Tuesday, July 1, 2014

Investing in UOA REIT using margin financing



Disclaimer: This article does not represent advice to invest in UOA REIT or to use margin financing. This is my first time using margin financing and my understanding of how things work may be flawed. There may also be errors in my analysis, calculations and other errors. Do your own damn research and take responsibility for your own damn investments.


I recently decided to use margin financing to try to unlock some hidden value in my portfolio. I still have positions in 2 Malaysian stocks (my margin facility doesn’t accept foreign shares as collateral) which I think will perform decently over the long-term. However, I could get even more value out of my Malaysian shares by pledging them as collateral to get some financing. As I only have a small margin facility, the effective rate that I got was around 5.76% which isn’t great but it isn’t too bad either as I’m just experimenting with a small amount of debt. The effective rate drops to a pretty reasonable 4.71% if I have a larger margin facility and borrowed more. Just like how a kid starts off with a Happy Meal before moving on to a Double Quarter Pounder set, I need to start out small and learn how to effectively utilize debt. Before I continue, I would like to bring you guys a quick update on the Greedy Dragon Portfolio. Apart from investing in UOA REIT, I also sold my shares in Overseas Education Limited as it went up quite a bit since I bought it and I wanted to increase my cash holdings.


Anyway, I figured that if I could find an investment with a higher income yield than the margin loan’s interest cost, I could increase the cash my portfolio generates every year. I also needed to be confident that the investment’s yield is sustainable or I could find my margin financing strategy turning cash flow negative.


There weren’t many investments in Malaysia that had a high enough yield to pay off the interest and still have a little somethin’ somethin’ left over for me. However, I did manage to find UOA REIT which I think is a suitable candidate for this margin financing strategy. I invested in the REIT at Ringgit Malaysia (RM) 1.39 per unit. UOA REIT has a portfolio of office buildings located in Kuala Lumpur, the capital city of Malaysia. Based on the 2013 distributions per unit, the REIT’s after tax distribution yield of 6.91% is high enough that I can still service my debt if the REIT experiences a small drop in earnings and distributions. You don’t want to be in a situation where the spread between the investment’s distributions and the debt’s interest is like a dollar; you need a margin of safety. According to the 2013 annual report, UOA REIT’s properties also have pretty high occupancy rates of between 87.3%-98.5% which should increase the odds of the REIT being able to maintain the rental it charges its tenants. Another advantage of investing in REITs with this strategy is that REITs are required by law to distribute most of their earnings. So, unless a REIT starts making losses, investors should still receive some income even during downturns.


Note: According to this article in The Star, Malaysia REIT’s distributions will be taxed at the lower 10% rate for local and foreign retail investors until at least 31 December, 2016. I don’t know much about tax laws, so please do your own research or consult a tax expert before making any investments.


I also tried to reduce my risk to a very low level with this position as I don’t want to end up being my bank’s boy. One of the main risks of margin financing is that interest rates might rise and result in the cost of servicing the debt being higher than the income from your investment. Interest rate risk is very low for my position as my cash holdings are large enough that I can easily pay off my margin loan anytime; I also have cash inflows from other sources that can be used to service the debt. Another risk of margin financing is of course the dreaded margin call where your position can get wiped out if you don’t top up your account. I mitigated this risk by over collateralizing so something really bad would have to happen before my ass gets margin called. A major risk for this specific position is that there might be a supply glut in Kuala Lumpur office space for a while. However, I think that even if UOA REIT’s occupancy rates and rental rates do come down a bit, it should still be at a healthy level in the near future.


To further reduce risk, I will set aside RM 1,441.15 in cash (2 years of interest payments) specifically to help me meet interest payments in case this position turns cash flow negative and I decide to wait on a recovery. Any positive cash flows (and I hope the cash keeps rolling in) will be used to reduce the debt or replenish the cash buffer if I had to tap into it in previous periods. The idea over the long-term is to pay off the debt using the cash generated by the REIT and convert the position into pure, yummy, delicious equity.


A good scenario to use this margin financing strategy would be when there are opportunities to invest in assets with 9%-10% yields. If I find myself in such a situation and my capital structure can afford the extra debt, then I might take a margin loan large enough to get the lower interest rate of 4.71% (assuming that the base lending rate stays the same). However, I think that financing some UOA REIT units with a margin loan is alright for my portfolio. This is the case as the debt that I took on is small relative to my portfolio’s size. I’m also treating this position as a learning experience to build up my competence in debt and cash flow management. I also think that buying units of UOA REIT on margin at its current price actually creates value for my portfolio. The following table breaks down the returns that I could potentially earn assuming that UOA REIT’s distributions per unit and the base lending rate stay at current levels:

Cash buffer
RM 1,441.15
Borrowings
RM 12,510
Effective Interest
5.76%
After tax yield
6.91%
Interest cost
RM 720.57
Income distributions
RM 864.27
Net cash inflow
RM 143.69
Cash on cash return
9.97%

1Cash on cash return = Net cash inflow/cash buffer
2Again, the cash buffer represents the cash set aside specifically for this position and not my total cash holdings.

Whatever positive cash flow I get, I’m using to pay down the debt which gives me a reinvestment rate of 5.76% (not bad in this market, not bad at all). Really awesome things start to happen if UOA REIT is able to increase its distributions and/or if there’s an increase in the market price of the REIT’s units. If UOA REIT is able to boost its distributions per unit by 10%, the annual cash-on-cash return should increase to 15.97%. A 10% gain in the REIT’s unit price should result in about an 87% return on the cash buffer. I’m not taking this position with the expectation that UOA REIT will increase its distributions or that the price of its units will rise (although I think both of these things are likely to happen in the long-term).


Before I end this article, I would like to advice you guys to never take on debt for investing if you don’t understand debt and cash flow management. And even if you think that you can manage debt and cash flows well, don’t ever take on too much debt and put yourself in a position where your financial future is at risk of getting bitched out by a margin call. Thank you for reading. Take care and stay rational.

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