Question

Should A-REITs have high leverage, or low leverage? Describe the optimal capital structure for a generic Australian Real Estate Investment Trust (A-REIT). How does your answer change if the A-REIT is a stapled security? Please include discussion of target leverage, maturity, debt security and the influence of common debt covenants.

Answer 1

The gearing ratio tells us how much debt a REIT has incurred in relation to its total assets. The higher the ratio, the more debt the REIT has incurred, leaving less room to further increase its asset base with debt in the future.

In Australia, REITs have to adhere to regulatory guidelines of having a gearing ratio of not more than 45%. This is to ensure that REITs do not take on too much debt, which may cause them to be exposed to the risk of default.

So why is having a low gearing so important? For one, REITs that have less debt will be able to more easily grow their portfolio in the future by increasing their borrowings to purchase properties.

For example, let’s assume there are two REITs in the market now: ABC and DEF. REIT ABC has a 45% gearing ratio and thus cannot take on more debt unless it increases its asset base. Therefore, if the REIT’s manager wants to expand its property portfolio, new units will need to be issued to raise funds to prop up the asset base. Existing unitholders of REIT ABC may be diluted in the process.

REIT DEF on the other hand, has a 20% gearing ratio. It thus has leeway to take on more debt to fund the purchase of properties and grow its property portfolio without having to issue new units and potentially diluting the interests of its current investors.

The second reason why having a low gearing is important is that REITs that have higher leverage will also face higher interest expenses when interest rates rise.

Although most REITs in Australia are well placed to manage any interest rate hikes, a rate hike can still eat into a REIT’s bottom-line.

It is therefore important to look at the interest rate hedges that a REIT has in place to defer some of the risks of interest rate fluctuations.

Investing in REITs has become more popular as more Australians learn about the high dividend yields they offer. But, as investors, we should take note of what can make a REIT stand out from its peers. A good place to start would be the gearing ratio; a low ratio allows a REIT to grow its portfolio with greater ease in the future, increasing its dividend yield in the process.

Stapled securities are listed property securities that are a bundled combination of either REITs, property investment companies, property trusts, or business trusts. This occurs when the investment vehicle wants to apply a REIT model to a portion of its property portfolio, but not to others. As such, only that part of the property portfolio will be bounded by REIT regulations and enjoy the associated tax benefits.

Likewise, stapled trusts are obligated to pay the required distributions to their unitholders only for the properties that are bound by the REIT structure.