IN THIS ISSUE: Last year’s financial crisis has left much of the economy sunken and struggling to find stability. Where does one invest when practically all asset classes have dropped and there is limited refuge in diversification? In a few cases, these price drops have happened to solid companies whose distributions have remained in tact. One such asset class to experience this is REITs (Real Estate Investment Trusts). In this issue, John Nicola offers his view on the potential value to be found in REITs, so long as one does their proper due diligence and implements an effective strategy.
Unless you have been drifting through space without a radio, you are well aware of the carnage that has reduced the value of global equity markets by approximately $30-trillion – about 50% according to an article in the Economist magazine (When the Golden Eggs Run Out, December 6, 2008). What makes this financial crisis unique when compared to other bear markets in equities is that virtually all other asset classes have dropped at the same time. This has meant very little safety in diversification.
As of the end of 2008:
- The Case Schiller House Index was down 18.4% for the last 12 months in the U.S. In Canada, housing prices are down almost 10% and in some markets the drops are much higher from previous peaks.
- Commodity prices have dropped almost 60% since July with oil prices now in the mid-$30 to $40 range vs. the mid-$140’s. (At least one does not require a home equity loan to fill up with premium.)
- Corporate high yield bonds have had their prices fall over 40% in the U.S. and Canada. Even with interest being paid, total returns are still down 25% or more. Current yields are much higher than government bonds. There is a flight to safety and many of these bonds are priced to reflect massive default rates.
This brings us to the topic at hand: Real Estate Investment Trusts (REITs). This asset class has also experienced large losses in share prices, even though most REITs have been able to continue making their distributions.
As a result, the yields for the Index have risen from less than 5% in the spring of 2007 to about 12% now; which, of course, means that the price of this REIT ETF (XRE-T) has dropped from $17.80 per share to $7.61
Over the last 10 years, investment grade real estate has been a cornerstone for many of our clients and has provided excellent returns made up of both capital appreciation and income. In our opinion, most individuals do not have enough high quality commercial real estate in their overall portfolio.
While over very long time frames commercial real estate has not outperformed large cap equities, it has provided returns that are quite close. More importantly the income on real estate makes up a much higher proportion of the total return than it does for stocks (in other words, less capital gains and more income). In this era of low interest rates, income-producing real estate can be very important to insuring consistent cash flow.
While REITs have traded in public markets since the 1960’s in the U.S., they only became available in Canada in the early 1990’s. A rough approximation of the value of Canadian REITs as of the end of 2008 is $17-billion.
The major real estate categories represented by REITs include:
- Residential apartments
- Hospitality (hotels, motels, etc.)
- Senior’s housing
Most REITs have very simple capital structures. Investors put up equity which is used to acquire income-producing properties in the categories above, while using borrowed money in the form of mortgages to fund part of the purchase price of assets they are acquiring. This is similar to what a private investor would do.
Over time, the retail income will pay off the debt while allowing for distributions of income to investors. If one assumes that rents rise over time more or less in line with inflation and that the mortgage balance is reducing, then both the net cash flow and the equity attributed to investors will increase.
This makes real estate an attractive investment, because it normally shows the following characteristics:
- Stable rental income that increases over time (inflation protection)
- Relatively easy to finance with mortgages, provided debt ratios are reasonable (70% or less of appraised value)
- Tax deferral on some of the income through depreciation on the value of the building
- Increase in equity value because rental income is rising.
So if these attributes are true for the majority of REITs, how can they drop in value by 60% – more than the drop for common shares (see chart next page)?
And why are some REITs cutting distributions if there has been little change in rental income and interest rates are falling?
There are several reasons for this unusual situation to exist.
- For many years, REITs were able to take advantage of very low cost financing. Much of the competition for this cheap money came from the same conduit lenders who financed and securi-tized subprime mortgage debt in the U.S. and Canada. By the early part of 2007 it was not uncommon to be able to borrow commercial mortgage funds for 100 bps over Government of Canada bonds (GOCs), and even less for CMHC insured mortgages used in multi-family residential properties. Today those rates are as much as 300-400 bps over GOCs. Even though overall government bond rates have dropped in this economic crisis, the cost of borrowing on real estate has risen.
- Many lenders have dropped out of the commercial mortgage market (including all of the conduits such as Merrill Lynch). In addition, the remaining lenders are increasing their standards for loans, which means a lower loan-to-value ratio. Whereas in the past they might have agreed to lend 70% on a good quality asset, now they may refuse to go above 55% to 60%. This means less leverage for the borrower and lower returns in the long run.
- As the price of money got cheaper during the years leading up to 2008, the cap rates used to determine the selling price of a building kept falling as well. The lower the cap rate, the more expensive the underlying real estate. The following is a simple example of this cap rate system.
Let’s assume a building earns net rents after expenses (but before mortgage payments) of $1,000,000. That is the building’s net operating income (NOI).
If this building sells for a capitalization rate of 6%, this means that the $1-million of NOI is equal to a 6% cash return to the buyer.
i.e.: $1,000,000/Building Value = 6%
Building Value = $1,000,000/6% = $16,670,000
Now let’s assume in a tighter marketplace that cap rates increase to 7% because the buyer is worried about increasing mortgage rates or a tougher economic environment where some tenants may have trouble paying their rents. To make up for that risk, let’s assume the new cap rate goes up to 7%. This reduces the value of the building as follows:
Building Value = $1,000,000/7% = $14,300,000
In this case, the building has dropped in value by 14% even though its net income remains the same at $1,000,000/year. What makes this picture much worse for an investor is that if we assume the building had an $8-million mortgage on it, then, in fact, the investor equity has dropped from $8,670,000 to $6,300,000, or 27%.
After many years of falling, cap rates are now rising; primarily driven by a tougher economic environment and the difficulty in obtaining traditional mortgage financing.
- REIT prices have always been more volatile than the actual value of the real estate that they own. In some parts of the business cycle, they trade at prices that are higher than the value of the real estate they own. Less frequently, they traded below the Net Asset Value (NAV) of that real estate. The reason for this is that for many investors, REIT’s are much easier and cheaper to acquire than a building and they offer substantially more diversification and liquidity.
The chart on the back page from CIBC World Markets shows this to be the case. What it also shows is that as of the end of November 2008, REITs as an asset class were selling at a record 45% less than their NAV. This has never occurred before.
All of the above are legitimate reasons for REITs to have dropped in value over the last two years. In January 2007, they traded at 18% more than the underlying real estate which in turn was arguably inflated by a very low cost borrowing environment.
Public markets, however, have a tendency to overshoot on both the upside and the downside and we feel this is a compelling reason to look at selected REITs as the least expensive (and least risky) way to increase exposure to investment grade real estate and to dramatically increase cash flow from equity based assets.
So what factors should one consider when selecting REITs to invest in?
- Type of real estate. Trditional multi-family residential property has proved to be the most resilient in recessions while Hotel REITs are arguably the most vulnerable. High yields on some REITs are very enticing, but risk of distribution cuts needs to be more carefully examined in this market. One measure of free cash flow in a REIT
is AFFO (Adjusted Funds From Operation). Ideally, one wants to see the current distributions around 90% of that number so there is a cushion.
- Price-to-Net Asset Value. As we noted above, this can be a moving target since the NAV is a function of cap rates which may be rising. However, we can measure the current price-to-NAV and compare with other periods to see if we are in a period of relative value. The greater the discount, he greater the margin of safety we have.
- Sustainability of current cash flow. This, in turn, is dependent on the terms of mortgage and other debt the REIT has. If most of the debt is long-term mortgage debt that is not due for many years, then the risk of having to refinance a property in this tough lending environment is greatly reduced. It is also dependent of the quality of the tenants.
The following are our observations and conclusions about the REIT marketplace and where it fits into client portfolios.
- 2009 will be a very tough year for the global economy. We will likely see reduced inflation (possible deflation), reduced interest rates and more business failures. For REITs, this is both good and bad news. Strong REITs will be able to renew mortgage financing at competitive rates, but they will feel pressure on the revenue side as some leases renew at lower rates and some tenants get temporary rent concessions.
- Presently, REITs are the lowest cost way to acquire high quality commercial real estate. In Canada, cap rates for investment grade real estate are in the 6% to 8% range depending on many factors. While pricing for some REITs suggest higher cap rates, our main focus is on value and the cash flow they generate within your portfolio.
- We have developed a pool of 8-10 REITs which, in our opinion, blend both value and cash flow. A pool such as this helps reduce risk in the same way an ETF would. At the same time, we can choose to leave those REITs where we feel overall risk is high. Best of all, the cost of this pool is a bit lower than the ETF.
Many of you have done very well over the years participating in SPIRE and other real estate partnerships with us. While we have not normally recommended REITs as the way to get the best results in investment grade real estate, right now they represent compelling value.
We believe that when this recession is over, their prices will revert back to their traditional premium over their underlying real estate (i.e., they will be relatively expensive). If and when that occurs, we will recommend winding up these positions.
In the meantime, this will not stop of us from looking for good value in the “hard assets” of bricks and mortar real estate. Some REITs will sell assets to raise much needed capital, and some of those sales will be at distressed prices, representing an opportunity for investors with 3-5 year time horizons or longer.
These markets have cut many asset prices by more than 50%; some deservedly so and some to a level that will create strong investment results over the next few years. Selected REITs is one asset group that falls into that latter category.