|Tuesday, 28 June 2011 04:19|
Adjusted Funds from Operations (AFFO)
AFFO is a “REIT thing” and specialist analysts pour over REIT accounts’ to try to calculate a REIT’s “real” cash-flow ie that produced by operations after sensible (legal) deductions, so as to be able to have a single number to capitalize at a "market" determined rate, for a portfolio of the type, and given the particular REITs track record and stated goals. It is, of course, a refinement to Funds From Operations (FFO), whereby capital expenditure (CapEx) is also deducted, which can be / is, almost by definition, irregular in nature and so “misleading” if not taken into account in the context of “normal” CapEx expenditure. Attention also needs to be drawn to the fact that, because the US operates by American accounting and valuation standards, many US REITs don't report an AFFO in the way other countries REITs do. For example, "Cash Available for Distribution (CAD)” or “Funds Available for Distribution (FAD).” Fortunately (if nothing else), the Credit Crunch has drawn all parties attention to the need to develop more uniform global reporting, accounting and valuation standards (though the bickering continues, especially over the Market Value vis-à-vis Book Value conundrum).
Alpha is the excess return of an investment above the market or benchmark return, so for listed stocks, Alpha is the excess return above a benchmark (like the S&P 500 or NAREIT / sector indices. The Alpha return in CRE is primarily generated by the investment owner / manager through its “hands-on” control of the real estate assets: (weight adjusted) leases / WALE, rent reviews / expiries, operating costs; and (weight adjusted cost of) capital structure / WACC. Obviously, an apartment REIT will have more day-to-day headaches from owning an apartment portfolio compared to externally managed hotels. The net of the gross income (after operating expenses: (periodic or one-off) repairs & maintenance; taxes; insurance; management fees; salaries; utilities; and administrative costs), is the net operating income / NOI, which can then be capitalized at the market discount rate / yield (which, in theory, should be the same as a DCF discounted at the purchaser’s WACC). To create Alpha, the landlord can adopt various policies and strategies such as: revenue enhancing capital improvements / CapEx to realize incremental NOI gains and thus value increases; altering the ownership and management structures; or via ‘cunning’ financial engineering eg buying shares, issuing bonds to alter the debt-to-equity, etc. Alpha is the excess return of an investment above the market or benchmark return, so for listed stocks, Alpha is the excess return above a benchmark (like the S&P 500 or NAREIT / sector indices. The Alpha return in CRE is primarily generated by the investment owner / manager through its “hands-on” control of the real estate assets: (weight adjusted) leases / WALE, rent reviews / expiries, operating costs; and (weight adjusted cost of) capital structure / WACC. Obviously, an apartment REIT will have more day-to-day headaches from owning an apartment portfolio compared to externally managed hotels. The net of the gross income (after operating expenses: (periodic or one-off) repairs & maintenance; taxes; insurance; management fees; salaries; utilities; and administrative costs), is the net operating income / NOI, which can then be capitalized at the market discount rate / yield (which, in theory, should be the same as a DCF discounted at the purchaser’s WACC). To create Alpha, the landlord can adopt various policies and strategies such as: revenue enhancing capital improvements / CapEx to realize incremental NOI gains and thus value increases; altering the ownership and management structures; or via ‘cunning’ financial engineering eg buying shares, issuing bonds to alter the debt-to-equity, etc.
A REIT might trade at a premium to Book Value because:
1 - Book value is old, and the value has gone up (like with real estate)
2 - The buildings can produce a reliable income that when capitalised is worth more than bricks-and-mortar cost
3 - A REITs competitive advantages make it worth more than just the sum of the parts
4 - Investors believe that a REITs management can improve the current income (via imminent rent-reviews or CapEx improvements), or acquisitive growth
Conversely, a REIT might trade at a discount to Book Value because:
1 - It is struggling to improve revenues
2 - The market thinks the assets are overstated
3 - It is out of favor with investors, even though it continues to be profitable
4 - It is too small so little traded and unfollowed by analysts
If a REIT is struggling to generate increased income, they’re often priced close to the value of their assets or, if there is significant debt, trade at a huge discount to the value of those assets, until the income increases and / or debt reduced, or they go bankrupt. Therefore, investors are espeicially interested in: the net asset value; the revenue / cash-flow; debt; and dividend history / growth over time. Similarly, buying into a REIT that is trading at a substantial premium runs the risk of over-paying for the income stream, irrespective of how secure it is, since growth projections can become overly optomistic.
Capitalisation Rate (Cap Rate)
The Cap Rate is an expression of the return expected from an investment by a buyer. In the context of REITs it can be described as the ratio between the “value” and Adjusted Funds from Operations. However, as the expression goes "The meaning of life I can tell you about; The meaning of Years' Purchase (YP) is slightly more complicated." Years' Purchase and Cap Rate can be regarded as almost interchangeable since both are the multiple of the rent-to-value like the Price Earnings ratio for equities. The Yield is 1/YP and put simply, prime properties have lower yields than secondary premises, so higher ap Rates indicate higher returns but also higher risk. Most REITs only own "institutional standard" properties, but small differences represent large amounts of money. The 'market' / economic strength / weakness of a country / city / property sector drive yields up and down. Some people simply prefer to cut-to-the-chase and just say "Pay-Back” period, but whatever you call it boils down to being a single multiple before or after tax, etc. See calculation of Implied Cap Rate worked example - Link.
Cash / Funds Available for Distribution
Cash (or Funds) that are easy to access for distribution (CAD or FAD) are measures a REIT’s ability to produce cash and distribute dividends to shareholders. Similar to AFFO but without taking specific account of “exceptional” non-recurring items of expenditure, such as full-scale refurbishment programmes.
Cost of Capital
Since the Credit Crunch everybody seems to be an expert on what the “cost of capital” is, and how much debt is “good”. In the context of REITs this is the cost of increasing funds in the form of equity (common or preferred stock) or debt. The cost of equity capital can be calculated by reference to the share price, which in turn reflects the market's estimate of both dividend and price growth. It’s an inter-connected matrix. By contrast, the cost of debt is simply the interest expense.
Together with UpREITs and Stapled / Paired-Shared REITs, it is a legal structure by which property ownership, property management, and "sponsors" can most tax efficiently set up a REIT, given their sometimes different goals. DownREITs are similar to UPREITS, in that both allow real estate owners to contribute to a partnership controlled by the REIT on a tax-deferred basis, but DownREITs typically hold their assets through multiple operating partnerships (each of which may only own a single building), whereas UPREITs typically hold all of their assets via just the one. Furthermore, in DownREIT structures the value each operating partnership is not directly linked to the value of the REIT shares because the value of shares is determined by reference to all of the REIT’s assets, rather than those of any one operating partnership, which can affect the liquidity of the units, hence in practice most DownREITs tie the redemption to a 1:1 ratio, which can also have negative tax implications.
Because REITs are legally compelled to pay out almost all of their net profit in dividends, they can at time be a bit ‘cash-light’ in comparrison with other "normal" companies. So, in order to make new acquisitions they must therefore raise debt which can be done by: selling additional stocks or shares, but because of the effect of dilution (which is tightly regulated), this is usually done via issuing preferred stock or simply borrowing money from the bank; the debt markets (via issuing unsecured notes or debentures); from selling assets or private placements; or doing JVs. Many REITs also are backed up by strong ‘sponsors’ who hold significant shareholdings (directly or indirectly), which can also be utilised and exploited for mutual advantage.
Is the ratio of the dividend paid per share to the price of the stock. Thus, if the price goes down, the dividend yield goes up. For illustration, US REIT dividends apparently averaged 4.7% compared with 1.7% for S&P 500 in 2004, and 7.56% compared with 3.11% in 2008.
As opposed to a Mortgage REIT. Equity REITs hold direct “equity interests” in properties (such as freeholds), instead of the paper loans secured against them as collateral.
Funds Available for Distribution (FAD)
FAD, like AFFO, is also a more accurately represents cash flow growth and returns on investment, which keeps management focused on sustainable value creation and dividend growth over accounting and financial engineering. While FAD is not a consistently defined and reported metric, it is a much better measure of recurring cash flow than FFO because FAD excludes the benefit of non-cash income and takes into account the burden of recurring capital expenditures needed to maintain the quality of real estate portfolios.
Funds From Operations (FFO)
FFO is a measure of the cash flow generated by the REIT. Net Operating Income is the start, but can be misleading if looked at in isolation of depreciation & gains. Hence FFO is, historically (and legally), the normally accepted reporting measure of a REIT’s operational performance, as it is essentially represents the “net profit” ie Net Income + Plus Depreciation + Gains on (Depreciable) Property Sales (-ve) + Other Miscellaneous Depreciation Items & Gains less any gains made from the sales of property. REITs typically disclose their FFOs in the footnotes of their financial statements and are required to show their calculations. For refinements see (AFFO).
Hybrid REITs are Equity REITs that “like to dabble” in mortgages ie a “hybrid” of Equity & Mortgage REITs. Largely a “US thing” as most investors don’t like the idea of mixing the two, and national legislation sets strict limits both on the amount and type investments that REITs can make. Interestingly, NAREIT seem to have recently stopped analysing them as a separate catagory.
This is another US term where only “eligible” investors with over USD$1m or USD$300k in income for 3 consecutive (for example) can invest in some private companies. It follows that institutional investors will levy an “illiquidity premium” on such stocks / shares and demand a higher rate of return from them as, if nothing else, they should be harder to sell-on.
What’s interesting, paradoxically, is that some research into the performance of (such) private real estate investment funds indicates that publicly listed REITs have outperformed the private ones, with explanations including that listed REITs are not so prepared to chase short-term profits (or be faced with fixed-term time-lines in the case of closed-end funds); that listed REITs can better focus on long-term stability of rental income; and that listed REITS are better able to employ more conservative managers less absorbed by the “bonus culture” of achieving short-term targets. But there are two sides to every coin, and advantages and disadvantages of each. An interesting discussion piece going forward.
Leverage / Gearing / Loan-to-Value (LTV)
This is essentially the amount of equity relative to the amount of debt. The WACC (Weight Adjusted Cost of Capital), takes things a bit further by factoring in the cost of equity and the cost of debt (before or after tax ie the “tax shield”).
Shareholders are keenly interested in management's ability to do more with what has been given to it, and can be measured by the returns generated from the assets under its control, and from the equity invested into the company by shareholders.
Mortgage REITs invest in loans and other obligations with rental income / real estate as the guarantee eg Collateralised Debt Obligations (CDOs, etc). As we all know, the Financial Crisis originated partially because of the difficulty the ratings agencies had in accurately valuing them (playing off the interest differential margins between what they receive and can themselves obtain), so they can be pretty volatile, and the risk factor needs to be carefully considered. In the US there are Residential Mortgage Backed Securities (RMBS), for which the principal and interest payments are guaranteed by a US Govt agency, such as the Government National Mortgage Ass / Ginnie Mae, or a US Govt sponsored entity (GSE or Agency), such as the Federal National Mortgage Ass / Fannie Mae, or the Federal Home Loan Mortgage Corp / Freddie Mac - collectively known as Agency RMBS, and as opposed RMBS backed by prime jumbo & Alternative A-paper / Alt-A mortgage loans - Non-Agency RMBS; Collateralised Loan Obligations / CLO's; pure or hybrid ARM's / Adjustable Rate Mortgages; interest / princial only or inverse interest only instruments (collectively known as IO's & PO's). See -Link- for more detailed information.
Net Asset Value (NAV)
Net Asset Value is the net market “worth” of the assets after all deductions. Obviously in the context of a REIT the starting point is the value of the property portfolio less taxes, debt, management & fees, sales costs, etc. The adjusted NAV of the properties held by a REIT is usually expressed on “per share” basis, which means the value is divided by the number of total outstanding shares.
Paperclip REITs were invested to overcome the problems of Section 269b(a)(3), since such REITs do not own the operating subsidiary directly, but rather closely co-operate via inter-company agreements such as Rights of First Refusal either for the REIT to acquire any buildings being offered by the operating company, or for the operating company to manage any buildings acquired by the REIT. Furthermore, both are allowed to have the same management teams and board directors, and shares in both maybe paired or traded together (effectively as a single unit), hence the term “paper clip” REITs.
The Pink OTC (Over the Counter) market is the “speculative trading" marketplace, as Pinks have lesser financial standards or reporting requirements, and companies in this tier can better choose the level of information they provide to investors; there maybe limited or no public disclosure.
Different parts of a REIT's capital structure are its debt and preferred stock. The fact is that REIT equity is an income play: Investors buy REITs for the dividends. But the common stock isn't the only way to get a fat dividend yield. We could talk for days about the differences between common and preferred stock. But when it comes to REITs, the big difference that matters is growth. REIT preferred stock pays a consistent, fixed dividend. REIT common shares usually pay a consistent dividend, but one that is subject to change. For the most part, quality REIT common stocks pay bigger dividends over time. But just because the dividends grow over time does not mean the common stock is a better investment. In many cases, investors may be better off owning the preferred stock, even though the dividend won't grow over time - Link.
Price / Value / Worth
The price of something can perhaps best be described by looking at historical transactions,......the price that WAS paid. The value of something can be described by looking at the negotiations for something NOW. The buyer and seller with both have different ideas as to what the "price" should be. The worth of something is subjective. Think of the man dying of thirst in a desert; a bottle of water is worth all the money he has. People often get emotionally attached to (particularly residential) property and will only sell at a premium over and above the 'open market value' or what they perceive as being the 'price.' Conversely, some people absolutely must sell NOW eg a 'fire sale' to raise money, so will sell for a discount. Subtle but important differences.
Price-to-(Adjusted) Funds From Operations (P/FFO)
REITs are considered by many to be the same as "stocks and shares," so the P/E ratio (Price-to-Earnings) is a common unit of comparison. But REITs are different from “normal” stocks and shares since they MUST pay out @90% of net income in dividends (or shares), so comparison with other investments is / can be misleading. Hence, the P/FFO & F/AFFO.
A company's margins are important in determining how much profit the company generates from its sales. The operating margin indicates the percentage earned after operating costs, such as labour, materials and overheads, whilst the profit margin indicates the profit left over after the operating costs and all other costs, such as debt, interest, taxes and depreciation, have been deducted.
Real Estate Partnerships
Time for a quick bit of US real estate investment history, since these were abolished 1986. They were dreamed up a great way for people to offset tax by setting up and then selling off shares in property companies in which the General Partner retained operational control, allowing them to largely “cash in” their properties whilst simultaneously charging fees. However, the IRS have since changed the tax code so that losing money on an investment can no longer be offset against gains from other income. Another cunning plan foiled!
Stapled / Paired-Share REITs
A paired-shared or stapled REIT is a structure by which the REIT owns buildings and an affiliate operates them, although the shares of both are combined and traded as a single unit under one ticker (but with different tax implications since the REIT can receive pass-through tax benefits), which resolves the problem of lack of control over properties owned by a REIT. Note however, that the Deficit Reduction Act of 1984 added Section 269b(a)(3) which stipulates that all stapled REIT income (including that from affiliates income), is aggregated for purpose of determining REIT eligibility if more than 50% is derived from subsidiaries. The Act also included a “grandfather” clause which allowed existing stapled REITs to unwind without time limit. These REITs are particularly relevant for hotel companies where it is arguably too ambitious for a management to try to do both functions “expertly” - particularly where the company has a large portfolio of properties.
Many REIT investors are particularly interested in the ‘certainty’ of cash dividends, since these are usually paid Quarterly (with the rent). Most countries make it a condition of granting REIT status, to insist that the dividends are paid out in cash. Obviously, the Credit Crunch hit the US financial services system very hard, one of the impacts beign that it became almost impossible for even large corporations to borrow money at feasible rates of interest. So, the US government allowed its REITs to instead pay out upto 90% in stocks as a way better enabling them to access cash for operations (and service debt). Like all such ‘emergency’ measures, introduced by governments for time immemorial as a ‘temporary’ measures, this ‘temporary bending-of-the-rules’ could be around for a good while to come.
Taxable REIT Subsidiary (TRS)
Another US tax term, though with global relevance, since REITs ordinarily enjoy tax perks that “normal” property management companies don’t. In the case of the US, the 1999 REIT Modernization Act (RMA) allowed REITs to establish wholly owned companies to undertake the daily grind eg day-to-day property management and / or asset management, The legislation took effect from 2001 and the IRS was promptly swamped by a deluge of @400 requests. And why not? Hotels in particular have to pay huge chunks of their before tax gross revenue to operators. Similarly, in most of Asia where office leases tend to be just for a few years, a one-month’s rent "commission" could have some real value.
Umbrella Partnership Real Estate Investment Trust / UPREIT is the term used to describe a particular structure through which a REIT can hold its assets. UPREITs are the most common operating structure for publicly traded equity REITs, whereby they hold substantially all of their assets through one Operating Partnership / OP, which is typically majority owned by the REIT with other minority partners / OP Unit Holders. The UPREIT can be set-up either as part of the original REIT formation by a sponsor in exchange for OP Units when the REIT contributes cash raised from stock issuance to the public, or subsequently, in connection with the acquisition of a particular portfolio. Typically, the OP holders’ units are redeemable for cash or, at the option of the REIT, shares in the REIT after an initial holding period.
The main benefit is that UPREITs enhance a REIT’s ability to acquire properties in exchange for Units on an (almost indefinitely) tax-deferred basis (under Code Section 721). By contrast, a transfer of properties to a REIT in exchange for REIT shares would ordinarily be fully taxable. Furthermore, OP Units received in the exchange offer a couple of liquidity advantages over the original direct ownership of the real estate because a fair market value can be established for the Holder’s OP Units, which can then be borrowed against without being subject to immediate taxation; and because the redemption feature itself provides liquidity (the holder may sell publicly traded REIT shares or receive the cash of equivalent of the fair market value of the OP units). However, unit holders will typically not elect to redeem the units as they then become fully taxable, and instead retain them until death so that they will then receive a fair market value “stepped-up” tax basis, allowing the individual’s estate or beneficiaries to redeem or convert the OP Units on a tax free basis.
The drawbacks are that UPREITs are legally complicated, and any subsequent sales of the concerned properties may result in tax liabilities (and hence a conflict of interests), for that partner, and the pre-contractual negotiation of minimum holding periods which may affect the management’s ability to optimize the financial performance of the REIT.
Monthly Dividend Reinvestment Plans / DRIPs v Annaul Payments
The chart shows how USD$100k invested at 7% grows $4.251 more with monthly reinvested dividends after 10 years because the sooner you reinvest a dividend, the more time it has to generate compound growth. Furthermore, the monthly paying companies also offer less market risk and you have just one opportunity a year to buy additional shares via a dividend reinvestment program.
|Last Updated on Wednesday, 05 August 2015 08:38|