You are about to retire or simply search to generate higher income from your portfolio? Chances are you will be looking for companies paying yield over 4-5%. Such higher yields usually come with higher risk. You don’t really want that if you are looking for a stable income. Good news; a few sectors come with higher yield without the higher risk. Investing in Real Estate Investment Trusts (REITs) could be a good solution for income seeking investors. As REITs must distribute 90% of their taxable income to enjoy their structure, this allow this type of corporation to offer higher yields to their units’ holders.
You can download the complete list of strong dividend paying REITs here:
|AAT||American Assets Trust||3.12%|
|AKR||Acadia Realty Trust||4.45%|
|AP.UN.TO||Allied Properties REIT||3.72%|
|ARE||Alexandria Real Estate||2.83%|
|BEIJF||Beijing North Star Co||2.71%|
|BRE.TO||Brookfield Real Estate||7.96%|
|CAOVY||China Overseas Land||3.00%|
|CHSP||Chesapeake Lodging Trust||5.41%|
|DIFTY||Daito Trust Construction||2.79%|
|DIR.UN.TO||Dream Industrial REIT||6.88%|
|DWAHY||Daiwa House Industry||2.29%|
|EDR||Education Realty Trust||4.66%|
|ESS||Essex Property Trust||2.90%|
|EXR||Extra Space Storage||3.48%|
|FCD.UN.V||Firm Capital Property||7.12%|
|FCR.TO||First Capital Realty||4.22%|
|FRT||Federal Realty Investment||3.43%|
|GRT.UN.TO||Granite Real Estate Investment Trust||5.27%|
|GZUHY||Guangzhou R&F Properties||6.12%|
|HKHGF||Hongkong Land Holdings||2.05%|
|HNLGF||Hang Lung Group||3.21%|
|HPT||Hospitality Props Tst||8.18%|
|LHO||LaSalle Hotel Properties||5.78%|
|MPW||Medical Properties Trust||7.64%|
|NHI||National Health Investors||5.69%|
|NNN||National Retail Props||4.84%|
|PDM||Piedmont Office Realty||4.78%|
|PSB||PS Business Parks||2.88%|
|ROIC||Retail Opportunity Inv||4.40%|
|SBRA||Sabra Health Care REIT||9.88%|
|SIOLF||Sino-Ocean Group Holding||3.18%|
|SKT||Tanger Factory Outlet||6.02%|
|SPG||Simon Property Group||4.82%|
|UHT||Universal Health Realty||4.28%|
There is nothing perfect in this world and REITs are not even close to perfection. There are several things you must look out for before considering investing in any REITs:
Be Careful – the Tax guy has an eye on you!
As opposed to dividend stocks, distributions from REITs are mostly considered as income with a portion of return of capital (ROC). Remember that income from REITs is fully taxable while ROC will reduce the average also distribute a part of their income as dividends. There are no official rules, and it is important to verify each REIT before making any purchase.
Remember that chances are you will pay higher taxes on REITs distribution than dividend stocks. Therefore, it will be important to include your REITs in your RRSP or TFSA. Holding REITs in a non-registered account will result in much higher taxes!
Interest rate could hurt
The cost of financing has risen significantly since 2008. It might sound counterintuitive as interest rates for personal consumers have never been so low. However, a 6 billion REIT doesn’t go to the branch on the corner of the street to get financing. It usually has to issue bonds at a “commercial rate”. This is how cost of financing in this industry has risen because it is considered riskier than it previously was. Prior to 2008, financing was easy to get as banks thought they were able to manage all the risks and still remain well capitalized. Now that the capitalization rules are going toward Basel III, banks will charge a higher interest to finance any commercial activities.
The effect of a higher cost of financing has been amortized by the existing long term debt structure. Most REITs have already secured their lower rates for several years (read 15 to 20). Therefore, the immediate impact on income from a rise in interest rates is minimal. Over time, it will definitely reduce income distribution abilities.
You are not the landlord
Not being a landlord and not having to deal with tenants from hell is an advantage, if you like to control your investment with a close eye, investing in REITs will be a great deception. The management philosophy as presented to the investor is usually vague. Therefore, you blindly give the power to the management team and your investment return will depend on their ability to deliver.
Higher fluctuation than Real Estate
How can investing in real estate asset classes be more volatile than investing in… Real Estate? The fact that REITs are accessible through the stock market like any other stock is a great advantage, it is also a source of higher fluctuation as explained in the first part of this series. Units value will be following stock market trends and you will see those drops in value on your investment statement. Such situations don’t happen if you own your triplex, as the only statement you receive is your mortgage statement! The value of your triplex is not assessed on a daily basis as opposed to the price of your REITs units.
Finally, the uncertain future of retail stores
Another situation worries me now. The state of retail stores. I’ve made an extensive study on Amazon (AMZN) Vs Target (TGT) and Wal-Mart (WMT) in 2016 and it’s not getting any better today. The outcome of this study was clear: brick & mortar stores are having a very hard time. Growth in the retail stores is being found nowhere but online. Therefore, what will happen with all those empty stores?
In Canada, Zellers closed their doors a few years ago. Their empty leases found a new company… Target (TGT). Do I have to tell you the end chapter of this story? Those leases are now empty again!
In the U.S., the situation isn’t better with Toys”R”Us going out of business in 2018. The next graph is alarming:
Many retail stores had the brilliant idea of leasing their space to REITs. This is a great way to diversify the risk and concentrate on their business while REITs benefit from a wide experience of managing properties. However, REITs have little to no control over who rent their space. If a big retail chain has to close 200 locations, the REITs will be affected once the penalty of the contract will be assumed by the renter.
Because of their structure and business model, it is almost impossible for a REIT to move quickly and transform their business. Therefore, all retail-focused REITs will enter in a business-model-changing era in the following decade. Will they be able to sustain their dividend payouts in the future? This is a very hard prediction to make.
In other words, REITs aren’t bulletproof
I can’t stress this point enough; REITs are NOT bulletproof. The main reason why you should invest in a REIT is because of its stable distribution. That doesn’t mean a REIT cannot cut its distribution or that its units won’t severely drop in value. A bad investment, rising interest rates, or a bad economy (leading to a high number of bad tenants) could results in some serious financial problems for the company. I understand they pay juicy yield, but there are still businesses and they must remain profitable. Remember that REITs must distribute a minimum of 90% of their revenue. This leaves very little room for mistakes or a volatile real estate market. You can get the list of stronger dividend paying REITs to start your research here:
How to Analyse REITs
When you are bout to analyze REIT’s you will have to rely on data that is not provided in stock screeners, as it is not part of the GAAP (General Accepted Accounting Rules). Funny isn’t? If you own REITs shares already, you’ll know what I am talking about: the FFO (Funds from Operations) and AFFO (Adjusted Funds from Operations). So let’s start with this one:
FFO & AFFO Less Funny but more useful than LMFAO
The FFO & AFFO are probably the most useful tools to analyze a REIT. Since REITs main reason for existing is the distribution of its revenue, you must look at how healthy this distribution is, right? This is a similar thinking to dividend stock analysis, but with different data. But in the end, it’s all about cash flow.
The main problem when looking at a REIT financial statement is the inclusion of amortization in the calculation of its earning. The amortization concept is a GAAP that allows a company to reduce its income by applying a virtual loss in value to its equipment or buildings. Since REIT’s are in the business of owning and managing properties, they show an important amount in amortization that reduces their earnings on paper.
On top of that, in January 2011, the application of International Financial Reporting Standards (IFRS) modified the known definition of net income. In fact, IFRS requires REITs to consider their buildings as “investment properties” in their financial statements. Investment properties allow accountants to use the Fair Market Value model (FMV) in order to reflect the true value of the assets instead of a falsely depreciated asset according to amortization rules. This will help bring ratios closer to the business reality. However, there is already a measure existing that avoids any confusion among investors.
In reality, most properties will gain in value instead of losing value over time. Therefore, this GAAP is mixing your analysis. This is why we are using a different approach by looking at the FFO & AFFO. The AFFO will give you hints on the sustainability of future distributions. In other words, looking at the AFFO is like looking at the company’s real profit.
The difference in the FFO and AFFO is the consideration of the capital expenditure. The FFO will consider the company’s earnings and add the amortization to have a real look at the company’s income flow. It will withdraw the proceeds from property sales in order to show a net income flow. A new approach with the AFFO will go a little bit further by withdrawing capital expenditure to the ladder. This is to ensure the true net income flow from the REITs operations. Since each company will have to spend money in order to maintain and manage its property, it makes sense to include capital expenditures in your calculation. Therefore;
FFO = Earnings + Depreciation (Amortization) – Proceeds from Property Sales
AFFO = Earnings + Depreciation (Amortization) – Proceeds from Property Sales – Capital Expenditures
Before you let a big sigh out of your mouth I would ask you to hold your breath a few more seconds. I told you that the AFFO can’t be found with a free stock screener such as Google Finance or the TMX. However, REITs are giving the AFFO in their quarterly financial statements. Even though it’s not a GAAP and you would technically have to calculate it yourself, REITs management teams are well aware that you are looking for this info and therefore provide it to you on a quarterly basis. You can surely waste a few hours trying to calculate AFFO for each REIT yourself… or you can simply get the financial statement and read a few pages to find the information you are looking for ;-).
What do you do with them?
Both FFO and AFFO must be brought down on a per unit basis. You basically have to divide the number by the number of units and compare it to the distribution per unit. Then again, those numbers are provided in the company’s financial statement.
Here’s a quick example:
- Number of units: 100,000
- Distribution: $1.00 per units
- Earnings: $100,000
- Depreciation: $25,000
- Proceeds of sales & Capital expenditures: $20,000
AFFO would be:
$100,000 (earnings) + $35,000 (depreciation) – $20,000 (proceeds of sales & capital expenditures) = $105,000
AFFO per unit would be:
$1.15 ($105,000/100,000 units)
So if you would have looked at the payout ratio (distribution/earnings), you would have seen a 100% payout ratio. However, if you look at the percentage of distribution on the AFFO, you get an 87% ratio. The company could technically distribute up to $1.15 per units without being cash flow negative but would then show a 115% payout ratio.
The FFO and AFFO per unit should be lower than 100% in order to keep a healthy distribution over time. So the magic number will be high, but should be under 100%. That’s normal as REITs are required to distribute most of their income. One thing to consider is that if the REIT is distributing 100% of its cash flow, it leaves very little room for flexibility (unless the company accesses additional financing). However, it is also possible that the number exceeds the 100% mark. So is a 110% distribution rate dramatic? Not at all. Say what?
If the company distributes more than 100% of its AFFO, that means that it distributes more money than it receives. A negative cash flow position could eventually lead to a distribution cut or less attractive overall financial position. This is a similar rationale to the one that we apply on a dividend stocks with a payout ratio over 100%. However, there are 2 situations where a REIT can have a negative cash flow position and still be a good investment:
Consider the amount of units in DRIP. If you take the 2011 Q3 financial statement of RioCan (REI.UN), it shows a 104.5% distribution rate of AFFO. This technically means that the company is distributing more money than its cash flow. RioCan also shows 22.9% of its units to be part of the DRIP (Dividend Reinvestment Plan). Those investors don’t receive payouts, but more units on a monthly basis. When considering the distribution net of DRIP as a percentage of AFFO, the company shows a healthy 79.5%. REITs count a lot of investors participating in their DRIP which allows them more flexibility in regards to their liquidity.
Future income growth. If the company recently purchased an important complex, chances are that its distribution percentage will be higher than usual. You will then rely on the management’s ability to raise rents and improve profitability of the newer complex. If the future income should be higher due to better management on the recent acquisition, you can tolerate a higher distribution rate. As you can see, analyzing the payout ratio of a REIT incurs a lot more gray areas than dividend stocks!
Loan to value ratio
I have already mentioned this several times so far; REITs are not like regular stocks. Another example is when you consider REITs financing structure. As opposed to many companies or individuals, REITs don’t get much benefit from completely paying their mortgages. Instead, they use the equity built in their existing property portfolio in order to extend their business and create value for their unit holders. Therefore, many REITs are overleveraged.
This strategy is great in a prosperous economy, but it is important to make sure that management teams don’t go overboard with leveraging. As I have mentioned before, the cost of financing has been rising for REITs since 2008. This means that overleveraged properties will have a hard timing refinancing their mortgage later on.
The use of the loan to value ratio (LTV) is a great tool to analyze the future ability to raise cheap debts for REIT. The LTV is easy to calculate from the financial statement, as you only need 2measures of data:
LVT = Mortgage Amount / FMV of properties
With the new International Reporting Standards in place, it has become easier to calculate the LVT. This ratio will tell you how much the company can seek through refinancing and will also tell you if they can raise debt at a lower rate than their competitors. For example, if Rio Can has an LTV under 50% and Calloway’s is at 70%, chances are that Rio Can will raise debt cheaper.
Net Asset Value (NAV) – Another Non GAAP Data
Investing in REIT’s differs a lot from investing in other varieties of stocks. The NAV (usually shown by units) can be translated to the equivalent of a Price to Book ratio. You can’t do the calculation by using the GAAP once again since the property value won’t reflect the FMV. Therefore, what you need to calculate the NAV is:
NAV = Total Property Fair Market Value – Liabilities
Once you divide the NAV by the number of units, you have the equivalent of price to book valuation. In order to get a real use of the NAV, you have to compare it among its industry. After calculating it for a few REITs, you will have a better understanding of if the market is overrating one company compared to another. A lower than industry NAV is considered to be either a risky play or a value play. The AFFO and LVT will tell you which one it is.
Considering the Financing Structure
After looking at the LVT to know if the REITs have leverage potential, another factor to consider is the overall debt structure. You need to look at the current mortgages expiring matched with leases expiring. A great combination would be leases expiring soon (as the company has the ability to increase rents) with long term locked-in mortgage since borrowing rates are still pretty affordable right now.
Another point to look at in the financing structure is the number of units issued on a yearly basis. Most REITs will issue a lot of new units due to their popular DRIP. As issuing more units to pay its shareholders is not a problem over a short-term period, an increasing number of units combined with a slow growth will be catastrophic for the shareholders. If the main source of financing is done through issuing new shares, you could go closer to a turn around and give that money back to existing shareholders. It doesn’t sound healthy, does it?