WCM Educational Recap #15: Intro to Real Estate

Recapped by Morgan Tannis

Welcome back to the Western Capital Markets blog! This week, we dive into the fundamentals of real estate investing.

Real Estate Overview

Major Types of Real Estate

• Office: Usually the largest property type. Typically located in downtown cores
• Retail: Includes large shopping malls and tenant buildings. Demand-driven by location, population density, and consumer income level
• Industrial: Requires smaller investment than office and retail, less management required and usually has lower operating costs
• Key Real Estate Players: Ventas, DLF, Equity Residential, Avalon Bay Communities, PS Business Parks

Property Class Drivers

Multifamily

Market Drivers: Demographic trends, Homeownership, Population growth, and Employment growth

Asset Level Drivers: Proximity to public transportation and Proximity to amenities

Industrial

Market Drivers: Global trade growth, Access to major highways, and E-commerce shopping trends

Asset Level Drivers: Ceiling heights, Number of docks, and Proximity to cities

Office

Market Drivers: Employment growth, Regional economic focus, and High parking ratios

Asset Level Drivers: Unobstructed views, Tenant lease contracts, Tenant credits, and Number of tenants

Retail

Market Drivers: Income growth, Employment growth, and Population density

Asset Level Drivers: Tenant mix, Tenant lease term, Parking ratio, and Tenant performance

Hotels

Market Drivers: Travel activity, Airport, and Proximity to potential group demand generators (e.g. office)

Asset Level Drivers: Guest type, Management company, Meeting space, and Room space

Current Market Trends

Industry Fundamentals

• Real estate tends to be a particularly cyclical industry and performance is generally tied to the economy at large
• Real Estate is particularly sensitive to interest rates; changes in rates affect the profitability of taking on new projects or expansions by changing borrowing costs for firms
• Real estate securities, on the day-to-day, tend not to be very volatile (generally lower potential for capital gains), and are instead purchased as a reoccurring income source
• The largest Canadian REITS all have betas in the 0.15–0.40 range

Real Estate Investment Trusts

A Tax-Efficient Business Structure

• REIT — A special type of investment vehicle that invests in real estate and trades on exchanges like a stock
• Comparable to a mutual fund where people invest in a managed portfolio of assets

REIT Characteristics

• Income is not taxed at the corporate level (you would not see income taxes on the income statement)
• In order to maintain this tax-exempt status, REITs must distribute 90% of their income (dividends)
• At least 75% of REIT assets must be invested in real estate, cash, or US treasuries

Types of REITs

• Equity REIT: Invest in and develop properties (the most common of the three) to generate rent revenues or sell for a capital gain
• Mortgage REIT: Investment and ownership of mortgages and earn revenues from interest from loans
• Hybrid REIT: Combination of both equity and mortgage REITs

Why invest in a REIT?

• Exposure to the real estate industry without having to manage a property yourself (e.g. be a landlord)
• Access to a diversified portfolio of real estate (office, residential, industrial etc.)
• More liquid — selling a share in a REIT is a much smoother process than selling a house
• High cash flows from distribution yields

Real Estate Securities

Increasing Popularity and Development of Real Estate Securities

• The unprecedentedly low-interest-rate environment since the recession of ’09 has left many investors, both retail and institutional, “starved for yield”
• This has led many investors away from bonds and towards other income-producing securities that provide higher returns
• Real estate securities such as REITs and Real Estate mutual funds have filled the gap
• High yields, combined with low price volatility have resulted in increased interest in real estate securities and has increased the number of securities on the market

Real Estate Valuation Overview

Introductions to Valuations in the Real Estate Industry

• Valuations in real estate are divided into valuing individual properties, entire REITs, or real estate-related companies such as real estate developers
• Real estate valuations are heavily influenced by macroeconomic factors
• Low-interest rates may increase demand for properties given the access to cheap capital
• High disposable income increases the capacity for individuals to pay monthly rent
• Real estate valuation requires a lot of common sense; while performing a valuation, continually ask yourself “does this make sense?”

Key Considerations

• Valuation is an art, not a science — use good judgment when making assumptions
• Different valuation methods will often yield different valuations for the same property
• Consider the assumptions and drivers in each method before choosing a preferred method
• A good valuation should reflect the competitive advantages and shortfalls of a company
• Valuation is merely a starting point in the process of negotiation; deals are rarely successful just because a model computed the right number

NOI & Cap Rates

Net Operating Income (“NOI”)

• NOI is similar to EBITDA for normal companies because it excludes: D&A, Interest, Gains (Losses) on Asset Sales, Income Taxes (property taxes are still accounted for)
• NOI = Rental Revenue — Property Operating Expenses
• Occupancy rates: how much of the property is rented and generating income
• In-Place Rent: how much is the landlord charging, increase and decreases in rent prices
• NOI is often used because it’s less likely to be manipulated, it represents the earning potential of the property
• Can only be increased by raising the rent or reducing operational costs

Capitalization Rates

• The capitalization rate for a company is the same as its interest rate
• Rates are based on the property’s likelihood to lease-up and generate NOI
• Different types of properties have different capitalization rates
• NOI and Cap rates allow us to value property into perpetuity
• Market Value = NOI / Cap Rate

REIT Valuation

Operating and Valuation Metrics Meaningful for REITs

• Funds from Operations (FFO): Net Income + D&A + Losses on Asset Sales — Gains on Asset Sales
• Approximating how much the REIT can actually issue in dividends on a recurring basis from year to year: D&A is non-cash, and Losses/Gains are assumed to be non-recurring
• Adjusted FFO (AFFO): FFO — Maintenance Capex + Other Adjustments
• Many argue that AFFO is better since maintenance isn’t something REITs can avoid
• Dividend Payout Ratio: important to track since REITs must payout at least 90% at all times to avoid corporate income taxes (Dividend / FFO or AFFO)

Operating and Valuation Metrics NOT Meaningful for REITs

• P / E: includes Depreciation, a major non-cash charge for REITs
• P / BV: REITs have a huge amount of Accumulated Depreciation, so Book Value isn’t used

Relative Valuation — Multiples

• Multiples like P / FFO, P / AFFO, occupancy rates are used to determine the relative value for REITs
• P / FFO is the main earnings metric, similar to the P/E ratio in other industries
• Funds from operations add depreciation and subtract gains on sales to depreciable property
• Because real estate properties rarely lose value, we want to add back depreciation
• Adjusted funds from operations account for maintenance capital expenditure and rent expense
• Better approximation for the cash available to shareholders

Intrinsic Valuation — Net Asset Value (NAV)

• Assets — Liabilities = Equity Value
• Valuation of a company’s assets which have a finite life

Intrinsic Valuation — Discounted Cash Flow (DCF)

• Valuation based on premise that assets should be considered a going concern
• The most popular intrinsic valuation method

Intrinsic Valuation — Dividend Discount Model (DDM)

• Present value of all future dividends = implied share price
• Relevant due to the high payout ratios seen in REITs

The underlying concept: The value of an asset is the present value of its future cash flows

External Opportunities & Resources

Third-Year Opportunities

• Oxford
• Blackstone
• Slate
• Brookfield

Resources

• WSO
• Financial Times
• BIWS