This is not investment advice and is general in nature. Do your own research before taking any positions in the securities listed below
How broad is the definition of REITs and why bother with them?
Like all rules, there are exceptions, but there are a few basic rules of REIT investing:
Generally, REITs, excluding housebuilding, can be fairly easily/accurately valued so the returns on REITs are range-bound
Like any rule though, there are plenty of exceptions and I see the major exceptions to be
When there is an embedded OpCo (e.g. $LIC which has deferred mgmt fee stream)
A REIT that is trading a large % of its assets above/below book value (e.g. the US REIT loved by FinTwit - Seritage Properties)
Vertically integrated developers (e.g. $LLC who does construction and development)
When there is an embedded fund manager (e.g. $CHC whose returns are more aligned to FUM and PFs)
Plain old REITs; When there is a wide spread between private/public markets (e.g. the current market)
For absolute clarity, I am not necessarily saying the exceptions are better investments than vanilla REITs, I am saying they are most likely to be under/overvalued. For example, if you compare some generic REITs to $CHC
Over the last 1yr, $CHC underperformed most REITs BUT you would have outperformed REITs over a 5yr period
Moreover, the peak-to-trough returns can be much more dramatic (e.g. 2020 crash) when capital markets
Over the last 6yrs, 30% of FUM growth came from valuations. Of this FUM, c.90% is external capital. From this fee income - the fees generally trade on 12x earnings (so there is a lot of operational leverage when the valuation cycle works your way)
So why write about REITs now As you probably know, an easy way for a REIT to generate earnings accretion is as follows
Raise equity at a premium to book or tight Adjusted Funds from Operations (AFFO) yield
Buy a core/core+ asset with a big AFFO yield or development asset with a wide Yield on Cost
Investors capture the spread between the current AFFO yield and the yield of the asset
However, the issue comes when REITs trade to a big enough discount to NAV that
AFFO of private assets is tighter than public markets
The discounted share price means that gearing headroom is limited OR they go up the development risk curve to make the YoC stack (e.g. instead of doing a Build-to-Suit in a prime area they do spec development in a secondary area)
The REIT starts doing excessive asset swapping to earn transaction fees but remains lowly geared
What you want in a REIT is an internally managed REIT that has not got addicted to issuing shares & FUM fees
Without going into names, I looked at two different REITs with the following attributes
Company 1
Operates in a pure-play property asset class
Trades at a 35% discount to NAV
Externally managed with 65bps on GAV MER
Generates material income from transaction fees
Share count by 27% over the last 7yrs
Company 2
Operates in a pure-play property asset class
Trades at a 25% discount to NAV
Internally managed with an equivalent MER of c.35-40bps
Limited transaction fees
Share count grew by 5% over the last 7yrs
Without looking at the more variable parts of the real estate market (e.g. OpCos, Fund Managers etc) I can confidently say I would prefer the return prospects for Company 2 than Company 1
Conclusion
For REITs, It is important to look at the incentive structure (FUM vs. Property-level returns) in this market and the quality of the underlying property being purchased (e.g. prime vs. secondary).
Alternatively, if you are interested in buying an integrated OpCo or Fund Manager - it is worth doing A LOT more work around the prospective returns of this business and giving little attention to the trailing dividend yield or P/E multiple.
These businesses require a unique product offering (e.g. LIC was an earlier mover into this space) and positive momentum (e.g. book of future fees) to make for great investments and a large amount of the outsized returns in recent years has come from valuation growth (e.g. 30% of CHC FUM growth in last 6yrs)
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