Top Down and Bottom Up Long Term REIT Performance

REIT Index Performance

From a top down viewpoint, Investors has been rewarded investing in REIT over the last 20 years. While historical returns is not an indication of future returns, it does provide a backdrop to understand the key drivers of the sector.

The attractiveness of steady income and capital gains with rise in asset prices overtime resulted in the REIT performance outpacing the broader S&P 500 market. We have written up some of our thoughts based on the fantastic work done by AT Kearney.

Chart below shows annual return of the NAREIT Equity REIT Total Return index at 10.6% outpaced the S&P 500 over the same period of 9.3%. On a compounded basis this is a total outperformance of 32% over the 20 year period.

Long Term REIT Performance

Post the financial crises where the interest rates have been at record low, it is not unexpected that it has supported performance also.

The institutionalisation of the sector drove improved underlying asset operating performance, economic and consumer spending growth has underpinned the strong returns.

REIT Performance Rising Interest Rates

Key question in investor mind is the performance of REIT under rising interest rate environment. Interestingly, the chart below shows REIT performance under rising interest rate environment. You can see that in the shaded grey area where rates are rising with the 10 year bond rate as proxy for rate changes. 

Our view is that the risk for REITs is not the first rate increase, although important to take into consideration of market expectation of rate change impact on the sector.

However investors should be cautious at the middle and end of the rate increase cycle as that is when the risk is the highest. Intuitively at the end of rate cycle when the economy is signalling weakness is when the risk for REIT investors is at its highest. 

REIT Performance Rising Interest Rates

There are two ways investors can capture the return of the sector. Either through REIT ETFs which allows investors to gain exposure to the sector or use individual REITs. Note that the above relates to US listed REITs. Investors looking for international real estate can use international REIT ETFs.

Bottom Up REIT Performance Measurement

Instead of broader market with REIT ETFs, Individual REITs allow investors a more direct exposure to specific real estate markets, asset class or a combination of both.

REIT Performance 2015

2015 REIT Performance

Above shows the sector REIT performance in 2015. Our list of largest REITs highlight some the best REITs in each sub sector.

When investors are looking at which REIT to invest in the critical factor is always performance. Whether historical or future returns, there needs to be standard measurements so different REITs can be compared with other in an apples to apple comparison. While the list below is not exhaustive it is a good start point to understand the most important drivers of REIT performance.

Investors with a global remit investing across multiple markets needs to understand different treatment of real estate accounting in the respective local market and adjust if it needs to be to ensure the financials are comparable in the first place (see the end of the post for example).

REIT Occupancy Performance Metrics

Occupancy performance while not strictly financial measures the underlying performance of the real estate assets.

Building Occupancy Level – Shows how much percentage of the net leaseable area is occupied. It measures the overall efficiency of the trust. If the vacancy is below market, it could be an indication that the REIT’s leasing team is outperforming the market (assume rentals per SF are consistent with market for comparable assets).

Weighted Average Life of Lease (WALE) – This metric shows the average life of the tenants committed in the asset. If tenant have right to extend leases, the trust include the extended period only if the tenant has informed the landlord that they intend to exercise the renewal option.

Average Building Age – This represent the quality of the portfolio. REITS focused on development tent to have lower average if developments are for internal management.

Financial Performance Metrics

Per Square Feet measurements

Rent per Square Feet – most important standardized metric showing how much revenue is derived. For comparable measurement

Net Asset Value / Tangible Asset Value = Total value of the assets divided by the SF. NTA shows how much total value of the REIT is backed by the actual asset. In the event that the NTA is below the REIT security price. Investors must question themselves if the market is pricing the REIT incorrectly or the underlying assets are inflated which have not been revalued to a lower market.

Transaction Metrics

Throughout the life of the REIT. Management buys and sells underlying assets to either take advantage of market optimism, lower debt or upgrading the quality of the portfolio. Important metrics measuring the effectiveness of REIT management in this area includes:

Cost per SF – apples to apples metric of relative cost of purchases and sales.

Sales per SF – measures the health of the underlying tenants in retail REIT assets.

Year on year changes of cost and sales per SF measures the quality of the financials.

Net Portfolio Change = total real estate purchases over total real estate sales – this measures the net change in portfolio over the specific period. Evaluating underlying assets of the net portfolio change over number of reporting period gives investors a picture the change in the portfolio overtime.

Financial Reporting Metrics

Funds From Operations (FFO) is one of the most important metrics as it captures the underlying cash generation ability of the assets. FFO excludes gains from assets and other one time items included by the management and it is the key source of dividend payments.

Adjusted Funds from Operations is FFO adjusted for maintenance capex which is the net cash flow of the REIT

Debt FFO Ratio – the level of debt relative to the cash flow of the REIT

Interest rate – interest cost / debt. Measures cost of debt, also important is the cost of the recently issued debt. This shows the marginal cost and the upcoming expiring debt which would capture the cost of debt going forward.

Cap Rate – Cap rate is the net operating income (rent minus operating costs which excludes depreciation) as proportion of the value of the building. Optimally, the cap rates of the buildings sold should be lower than the cap rate of assets added to REITS. This shows management adding value through actually buying low and selling high.

Investors using the above metrics should apply the it consistently across the same category of assets. Obviously debt ratio of healthcare REIT would differ to pure office reits and sales per SF is most relevant for retail reits.

 

Financial Reporting Adjustment Example

For example under US GAAP from the tenant perspective, assets are depreciated over the life of the lease while under some local laws fixed asset can be depreciated over a fixed term. This would create distortions similarly from the landlord perspective (i.e the REIT owner) as their own fixed asset specific to tenant requirements usually are required to depreciated over lease life rather than useful life.