Evaluation of a Real Estate Investment Trust: A Homemade Process

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Evaluation of a Real Estate Investment Trust: A Homemade Process Introduction (Beattie, 2009) Real estate has been around since our cave-dwelling ancestors started chasing strangers out of caves, so

1 Evaluation of a Real Estate Investment Trust: A Homemade Process Introduction (Beattie, 2009) Real estate has been around since our cave-dwelling ancestors started chasing strangers out of caves, so it's not surprising that there is a publicly-traded instrument equivalent of a real estate. A real estate investment trust (REIT) is created when a corporation (or trust) uses investors' money to purchase and operate income properties. Much like regular dividend-paying stocks, REITs are a solid investment for stock market investors that want regular income. Furthermore, REITs allow investors into non-residential investments such as malls, or office buildings, and are highly liquid, In other words, with REITs as financial instruments you won't need millions or billions of dollars to own a piece of Paragon or Vivocity. Assessing A Real Estate Investment Trust (REIT): A Different Process Altogether (Harper, 2010) If you try to estimate the value of a real estate investment trust (REIT), you will quickly find that traditional metrics like the earnings-per-share (EPS) ratio, growth, and the price-toearnings (P/E) multiple do not apply. We will introduce in this article, examples of metrics commonly used to evaluate REITs Funds from Operations (FFO) Is Better than Earnings Let's start by looking at a summary income statement of a REIT (Equity Residential) as an example, Source: 10KWizard

2 From 2002 to 2003, Equity Residential's net income, or the "bottom line," grew by almost 30% (+$122,500 to $543,847). These net income numbers, however, include depreciation expenses, which are significant line items. For most businesses, depreciation is an acceptable non-cash charge that allocates the cost of an investment made in a prior period. But real estate is different than most fixed-plant or equipment investments: property rarely loses value and often appreciates. Net income, a measure reduced by depreciation, is therefore an inferior gauge of performance. Therefore, REITs are instead judged by funds from operations (FFO), which excludes depreciation. FFO is reported in the footnotes, and companies are required to reconcile FFO and net income. The general calculation involves adding depreciation back to net income (since depreciation is not a real use of cash, as discussed in the above paragraph) and subtracting the gains on the sales of depreciable property. These gains are subtracted because we assume that they are not recurring and therefore do not contribute to the sustainable dividend-paying capacity of the REIT. Below we show this reconciliation of net income to FFO (with a few minor items removed for the sake of clarity) for 2002 and 2003: Source: 10KWizard It is clear that, after depreciation is added back and property gains are subtracted, funds from operations (FFO) equals about $838,390 in 2002 and almost $758,000 in FFO must be reported, and it is widely used, but it contains a weakness: it does not deduct for capital expenditures required to maintain the existing portfolio of properties. Real estate holdings must be maintained (for example, apartments must be painted), so FFO is not quite the true residual cash flow remaining after all expenses and expenditures. In estimating the value of an REIT, professional analysts therefore use a measure called "adjusted funds from operations" (AFFO). Although FFO is commonly used, professionals tend to focus on AFFO for two reasons. One, it is a more precise measure of residual cash flow available to shareholders and therefore a better "base number" for estimating value (for example, applying a multiple or discounting a future stream of AFFO). Two, because it is true residual cash flow, it is a better predictor of the REIT's future capacity to pay dividends. AFFO does not have a uniform definition. However, the most important adjustment made to calculate it is the subtraction of capital expenditures, as mentioned above. In the case of

3 Equity Residential, almost $182,000 is subtracted from FFO to get AFFO for the year This number was taken directly from the cash flow statement. We use it as an estimate of the cash required to maintain existing properties, although we could try to make a better estimate by going to the trouble of looking at the specific properties in the REIT. Look for Growth in FFO and/or AFFO Once we have the FFO and the AFFO, we can try to estimate the value of the REIT. The key assumption here is the expected growth in FFO or AFFO. This involves taking a careful look at the underlying prospects of the REIT and its sector. In general, these are the sources to consider: Prospects for rent increases Prospects to improve/maintain occupancy rates A specific plan to upgrade/upscale properties - A popular and successful tactic for REIT management is to acquire "low-end" properties and upgrade them to attract a higher quality tenant. Often a virtuous cycle ensues. Better tenants lead to higher occupancy rates (fewer evictions) and higher rents. External growth prospects - Many REITs favour fostering FFO growth through acquisition, but it's easier said than done. An REIT must distribute most of its profits and therefore does not have a lot of excess capital to deploy. Many REITs, however, successfully prune their portfolios: they sell underperforming properties to finance the acquisition of undervalued properties. Apply a Multiple to FFO/AFFO The total return on an REIT investment comes from two sources: (1) dividends paid and (2) price appreciation. We can break down the expected price appreciation into two components: 1. Growth in FFO/AFFO 2. Expansion in the price-to-ffo or price-to-affo multiple Let's look at the multiples for EQR below. Note that we are showing price divided by FFO, which is really market capitalization divided by FFO. EQR's market capitalization (number of shares multiplied by price per share) in this example is about $8 billion. Aside from making a direct comparison to industry peers, how can we interpret these multiples? Like interpreting P/E multiples, interpreting price-to-ffo or price-to-affo multiples is not an exact science, and the multiples will vary with market conditions and specific REIT sub-sectors (for example, apartments, offices, industrial). As with other stocks, we want to avoid buying into a multiple that is too high.

4 But remember that, aside from the important dividends paid, any price appreciation breaks down into two sources: growth in FFO/AFFO and/or expansion in the valuation multiple (price-to-ffo or price-to-affo ratio). If we are looking at an REIT with favourable FFO growth prospects, we should consider both sources together. If FFO grows at 10%, for example, and the multiple of 10.55X is maintained, then the price will grow 10%. But if the multiple expands about 5% to 11x, then our price appreciation will be approximately 15% (10% FFO growth + 5% multiple expansion)! A useful exercise is to take the reciprocal of the price-to-affo multiple: 1 [Price/AFFO] = AFFO/Price. In the case of EQR, this equals about 7.2% ($ ,000). This is called the "AFFO yield." To evaluate the price of the REIT, we can then compare the AFFO yield to (1) the market's going capitalization rate, or "cap rate," and (2) our estimate for the REIT's growth in FFO/AFFO. The cap rate is a general market-based number that tells you how much the market is currently paying for real estate. For example, 8% implies that investors are generally paying about 12.5 times (1 8%) the net operating income (NOI) of each individual real estate property. Let's assume that we determine the market's cap rate is about 7% and that, further, our growth expectation for EQR's FFO/AFFO is a heady 5%. Given a calculated AFFO yield of 7.2%, we are probably looking at a good investment: our price is reasonable when compared to the market's cap rate (it's even a little higher, which is better), and, even more promising, the growth we are expecting should translate into both higher dividends and price in the future. In fact, if all other investors already agreed with us, the price of EQR would be higher because it would need a higher multiple to impound these growth expectations. Summary When evaluating REITs, you will get a clearer picture by looking at funds from operations (FFO) rather than looking at net income. If you are seriously considering the investment, try to calculate adjusted funds from operations (AFFO), which deducts the likely expenditures necessary to maintain the real estate portfolio. AFFO is also a good measure of the REIT's dividend-paying capacity. Finally, the ratio price-to-affo and the AFFO yield (AFFO/price) are tools for analyzing an REIT: look for a reasonable multiple combined with good prospects for growth in the underlying AFFO. Lewis Phey This research material has been prepared by NUS Invest. NUS Invest specifically prohibits the redistribution of this material in whole or in part without the written permission of NUS Invest. The research officer(s) primarily responsible for the content of this research material, in whole or in part, certifies that their views are accurately expressed and they will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this research material. Whilst we have taken all reasonable care to ensure that the information contained in this publication is not untrue or misleading at the time of publication, we cannot guarantee its accuracy or completeness, and you should not act on it without first independently verifying its contents. Any opinion or estimate contained in this report is subject to change without notice. We have not given any consideration to and we have not made any investigation of the investment objectives, financial situation or particular needs of the recipient or any class of persons, and accordingly, no warranty

5 whatsoever is given and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of the recipient or any class of persons acting on such information or opinion or estimate. You may wish to seek advice from a financial adviser regarding the suitability of the securities mentioned herein, taking into consideration your investment objectives, financial situation or particular needs, before making a commitment to invest in the securities. This report is published solely for information purposes, it does not constitute an advertisement and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. No representation or warranty, either expressed or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein. The research material should not be regarded by recipients as a substitute for the exercise of their own judgement. Any opinions expressed in this research material are subject to change without notice NUS Invest

1/12/2013 Introduction to. Dividend Capture. By Joseph Soh, Research Analyst. NUS Students Investment Society NATIONAL UNIVERSITY OF SINGAPORE

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