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REIT Evaluation – More Than One Way To Skin The Cat

NAV, FFO, Governance – Just Some Of The Factors In Picking Go-ahead Real Estate Investment Trusts

by Frank Quin

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In the first of this two-part series Investing in REITs: A Guide to Going About It, we looked at the nature of REITs – real estate investment trusts – and the practicalities of taking a stake in this growth investment product. In this second instalment, we focus on the ways in which the prospective REIT investor can evaluate which company or companies to run with in building an exposure to the property market.

Again, the focus is on publicly-traded REITs rather than privately-held property investment companies or those which trade off-market. Aside from the liquidity afforded by stock exchange listing, publicly-traded REITs are obliged, or choose, to provide a large amount of information concerning their assets, operations and management, all of which is turned to account by markets and observers in the evaluation of these companies, relative to one another and to other investment sectors.

REITs – It’s The Little Differences

We can usefully start with a consideration of what makes real estate investment trusts different from other listed companies, leading in turn to the evaluation factors which, though they might be applied in other investment sectors, have a particular application in relation to REITs.

First and foremost, REITs differ from all other listed companies in that they don’t pay tax on their primary source of income. Meaning, in the UK and a number of other countries which have introduced REIT legal regimes, the rents generated on owned buildings or other real property. In the US, REIT status may also be assumed by companies which lend on the security of real estate – known as ‘mortgage REITs’ – and on hybrids of the two models, but primarily real estate investment trusts make their money, and pay dividends to their stockholders, from property rents.

Which payments, as just indicated, ‘pass through’ the REIT without the imposition of corporate income tax, with tax being paid only by individual stakeholders on the annual dividend – in REIT parlance called ‘PID’, for ‘property income distribution’ – which by law must be at least 90 percent of the year’s net income from property rents.

So REITs are virtually ‘total return’ investments, in the sense that they are not permitted to retain more than 10 percent of earnings each year, and thus are attractive to investors whose principal requirement is income generation and who will likely make their selection primarily on yield. But of course, not just present-day or historical yield: a related and key factor in REIT valuation is the prospects for future growth in the company’s income stream, with the market’s assessment of those prospects producing gains, and by the same token losses, in the price of the REIT’s securities.

The REIT Can’t Easily Change Course

Aside from their tax treatment, REITs also differ from conventional listed companies in the extent of their investment in ‘hard’ assets, namely, real estate. Whereas a widget-making company can decide either to manufacture its needed parts in-house or to outsource, to switch from one to another product in response to market demand, and either to own or rent its factory, as a general rule a REIT must itself own its key income-producing assets and confine its core business activity to generating rent from that property. This limited operational flexibility has the virtue of keeping the REIT focused on its core business but also exposes the sector to the economic fortunes of commercial tenants, an exposure starkly illustrated by the hit sustained by the UK’s then fledgling REIT market in 2008-09, which suffered more than equities in the property downturn which followed the global financial crisis.

Let’s move now from generalities to the specifics of evaluating REITs for investment purposes. The prospective investor looking at a range of listed real estate investment trusts – including REIT-indexed funds – wants to know, first and foremost, whether the price to be paid is a ‘fair’ market price and whether the projected income distribution will indeed be forthcoming when the time comes for the company to pay it.

Importance of NAV in REIT Evaluation

The fairness of the price for the security in question is of course very much the function of an active market which, in the case of REITs in particular, will or ought to be strongly influenced by the relationship of that price to the company’s NAV – net asset value. One champion of NAV as the primary yardstick for measuring a REIT’s worth is Newport, California-based real estate consultancy Green Street Advisors.

They’ve recently published ‘REIT Valuation - The NAV-based Pricing Model’, a detailed description of their pricing methodology and which, they assert, has been pivotal in the performance - a 25 percent return - of their recommended ‘buy’ stocks, mostly REITs, over the 20 years to 2012, versus a gain of 12 percent for the wider ‘universe’ of property stocks they cover and a one percent loss on those stocks they’d recommended as a sell over that period.

Green Street Advisors explain their belief in NAV as the core to REIT pricing in this way: Most equity investors focus a great deal of attention on P/E multiples and/or yields, so it is fair to question why NAV should be the primary valuation benchmark for REITs. The short answer is that investors elsewhere would use NAV if they could, but the concept doesn't translate well to companies that are not in the business of owning hard assets. Because the value of a REIT is, first and foremost, a function of the value of the assets it owns, NAV is a great starting point for a valuation analysis.

In principle, the prospective REIT investor should be looking for stocks which trade – and have a history of trading – at a generous premium to NAV, as the market’s expression of confidence in both existing performance and future prospects.

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