REITs' value getting harder to see
Fabrice Taylor, Chartered Financial Analyst, is a principal in Capital Ideas Research and writes the blog fabricetaylor.com
Here's a deal for you: It's a rental property that pays a 5-per-cent return on investment. You can have it for a million bucks and we'll lend you the money to buy it - at 7-per-cent interest.
If you're not laughing by now, you should, at the very least, be terribly skeptical. It's obviously difficult to make money when you earn a nickel on a dollar that costs you 7 cents. Yet real estate companies appear to be doing this and no one seems to mind.
True, they can bury the math, but if you dig hard enough, you'll uncover it.
Consider an example involving Canadian Apartment Properties Real Estate Investment Trust (CAP REIT). I'm using this example only because it's the most recent I can find. There are plenty of other similar stories.
Last month, the REIT bought a building in downtown Vancouver for $37.5-million. The so-called capitalization rate - net operating income divided by purchase price - came in at about 5 per cent. That's akin to the yield on the property.
Here's the thing, though: CAP REIT's implied capitalization rate at the time of acquisition, according to BMO Nesbitt Burns, was 6.6 per cent.
If your stock portfolio yields 10 per cent and you buy a stock yielding 5 per cent, what happens to your total yield? It goes down, of course.
This is no different. The deal, by the numbers, is dilutive to yield.
What's more intriguing is that CAP's units yielded 7.5 per cent at the time the deal was announced. This acquisition - a very big one for a single building - is dilutive to distributable cash.
If CAP had paid for the building by issuing new units, investors would have been furious. But, of course, it didn't. The building came with a mortgage at just under 5 per cent and the rest was financed with short-term debt. That said, one presumes that eventually there will be equity in the property. The blended cost of capital - part equity, part mortgage debt - looks like it'll be higher than the cap rate.
Isn't that a problem? CEO Tom Schwartz tells me it isn't. He says the REIT can do a better job operating the business by applying economies of scale and expertise to raise rents over time. That will move the cap rate north of 7 per cent.
I answered that every real estate operator claims to be the best; the truth is that, apart from a few bad ones, there a few exceptional operators. They're all reasonably good.
He doesn't agree. "You've got to assume we see value that others don't. We don't buy buildings we can't add value to."
Maybe, but it's hard to imagine that the previous building owner was charging considerably less than the market would bear.
I still wonder, and I think investors should too, how you make money with these economics. Mr. Schwartz and other CEOs say real estate is a long-term game; the payoff takes time. "We've made lots of money. It's not by accident."
When you really start digging into a REIT, though, it's difficult to see how a REIT is actually doing because there are so many moving parts in the financials. The only real advantage REITs can have is a lower cost of money. Aging investors love yield and the more they get, the happier they are. That puts a lot of pressure on REIT managers to pay out cash.
The accompanying table shows cash flow figures for nine randomly selected REITs. Distributions are lower than cash coming in. But if you include cash spent on investments, the outflow dwarfs the inflow.
They're not burning this money. Most of it is invested in new properties. But as we've seen, it's a seller's market. Are these deals, financed largely with new units, accretive? Do they add value or is the money raised used to pay distributions? Hard to say.
Unlike conventional borrowers, REIT debt payments include interest and principal. And assuming the properties go up in value over time, they can extract cash from them by refinancing - adding more debt - thanks to a higher value and the fact that the debt has been paid down. And when you factor in deferred maintenance (repairs that should be done but are postponed), it can be difficult to get a clear picture of what's happening.
Analysts try to adjust for all this with specialized yardsticks, which are not particularly stringent. But even using those, an awful lot of REITs pay out too much cash.
But that can pay off for management. One of the biggest overdistributors is Whiterock REIT, according to analysts. Over the past three years, the distributions look at least 20 per cent too high. Yet it just raised $34-million from retail investors to finance an acquisition.
The math doesn't work and eventually someone's going to pay dearly for it.
FOLLOWING THE MONEY
These numbers represent the aggregate cash flow figures for nine REITs going back to 2004 or since inception. The REITs randomly chosen were Boardwalk, CAP, Canadian, Huntington, Interrent, Scott's, Calloway, Artis and Allied.
Cash from operations
Cash paid in distributions
Cash spent on investments