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.
Positive Price/NAV Ratios Hard To Find
But in the turmoil in real estate markets since onset of the GFC, finding a REIT stock which is both in a preferred market segment and satisfies such a price-to-NAV criterion is no easy task. According to international financial data firm SNL, as of 31 December 2012 just two of 21 ‘REIT’ countries – being Switzerland and Canada – had a REIT sector with pricing at a premium to NAV. In the remaining 19, discounts to NAV ranged from 4.1 percent in Belgium to 88.8 percent in Denmark, with a median of minus 23.2 percent. There’s a similar picture in the UK. Accounting firm BDO’s ‘UK-REIT Survey 2012’ identified a median discount to NAV of 10 percent amongst the 20 companies in the survey.
And within the US, where the averaged price-to-NAV ratio was minus 7.7 percent at 31 December last, only three of the 12 property sectors being tracked by SNL were in premium territory. Best placed was healthcare, with the sector’s REITs on average a healthy 19 percent up on NAV whereas shopping centres and hotels were at the other end of the spectrum, with discounts of 11.6 and 12.3 percent respectively.
Green Street Advisors stress the critical importance of ‘high quality assessments of NAV’. This in turn is a function of the integrity of the individual REIT’s appraisal mechanisms and the degree of market scrutiny then brought to bear on those numbers. As SNL note, ‘There are different levels of independent appraiser involvement in producing these estimates [of NAV], depending on the precise regulatory regimes.’ So the prospective REIT investor, especially if considering a stake outside known and familiar territory, should pay close attention to just how the target REIT came by its claimed asset values. It would be wrong to assume that the market in that company’s securities has already done the necessary groundwork – a REIT’s stock price at any given point in time, and thus its price to NAV ratio, could be distorted by transient factors, such as deal or other rumours.
REIT Earnings – Disdain for Property Write-downs
Asset value is key to another primary yardstick for evaluating REITs, namely, their price relative to earnings, or P/E ratio. With their ‘funds from operations’ – FFO – approach to earnings, REITs report earnings differently from other listed companies and the prospective investor needs to be aware of the difference.
With a conventional listed company, earnings over a given period – annually, say – are determined in conformity with ‘GAAP’ – generally accepted accounting principles – as ordained from time to time by various accounting bodies and gradually becoming globally standardised. The bottom line is arrived at after a series of prescribed deductions from gross revenues, one of which is the charge booked for depreciation of the company’s fixed assets. For businesses in many commercial and industrial sectors, depreciation may not be an especially prominent item but that’s not the case with most real estate investment trusts. Although land does not depreciate, for accounting purposes buildings and other improvements certainly do and the compulsory booking of an annual depreciation charge can occasion a significant reduction in what the REIT could otherwise report as net earnings.
So real estate investment trusts routinely report earnings which have not been burdened with depreciation of their property inventories. The justification for this departure from GAAP is that straight-line depreciation models for plant and equipment are not appropriate for office blocks, hotels and other developed real estate which, so the argument runs, actually appreciate in value over time.
Thus in evaluating a selected REIT, it’s important for the prospective investor to keep firmly in mind the basis on which the company’s earnings have been computed. Also, where FFO is the chosen criterion, to ascertain whether capital maintenance costs have been properly accounted, in which case the company reports ‘adjusted funds from operations’ – AFFO. The upkeep and refurbishment of commercial or residential property can be a significant impost in any given year and the REIT’s management may be less than up front in acknowledging the burden it’s imposing on the bottom line, or may be deferring the expenditure, either of which scenarios should be a red flag to prospective investors.
Excessive Gearing a Sign of Stress?
Beyond these particular factors – NAV and P/E – there are other evaluation criteria applied to public companies generally which have, or occasion, a particular adjustment in the REIT context. As a for instance, there’s gearing. By law, under typical REIT legislation, there’s a limit imposed on the property company’s ability to borrow against its core, rent-generating assets. Typically, the limit is 60 percent, meaning the company must maintain a minimum 40 percent equity to assets ratio.
With less regulated property companies often assuming a much more aggressive leveraging stance, with gearings of 80-90 percent not unusual, this is a particular constraint on the ability of REITs to raise fresh capital. The prospective investor should look for stress signals here, since a debt/asset ratio which is constantly pushing the envelope could be a sign of cash-flow pressures and, of even greater concern, attendant problems with servicing income distributions when due.
Governance – Foresight and Nimbleness the Key Factors
Which conveniently brings us to governance. Of course, the direction and management of a listed company is critical to its performance – and by extension to that of its share price – whatever its industry but there’s a particular angle to REIT management. As noted earlier, and leaving aside peripheral activities, REITs make their money from renting real estate for more than the cost of owning and maintaining that property.
And it’s the nature of the beast that a REIT cannot easily switch from one to another income-generating asset. The purchase and disposal of commercial real estate is a lengthy process, often needing years rather than months to bring to fruition. So it’s critical that the REIT’s board and management have the skills, expertise and nous constantly to be ahead of the game in maintaining that income stream, from roll-overs of expiring leases on favourable terms to the on-schedule rollout of additional inventory.
REIT Boards – No Place for Vested Interests
A REIT’s directorial board justifies a special mention here. If the constraints on tight holdings in REITs are being complied with – a majority of voting shares can’t be held by five or fewer shareholders (the ‘5/50’ rule) – there should in principle be a board of directors with relatively widely-dispersed interests and who are not beholden to any one shareholder or other interest group.
Indeed, according to Green Street Advisors, achievement of a positive correlation with a healthy price/NAV ratio will feature a non-staggered board (meaning that all directors are re-elected annually), at least four-fifths of whom are independent of the REIT’s property inventory and all of whom have a meaningful personal stake in the company. And something that can be noted in passing – a non-staggered board of directors makes the REIT a more attractive takeover target, since the acquirer can be assured of gaining control in one foul swoop rather than having to await deferred elections.
Picking the Right Sector/s
A big factor in REIT selection is getting the sector right, a process much more of an art than a science. It’s one thing to look at the property market now and identify winners and losers, with healthcare in the former and malls languishing in the latter categories. But few pundits would have made that call five years ago and fewer still can, or are willing to, say where the money will be made in real estate in the future.
For REIT investment in the UK, the market still presents as primarily concerned with mainstream commercial property, being offices and retail, which as noted earlier have been especially hard-hit by Britain’s recession. Yet it’s not all doom and gloom. The country’s biggest REIT, Land Securities Group (LON:LAND), with major holdings in office, warehousing and shopping centres, is currently on something of a roll, its closing share price on 29 April of 889.50p a 12-month high and 20 percent up on the low of 704 pence last May. The current price is also bringing Land Securities’ price-to-NAV ratio back to near parity, based on the NAV of 922p per share in the 2012 annual report, compared with a discount of around 10 percent a year ago.
Compared with the still-juvenile UK market, the United States presents as an absolute smorgasbord for sector-specific REIT investment. Prospective investors who see particularly bright futures for REIT investment in retirement homes, student digs, prisons, army barracks, mobile phone towers and in-cave data storage have plenty to choose from. If that’s where you want to go.
Listed real estate investment trusts occupy the same investment space as all other publicly-traded companies and, to a large extent, are valued in the same way. But given the particular constraints on how they conduct their business, indeed on what the business may be, the valuation of REITs tends to be especially focused on the integrity of their hard asset values and the relationship of that value with the stock price.
And REITs adopt the stance that earnings should not be diluted by arbitrary depreciation of those assets, in a departure from generally accepted accounting principles. Finally, undue reliance on debt capital may be a sign of stress and should call into question the REIT’s ability to service its dividends. These are important factors for the prospective investor to keep in mind, as is the ability of a targeted REIT’s management to maintain a stable income stream in a business where changes of direction, like the Titanic’s, can be slow and costly.