By SA Editor Robyn Conti :
Since I've declared August "REIT month," and because the last issue of the Digest was so well received, SA Pro Editor John Leonard has joined me for a second Q&A on evaluating real estate investment trusts (REITs). Here, we go beyond the basics and delve into key metrics investors should consider when looking at different types of REITs, i.e., apartment, retail, hotel, etc. John provides some great insights and responds to some of the comments from Part 1, so if you want to learn more about how to make more informed investing decisions on REITs in specific niches and get more information about where to find key REIT metrics on Seeking Alpha and other sites, read on.
Robyn Conti: Continuing our previous conversation on how investors should critically examine REITs, let's turn our attention to the different types of REITs (e.g. office, industrial, retail, lodging, residential, healthcare, and self-storage), which each have unique drivers and catalysts. Can you discuss the factors that influence these categories?
John Leonard: I'll expand on several of the key drivers for REITs that I briefly touched upon in the first part of this series . It's critical to monitor these as they have a direct and material impact on the operational - and ultimately stock - performance:
Geographic mix of properties - are they primarily in cities (if so are they top or second tier cities) or suburbs, are there any supply or regulatory constraints (lack of available land to build; zoning laws preventing certain construction), are they concentrated in a few markets or diversified.
Market strength/outlook - this can include the health of the major industries in each market (energy in Texas), rental rates, job growth, median income level, income growth, population trends, household formation, major trends (away from suburbs towards city for residential/office, increase in renting vs. buying), amount/cost of new construction.
Economic sensitivity - is demand tied to economic growth (lodging, office) or is it relatively immune (healthcare as need is relatively inelastic/growing due to aging population; self-storage due to the 4Ds - death, divorce, downsizing and dislocation).
Occupancy - this goes beyond just the occupancy rate; need to look at the vacancy rate for the entire market as that impacts rental rates, time to find new tenant, length of lease, % of leases expiring each year, how many tenants renew their leases.
Quality/diversity of tenants - what is the credit rating/financial strength, is the property critical to the tenant's operations such as a major distribution or fulfillment center.
Property quality - (Class A, B for office; upscale vs. limited service for hotels), do properties need major renovations to be competitive.
Lastly, as an example, I'll discuss a few hotel-related metrics. One of the most important metrics (and a standard performance measurement for the industry) is RevPAR or Revenue Per Available Room. This is calculated by multiplying occupancy by ADR or Average Daily Rate.
On a standalone basis, this metric is less meaningful than when used compared to its historical trend (e.g., current RevPAR is $300, up 10% y/y) or relevant peers (e.g., full-service hotel A has a RevPAR of $300 and hotel B has RevPAR of $275).
Getting back to the calculation of RevPAR, the reason why occupancy alone is not sufficient to measure the operational performance of a hotel (or strength of its brand) should be readily apparent after this simple example. The delta between a hotel with 90% occupancy and an ADR of $200 compared to a hotel with 85% occupancy and an ADR of $300 is huge. Not to complicate this any further, but there could be instances where the hotel with a lower ADR could be more attractive. For example, if it's a limited service (compared to full-service) hotel, the operating costs will be significantly less, so the operating profit could be comparable.
As we discussed P/FFO last time, another relevant valuation metric is the value per room (or key), which is the value/cost of the hotel divided by the number of rooms. This can be based on recent sales (hotel A was just sold for $X per key) or construction costs (hotel A is valued at $X per key based on what it would cost to build the hotel today).
RC: The great unknown right now is what happens with interest rates going forward. What are your thoughts on that, and do the Fed's actions impact REITs?
JL: The conventional wisdom is that an increase in rates is negative for REITs, however, there are two important points to remember. First, if the Fed is raising rates (which they've already started to do), it's presumably because the economy is strong (or getting stronger), which should drive higher occupancy, rental rates, etc. and ultimately higher FFO. The second point (and anyone who has read the excellent book Moneyball by Michael Lewis will appreciate this) is that it's important to look at how REITs have historically performed during periods of rising rates and not just assume they will perform poorly because of a preconceived notion. Here is one study showing REITs' overall positive performance during periods of rising rates.
To be clear, don't just completely ignore interest rates because they do have an impact on REITs (and every other stock for that matter). However, to an investor (as opposed to a trader), I'd say it's just as important (and arguably more so) to base your decisions on the operational and valuation metrics we've discussed rather than let interest rates be the sole or even primary factor.
However, I'll just hedge this a bit and note that rising rates will obviously have a much bigger impact on REITs with floating rate debt, so given that we're now coming out of the zero interest rate environment, analyzing the debt structure (including any upcoming maturities that need to be refinanced) is critical.
RC: In our last article, we touched on some of the ways that valuing REITs can be confusing for investors. Are there similar stumbling blocks investors can encounter in the sectors mentioned above, or others, and if so, what are they?
JL: One of the biggest is equating the quality of the underlying REIT assets with the quality of the investment opportunity. For example, a REIT might have the highest occupancy, rising rental rates, longest leases, etc., but if the market is already pricing this in, then the risk/reward is less attractive (and this applies on the flip side).
Another is over-discounting secular trends. I'll give two examples. First, everyone is well aware of the secular trend of the aging population, rising healthcare costs, etc. While this is all true, this doesn't mean you can skip doing due diligence as there are a lot of moving parts that can negatively affect this thesis in the short-mid term such as oversupply of rooms, changes in Medicare/Medicaid reimbursements.
The second is the secular trend of online shopping and that it will "destroy" bricks and mortar retailers. There are two points to remember. First, this might even create an attractive opportunity if the market has overreacted and drove the stock down to an attractive valuation. Second, while a retailer might be facing secular headwinds, there is a significant difference between a retailer declaring bankruptcy (and canceling its leases) vs. simply facing slowing earnings growth (or even modestly declining earnings). Remember, you're buying the REIT - not the retailer.
To be clear, I'm not saying all you should care about is if the retailer pays its rent on time every month because a weak market for retailers will eventually impact REITs. I am saying that an "obvious" negative narrative shouldn't make one REIT industry "uninvestable."
RC: Is there anything else you'd like to add?
JL: I'd like to wrap up by highlighting two comments from the last article.
Golfbud asked about resources to calculate FFO/AFFO. As this commenter mentioned, a lot of the popular finance sites such as Yahoo Finance or MSN don't provide this data. Your suggestion to go directly to the filings was a great idea. The great news for Seeking Alpha readers is that they have three places to find FFO/AFFO data - conference call transcripts (these figures are almost always discussed - just CTRL-F "FFO" or "funds from operation"), SEC filings (you can now access the full SEC filing without leaving Seeking Alpha - just click on the "Filings" tab), and the press release/slide decks.
If you're interested in valuing REITs and can't find a free site that provides accurate P/FFO, P/AFFO data (and readers should certainly leave suggestions in the comments), one free (if a little tedious) way is to set up a spreadsheet (doesn't have to be Excel - could be Google Sheets) that automatically pulls/refreshes market cap data and you manually enter the most recent FFO/AFFO data. Even if you're following 20 REITs, it wouldn't take that long to update considering you're only doing it once a quarter.
Moving on to the next comment, Giofls mentioned the importance of monitoring the debt levels. I'll add that one metric to monitor is the interest rate (or even the after-tax interest rate) compared to the cap rate of the properties it's buying. For example, borrowing at 4% to buy a property at an 8% cap rate is obviously attractive (all else being equal). If the cap rate is 4%, management has to work a lot harder to create value (rely on rent increases, upgrade property, etc.).
Now it's your turn to weigh in. How does market sentiment about interest rates play into your evaluation of a REIT investment? Are there any other metrics you use when considering niche-specific REITs that we didn't mention here? What do you think about secular trends and how they impact REITs and their "investability?" Please share your thoughts in the comments below.
And now, on to the week's Dividends & Income news and analysis:
Dividend Stock Yields 18%, Big Growth, Ex-Dividend This Week, Below Book Value by Double Dividend Stocks
Nike & Starbucks: That's What I Bought, Y'all - Part 2 by Mike Nadel
Top 4 Large Cap Dividend Champions To Keep Forever by ColoradoWealthManagementFund
Chipping Away At Bad Debt And Bad Habits - But Is It Too Little Too Late For Memorial? by WilliamsEquityResearch
Oxford Lane Capital: Overview Of Q2 Results - Is It A Buy? by Downtown Investment Advisory
Dividend Investors: Get Ready For Multiple Contraction... by Reuben Gregg Brewer
Why You Should Wait Before Buying Any REIT - Except One by Michael Foster Financial Services
Cisco's Amazing Results Give It 69% Upside Potential by Dividend Sensei
Dividend Investors: Should You Really Be Worried About Multiple Contraction? by Adam Aloisi
Exxon Mobil Acquires At The Bottom by Casey Hoerth.
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