climate of volatility and uncertainty in global equity markets where there is a danger of a sudden double-digit plunge in equity prices to reflect an increased risk premium in the market, Reits, relative to other equities, stack up well.

Interest rates may go up but the US Federal Reserve will, in all likelihood, hike rates at a measured pace. Meanwhile, a Reit trading at a yield of around 6 per cent gives investors a significant pick-up in yield compared with promotional fixed-deposit rates that are just north of 3 per cent.

While interest rates may go up, so can Reit distributions. Historically, Reits here have posted growth in distribution per unit year-on-year in the high single digits or even in the double digits.

Singapore-sourced and Singapore dollar-denominated cash flows are highly valued by global investors because of the low-risk environment here and the strength of the Singapore dollar. These factors are also providing support for Singapore real estate as are the plans being implemented to make Singapore a better place to live, work and play.

There is little doubt that there are good times to come for owners of prime office and retail property in Singapore. On this basis, investors could do well to look closely at Reits that own such assets, an example being Suntec Reit.

With more new Reits coming on the Singapore market, investors have choice. New asset classes, new geographies and new structures will add to the depth of Singapore’s Reit market. But amid choice, investors can stick to the property asset classes like office and retail, which are popular with Reits globally.

There is no need to consider hotels, as earnngs streams of such assets can be highly volatile.

There is no need to consider trusts that focus on sale and leaseback of facilities, as such Reits could be hard-hit should tenants fail as these properties are often purpose-built facilities where rents may have been propped up to achieve certain capital values.

As for Reits with overseas assets, Singapore investors can consider them only if they are adequately compensated for the currency risks and if the assets are appropriately priced vis-a-vis risk free rates in the respective countries, which almost invariably exceed that in Singapore.

There may be an ever increasing array of choices, but investors can do well by going for Reits with properties that are leased to independent third parties, located in Singapore and in the sectors that benefit from Singapore going up the ladder in the league of global cities.

Not surprisingly, Reits first emerged in the Singapore market a few years ago amid an environment of extremely low interest rates. With sufficient investor education, Reit prices then trended upwards substantially as investors appreciated the good yields they could get from Reits.

Today, more sponsors see the value of launching Reits and Singapore continues to gain in popularity as a listing venue for Reits. But the spectre of rising interest rates looms as a major challenge to investors.

Let us not be unduly worried by rising interest rates but instead remember that Reits can be an excellent proxy for income streams from quality assets and focus on those Reits that offer such exposure.

Source : Business Times - 28 Jun 2006