An Intro to REIT Investing (2020)
Dear Readers,
I recently took an informative class called Global Real Estate at Wharton taught by Professor Maisy Wong. It was a class I never anticipated taking, but one I learned a great deal from. It gave an overview of the basic principles of real estate, and an understanding of global investing strategy. I want to share some of my takeaways from the topics (basic Pro-forma modeling, REITs, key real estate risks). To keep my posts bite-sized, this post will outline a very high-level overview of REITs and the historical origins of the vibrant and dynamic real estate industry.
It is appropriate to start this conversation with a small word on the COVID situation. We are in the midst of a public health crisis that may speedily amplify into an economic crisis. There may be increased cash flow default and term default from companies due to the pause on consumer spending, leading to more non-performing assets and alternative credit opportunities for global investors. Hospitality and Retail REITs are badly hammered by the coronavirus as they depend heavily on the travel industry which is stifled due to travel bans and virus fears. Under the same pressure from the virus, assets with greater human density are largely affected: for example, healthcare facilities and regional malls whereas industrial facilities, and data centers have faced less-significant declines (Mckinsey Report). COVID has also accelerated many trends, one of which is a potential exodus from big cities and permanent WFH. With big tech companies such as Twitter saying staff can work from home permanently and many other companies following, it begs the question whether people will be willing to pay the premium for prime real estate in big cities (New York, SF, London) if they can work remotely in cheaper suburban areas (even accounting for adjustments to salaries). Offices and retail may well reconfigure forever to hybrid structures. For example, some strip malls will possibly be turned into fulfillment centers for Amazon or other e-commerce businesses.
What is a REIT?
A Real Estate Investment Trust is an investment vehicle created to allow small investors access to real estate as an asset class. The global REIT sector is at the heart of the institutionalization of real estate.
People buy into REITs for the indirect ownership of a portfolio of properties (owning a slice of all the companies in the REIT) rather than owning and being tied down by a single home. REITs also display a low correlation between REIT sectors and between countries, making REITs a great diversification add to a portfolio. For example, despite trade wars, REIT share prices were not highly impacted (Nareit). REITs are also considered a natural hedge to inflation as the value of real estate and securities tend to increase alongside inflation. REITs further tend to have attractive yields because they’re required to distribute at least 90% of their taxable income each year as dividends to shareholders.
How Did the Securitization of Real Estate Come About?
To really understand the REIT industry, it is important to understand its development over time. Real Estate developments can be characterized in ‘phases’. Phase 1 is when cities first pursue structural development of land due to rural to urban migration. In this phase, there is limited debt, and projects were mostly government-subsidized to catalyze modernization. Most projects are development focused rather than NOI focused. In Phase 2, there is no more massive urbanization — developers turn to owner-operators (marked by the emergence of Build-To-Rent in Europe), and increased numbers of large professional landlords. Still within Phase 2, there is the emergence of a debt market. By Phase 3, the property market experiences product differentiation (higher margin properties) such as student housing, co-living, and senior housing as well as niche sectors such as data centers and wireless towers. The capital market in Phase 3 is much richer than in previous phases with a larger presence of institutional investors and the securitization of debt (mortgage-backed securities) and equity (REITs).
The theme of securitization came about due to these phases because when operators wanted to transition from phase to phase, they required capital to achieve scale. There are numerous benefits of creating a securitized market, including access to deep capital markets, risk sharing, and adding liquidity to an inherently illiquid asset. One interesting catalyst to the REIT market in the US was the collapse of commercial real estate prices in the 1990s. Banks were under pressure to reduce lending exposure to real estate while private real estate owners needed to repay maturing debt. They had to access capital and therefore had to IPO through REITs (Real Estate Investment Trust) — this was coupled with favorable tax reforms in the 1980s that empowered REITs to operate and lengthen depreciation lives. (I find it incredibly interesting how history adds to our understanding of this aspect)!
Roy Hilton March, chief executive officer of Eastdil Secured, ranked one of the most highly sophisticated real estate investment banking companies in the country, wrote in a thought piece that capital migrated into US real estate and developed REITs for 5 key reasons which I will summarize here: 1. Resolution Trust Corporation (RTC) in 1989 was a US gov. owned asset management company that was tasked with the liquidation of assets primarily from real estate (over $394 billion in assets!)— this jump-started co-investing with PE firms and entrepreneurs who saw the liquidity as promising. 2. The adoption of federal regulatory policies that encouraged REIT managers to go public 3. “The CIO’s dilemma”: due to investors seeking 8–9% returns during the interest rate decline in the 1980s, this led to an increased demand for high yield and more niche sectors in real estate. 4. The emergence of sovereign wealth funds that encouraged a flow of capital from overseas, and finally 5. the technological innovation that provided transparency to reporting requirements and spurned outside-industry investment.
Comparing US and European REITs
In the class, we learned that REITs carry country-specific risk. Global REIT investors factor in the risk profiles of the countries where the REIT is established. We can see the different countries REIT regimes ranked in phases from Nascent to Mature in EY’s stages of REIT regime maturity.
The reason REITs display a low correlation between countries is because of the slow development of REITs in history, and very different corporate governance practices in different parts of the world. A classic example would be to compare the US and European REIT system. The US REIT system is much older and deeper than the European system — namely because REIT governance started in the US in the 1960s, as compared to 2001 in Europe. The US has a clearer sector focus with more niche offerings (eg: Wireless Towers (AMT)), whereas Europe has much fewer sectors. The US system also has limited leverage, with a more sophisticated use of public markets for debt and equity, while the European system is more levered. The US REIT system has a market cap of over $1 trillion, while Europe’s market cap is around 200 billion Euros. Furthermore, the US has greater CEO alignment as compared to Europe, averaging higher CEO shareholdings to base salary (ratio of 25 in the U.S. vs 5 in Europe), giving them more ‘skin in the game’.
Looking towards Asia, India just launched its first REIT, and China kicked off a REIT trial in late April 2020. Activist investors in Japan bring more pressure to Japanese REITs for more transparency and structural reform. Asia has far to go in terms of catching up to the US REIT sector, but are taking steps towards that growth. Singapore REITs are steadily growing as well, here is an article to learn more.
The reason the history and corporate governance of REITs matter so much is because real estate assets are illiquid with no transparency in pricing. The owner-operator knows much more than the investor (information asymmetry) which therefore requires a great level of trust in the REIT owners that they do not take advantage of the information asymmetry through exorbitant management fees, cash flow tunneling or dropping poor-performing properties into the REIT.
A takeaway from this comparison between the US and Europe is that I’d personally prefer investing a larger allocation in US REITs as compared to Europe because they have a more mature market, with more liquidity and managers with more aligned interest due to skin in the game.
The Most Important Metrics in Valuing REITs
REITs are valued based on three main techniques namely FFO (funds from operations), AFFO (adjusted funds from operations), and NAV (net asset value) (NARET). P/E ratios are basically useless when valuing REITs because depreciation can skew profitability metrics.
This is usually listed on I/S and in the 10K report. The reason you use FFO rather than Net Income is due to the fact that depreciation can distort the value of the REIT due to GAAP accounting that requires the REIT to be depreciated over time using standard depreciation methods.
However, analysts usually use AFFO (Adjusted Funds from Operations) because it “ignores one-time accounting charges (usually from acquisitions, asset sales, or other non-repeated activities) that will artificially inflate or reduce a company’s observed financial performance” (Sure Dividend) and provides a better measure of a REIT’s cash generated or dividend-paying capacity (Investopedia).
Let’s look at an example. I chose Equinix (EQIX) —the world’s largest data center & colocation provider. Data Center REITs acquire real estate and build servers that offer data storage services. Equinix has clients in diverse sectors such as Financial Services, Cloud and IT, Enterprise, Content, and Digital Media with no heavy weighting in any particular sector.
First, go to their Investor Relations page. As a public company, EQIX has to disclose its financial statements. Using their 2019 results, you can find that the AFFO is $22.81 per share, a 10% increase over the previous year, or 8% on a normalized and constant currency basis. The P/AFFO ratio (the price of shares as of Jun 7, 2020) is $673.50/$22.81 USD = 29.53
If we use the guidance 2020 ratios (I’m using the midpoint of their predicted AFFO) $24.42 — $25.00 per share, the midpoint of $24.71, then the P/AFFO ratio is $673.50/$24.71 = 27.26
A good idea would be to 1) compare P/AFFO with historical averages, and 2) compare P/AFFO with EQIX’s peer group (a series of companies that are similar to EQIX). In this case, EQIX defines its peer group for us in its press releases to shareholders: Digital Realty Trust (DLR), CoreSite Realty (COR), and Cyrus One (CONE) and QTS Realty (QTS).
Just for comparison with peers, EQIX’s P/FFO it is 673.50/ 17.79 = 37.86
P/FFO (FWD) Using the 2020 guidance numbers from the data center peer group, you see EQIX has the highest P/FFO. It is trading at a significant premium to other data center REITs. Once you understand where a REIT is based on its history and its peer group, you have a better data point to log to support or disconfirm your hypothesis on investing in the REIT. Just be wary: a REIT with a high price does not necessarily imbue it with value — it can be overpriced just like a stock. EQIX’s dividend yield is 1.58%, by far the lowest among peers. During the past 13 years, the highest Dividend Yield of Equinix was 2.60%. The lowest was 0.63%. And the median was 1.84%. It is lower than the median yield over history. There are of course other important metrics not mentioned such as cap rate, net asset value, and debt coverage.
Along with the numerical comparisons, like all investments there must be an underlying thesis and qualitative factors to investing in a particular REIT sector: you believe it will grow and thrive even in uncertain situations, and it is trading at a fair price or a cheap price. Some positive factors would be a high occupancy rate coupled with long weighted average lease expiry — this means there is a higher certainty of rental income and limited idle capacity. A healthy yield of close to 6% or higher (but it is important to be discerning, as a yield that is too high may not be sustainable). A promising long-term outlook for the sector is also necessary — the reason why I chose a data center REIT to use as an example is that data centers benefit from the growth of big tech and increased internet usage globally. Data Center REITs in Singapore recouped their losses from March due to these reasons, while hospitality and retail REITs still lag. Think about the risks of having REITs with properties in its portfolio across countries. Data centers have geographically diverse customers. QTS, followed by EQIX, is by far the most geographically diverse which may contribute to country-specific, and currency risk.
Valuations are also impacted by numerous qualitative factors unique to REITs. Some risks are priced in — concentration risk, for example, is when a REIT only includes properties in a single concentrated area. Tenant concentration is the same concept but for types of tenants. Types of leases are also important to look into: a triple net lease is a lease where the lessee is required to pay maintenance charges, taxes, and insurance to the vendor rather than the landlord, which results in premium valuation for the stock (Net-Lease REITs Rule the Roost by Forbes describes it as the ‘landlord’s ideal deal’)
Risks in Investing in REITs
Over-levered REITs: check the LTV (Loan to Value Ratio) — if a REIT is over-levered this is a big warning sign (usually REIT investors should aim for 30–35% leverage or less).
Refinancing Risk: there may be pressure to issue new bonds to repay existing loans. When REITs fail to secure refinancing, it may be required to sell off some properties if they are mortgaged under the loan.
I hope you enjoyed this blog post. The history of the REIT market has not been discussed in many REIT overviews I’ve read but is essential to include because it contextualizes and characterizes the differences between global REIT markets. For me, I’ll likely be including US and SG REITs in my future portfolio due to the diversification it provides, as well as my general interest in the sector. In future blog posts, I will discuss Pro-forma modeling and some other learnings from the class.
Until then!
Nicole
