Here's our 30,000 foot view on REIT investing and how REITinvestor.ca FA figures in.
Investors buy REITs primarily because REITs are required to distribute nearly all their profits to their unit holders. Furthermore, since tax laws permit all built up real estate property to be depreciated the REITs are able to include a large non-cash depreciation expense in their operating statement and distribute all or a portion of the expensed depreciation to the unit holders.
REITinvestor.ca Fundamental Analysis has two objectives:
1) To examine the REIT’s ability to maintain or increase their present distribution rate.
2) To calculate the REITs Net Asset Value “NAV” to determine if a discount or premium exists relative to its current market price
REITinvestor.ca FA Data Sources
We monitor each REIT on a daily basis by reviewing press releases, news articles, listening to conference calls and any other information that will provide us with insight to how the REIT is performing. Following the release of each Quarterly Report, our team executes a complete due diligence and rebuilds our FA with the new data. Our accounting team studies the financials in every detail from the current performance to comparative examination of Q to Q and year over year. All this work goes into our FA.
Market Cycle
At REITinvestor.ca, we take the view that all real estate values, in every market are cyclical and that within each market there are sub-cycles. For example, some cycles move quickly, completing a rotation in three to five years while others move more slowly, taking decades to complete. In most cases, real estate cycles are tied to relevant economic cycles. Revenue properties tend to have higher vacancy, more delinquency and are less liquid in a weak economy. Lenders restrict lending during these periods both in terms of lower loan amounts and a higher rate spread. REITinvestor.ca views that since REITS have declined more than 50% in price, there are opportunities to realize excellent returns by investing in REITs,
In general, real estate sentiment lags the economy by 6 to 12 months. However, REITs are stock instruments with unit values that will follow the stock market sentiment more than the real estate market. Stock markets tend to inflex prior to the economy by approximately 6 months, while the real estate market lags. What does this mean to our fundamental analysis? Quite simply, it can create huge discounts and premiums to the NAV and hence opportunity. Another view on this would say that the stock market is trying to predict the value of a REIT 12 months out. Our view is that most holders of REIT units are uninformed and are making decisions without sufficient information. This is why REITinvestor.ca was created, to inform its members so that they can make informed decisions. REITinvestor Fundamental Analysis is an important part of that information.
So what are we looking for when we do our FA on a REIT?
SECTOR FOCUS ANALYSIS
The first matter to be considered is what is the real estate sector and geographical focus of the REIT. Sectors include; residential, office, industrial, retail, hotel & seniors residences. Geographical areas range from east or west, urban or rural, suburban or core. REITs that concentrate its portfolio in a geographical area are often dependant on the local economy. That local economy will need to be studied. Likewise we do the same analysis for the type of property focus. There is an abundance of resources that provide quality information. We search local real estate news and study economic factors to get a handle on the related market factors which could affect the performance of the REIT.
PERFORMANCE & VALUATION ANALYSIS
Basic real estate values are derived from market rental & sales comparables, replacement cost and income flows. However, REITs are operating companies, not simply real estate portfolios. Management talent plays a large role in how the REIT has performed in the past and how it will perform in future. Since REITs are instruments for cash flow-thru to the unit holder, our examination focuses on net operating income “NOI” and how NOI will impact:
- Yield - “Y” is a simple calculation of the annualized distribution “D” divided by REIT price “P” (D/P = Y).
- Adjusted Funds from Operations - “AFFO” is a useful measure of recurring cash flow of a REIT. It is net income + depreciation less gains on any assets sold (FFO), less reserve for recurring maintenance items that are capitalized and other deductions such as straight-line rents. AFFO ignores growth and non-performing assets such as land.
- Net Asset Value - “NAV” is primarily the value of the real estate using traditional real estate pricing methods. Each property held by the REIT contributes to the NAV. The total net operating income of the portfolio is assigned a capitalization rate to arrive at the market value of the real estate
Yield Calculation
We do not value a REIT by its yield but we do look for mispricing of the REIT which would provide for a high yield investment opportunity. On the other hand REITs that have low yields may be mispriced as too expensive and we would avoid accordingly. Yield Analysis ignores recurring cash flow, payout ratio and growth.
AFFO Calculation
We have an entire accounting team devoted to determining a reasonable estimate of AFFO for each of the REITs we cover. Since AFFO is non GAAP measure each REIT can use discretion in disclosing the inputs that used to formulate their calculation FFO & AFFO. As a result we must do our own calculations for each REIT.
NAV Calculation
In order to determine the Net Asset Value, REITinvestor.ca strives to select the right cap rate to apply to net revenue, growth prospects and risk of the existing portfolio.
DEBT ANALYSIS
It is extremely important that each REIT manage its debt appropriately. When total debt relative to value is too high the REIT is vulnerable to many potential problems and will have reduced options to deal with problems as they occur. Low debt/value ratio allows the REIT to raise new funds to meet current obligations, make expansionary purchases and accommodate other financial commitments. Low debt also smoothes the refinancing for individual properties as their mortgages mature. REITinvestor.ca examines each REIT’s debt load relative to NAV.
LIQUIDITY ANALYSIS
Our liquidity analysis examines the REIT’s ability to meet its short term financial obligations using only its cash reserves and undrawn bank lines. A REIT’s payout ratio that exceeds its distributable income will also need to draw on liquidity to support monthly distributions to unit holders. We measure Liquidity as a percentage of liquid funds available relative to total debt.
MORTGAGE MATURITY ANALYSIS
We monitor closely the schedule of near term maturing mortgages that the REIT will need to refinance. It is important to be aware of the willingness of lenders to renew or replace an expiring maturing mortgage. REITs with large amounts of mortgages maturing over the next 24 -36 months are of highest concern and will need to be tracked closely. REITinvestor.ca does this.
LEASE EXPIRY ANALYSIS
REITs for the most part receive their revenues from tenants who are obligated to pay rent according to a lease agreement. Tenants with leases coming due have no obligation to renew and may opt to vacate. We want to know how releasing of large spaces is going. Likewise, we also want to know whether expiring below market rents are realizing new higher rates. REITinvestor.ca tracks the schedule of lease expiry and releasing progress.
FRANCISE VALUE ANALYSIS
This work is more subjective but equally as important. As operating companies REITinvestor.ca examines management talent to:
- manage its portfolio,
- purchase & sell properties in a timely fashion,
- manage its capital requirements well,
- find growth opportunities,
We monitor the actions of Insiders to ensure their actions and interests are aligned with unit holders. We track Insider trading to determine if management is selling off or purchasing units.
REITinvestor.ca Rating Model
Once all the FA scores are calculated, we then rank all the REITs by their FA rating. Each of our members is free to agree or disagree with our FA ratings. In doing so, we know that they have examined our information and has formed an opinion based partially on our detailed Fundamental Analysis.
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