REITS • Publication date: 11 / 18 / 2023
Understanding REITs and its differences with other companies
The requirements for REITs make them a more homogeneous category of companies compared with other sectors and company profiles, facilitating their comparisonEG
Enrique García Sáez
11 / 18 / 2023
Real Estate Investment Trusts - REITs - are perceived as suitable investment vehicles for conservative and dividend investors, as they usually provide a steady income flow over time thanks to the durability and stability of their real estate assets.
This article does not pretend to be a full guide of information about REITs. Instead, the objective is to highlight their special characteristics and circumstances compared with other companies to better understand and assess their potential value as stock invesments. These special characteristics facilitate our analysis.
Characteristics that make REITs special
Let’s enumerate several specific characteristics of REITs that make them different from other companies:
- Most of their capital is invested in real estate or other associated assets with them.
- They are required to distribute - or at least encouraged - almost all their earnings through dividends. Exceptions and how these distributable earnings are estimated vary across jurisdictions. As a consequence, REITs rarely accumulate earnings to reinvest in the future, as is the norm in almost all other companies.
- It is not usually allowed that only one or a few shareholders control more than half of the voting rights. Again, specific thresholds and details vary across jurisdictions, but it can be assumed that these companies cannot be acquired without abandoning their REIT category and its benefits.
- They enjoy a corporate tax exemption or reduction. Again, specific rates and exemptions can vary across jurisdictions. The logic behind this favorable treatment is based on the fact that real estate assets usually attach important property taxes.
Regulation and objective requirements that allow to consider a company as a REIT make it easier to develop a specific analysis framework for these companies. For instance, we will not find a hybrid balance sheet with dozens of businesses and assets that are fundamentally different, as REITs are required to invest all their capital in real estate or other associated assets with them.
The fact that they tend to distribute almost all their earnings reduces the possibilities of capital management. In contrast, many other companies can decide how much of the earnings to retain, how much to reinvest in their business, stock repurchases, debt reductions, etc. One can also think whether those earnings are real, while REITs simply distribute them.
On the other hand, retaining earnings and internal reinvestment can generate large fiscal savings and significantly increase shareholder returns over time, which is the inconvenience of such simplicity in REITs. It is a tradeoff between the chance of obtaining extreme capital returns and having a simple and more stable capital management.
Therefore, REITs can be considered an almost objective investment category because they tend to have many similarities. The framework used to analyze one of them should also be useful to analyze others.
Alternative accounting method
Many of the accounting rules are designed to avoid abuse and manipulation. But the nature of the REITs and their assets allow alternative criteria to elaborate their balance sheet. This is why REITs update and revise their real estate accounting figures constantly, even if they are not transacted, a fundamental difference compared with the rest of companies. This is possible because their assets are not subjective to assess.
Therefore, an REIT balance sheet shows the fair value - also sometimes called appraised value - of its real estate assets and not its acquisition cost. As a result, the equity figure shown in the liabilities column represents a fair estimation of REIT value, provided that the fair value of its assets is reasonably well estimated. Then, the equity figure can be compared to the market capitalization of the company to assess if it is undervalued or not. Of course, investors could be anticipating or discounting a further deterioration or improvement of the company assets that is not well represented in the balance sheet. Nevertheless, this comparison is providing useful information for our analysis.
This analysis is not possible - or it becomes more complicated - for other companies which estimate their assets under a cost acquisition criteria. As the value of their assets is not updated until they are sold or acquired, their balance sheet figures are highly distorted. As a consequence, the majority of well functioning companies have a much higher market capitalization than equity. It is not a whim of regulators or accounting experts, as non-real estate assets are usually too subjective and difficult to obtain their fair value. This method would open the door for uncontrollable accounting shenanigans.
The fair value adjustment mechanism is also represented in the income statement as an extraordinary profit or loss, although neither have yet materialized. This is useful to follow the company, when earnings are released, it becomes a warning as to whether real estate assets are deteriorating or improving, considering a broad range of factors. However, this extraordinary profit or loss should never be considered as recurrent and should be subtracted when analyzing earnings generation. In fact, many REITs provide an alternative income statement excluding capitalization effects to show profits as a direct consequence of current activity.
In summary, the company can be assessed from two possible points of view: the sum of its assets value and its income generation. Both of them are useful and supplement each other.
Clean differentiation between operating expenses and capital expenditures
The nature of real estate assets and the incentive to not reinvest earnings allows to perfectly differentiate between operating expenses and capital expenditures. This is not an easy task for common businesses, as it is possible to consider that some current expenditure is an investment that could provide revenue over several years. This is a consequence of a large variety of different assets and complex investments made by these companies.
However, as REITs invest their capital in real estate assets, there is not much subjectivity when it comes to distinguishing between pure operating expenses and investments that are depreciated over several years. This significantly simplifies our financial analysis: the income statement is clean from subjective investments and the cash flow statements show almost perfectly how much the company is investing and earning.
As a consequence, this context changes how we should interpret some events and decisions around the company. For instance, raising capital is controversial for many public companies because the new funds can be used to cover operating losses. Even when the company argues that the raised funds will be used for new investments, investors may doubt it, as the distinction between operating expenses and capital expenditures is difficult - and the accounting may not be reflecting the real scope of operating losses temporarily. However, new investments for REITs are often easy to recognize and understand and this should help the investor to better comprehend the situation.
Meaningful metrics and data
There will always be many exceptions and details, but we can usually obtain meaningful metrics that provide a decent overview of the REIT and what expectations investors may have. This may not be enough to reach final conclusions about overvaluation or undervaluation, but these metrics represent clean and strong hints of what is happening. Again, this should not be extrapolated to other sectors, as the nature of other businesses can vary extremely.
First, a reasonable estimation of the company equity value can be obtained as we have shown above - alternative accounting method section. This is a consequence of the accounting criteria used to update the value of the REIT’s real estate assets, which is not applied for other companies. Then, if the equity attributable to shareholders is estimated at €2 billion and the market capitalization is around €1.1 billion, we can infer that investors are discounting a further deterioration of those real estate assets or that the fair estimation is flawed. It is possible to study the assumptions of that estimation, as it is usually provided in annual reports.
Second, it is sometimes possible to compare the fair value estimations with the market prices. Some REITs occasionally sell some assets and their fair value estimations can be tested to check whether they are reasonable or totally wrong. It is not unusual that the asset sale prices are higher or equal than their balance sheet fair value estimation at the time of the sale, as independent appraisals tend to be cautious in those estimations.
The following quotation is an example of this kind of information: a press release from Klépierre after selling some assets in 2021. Curiously, Klépierre’s market capitalization was - and is - significantly below its equity attributable to shareholders, while it has been able to sell assets at or above appraised values.
Klépierre, the European leader in shopping malls, closed by the end of last week, the disposals of 2 retail assets:- Boulevard Berlin (Klépierre equity interest: 95%), a shopping mall with c. 100 retail units anchored by Karstadt, H&M, Zara, Media Saturn and both supermarkets Edeka & Karstadt Perfetto, located in Schloßstraße in Berlin (Germany). Following the sale of the mall, Klépierre will continue to do facility and property management of the asset.- A retail park with 22 retail units (Klépierre equity interest: 71%) in Bordeaux in France.The total consideration amounts to €345 million (Total share - excluding transfer duties), 3% above appraised values as of June 30, 2021 and in line with appraised values as of December 31, 2020, implying a blended EPRA Net Initial Yield of 5.1%.
Klépierre Press Release - December 20, 2021
Additionally, it should be easy to measure the profitability of these real estate assets, as their revenue and operating expenses are relatively stable. This should help with our financial analysis, as the return on assets can be compared with the financial cost rate and other yields. Going back to the Eurocommercial Properties example, its balance sheet estimates its total assets at €3.9 billion as of June 30, 2023. At the same time, all these assets - mostly real estate assets - are generating a €172 million annual operating profit - excluding changes in fair values. This means a return on assets of:
return on assets = 172 x 100 / 3,883.9 = 4.4%
We have estimated its financial debt at €1.562 billion and its annual interest cost in 2023 will be around €44 million. Then, its effective cost rate is currently close to:
effective interest rate = 44 / 1,562 = 2.93%
This means that its indebtedness is still positively leveraging its initial return, obtaining a higher return on assets than the cost of its debt.
Another important indicator is its financial leverage. In this case is not very high:
financial leverage = 1.562 billion debt / 3.9 billion assets = 0.4 debt / assets
All these metrics can be obtained for other companies, but its significance is less conclusive. They are too noisy and are likely to be highly distorted without adjustments.
Conclusions
The requirements for REITs make them a more homogeneous category of companies compared with other sectors and company profiles, facilitating their comparison. Their full dedication to real estate assets and specific accounting rules make it easier to take a first glance into their financial situation.
The categorization of investments vs current operating expenses is simpler for real estate assets, limiting one of the biggest problems when analyzing businesses. It is easier to obtain meaningful financial metrics for these companies than many others, and these ones are very useful to describe investors’ expectations and a possible overvaluation or undervaluation.