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How to Analyze REITs Like an Owner
A simple way to cut through all the noise and accurately value REITs
Your author is a big fan of real estate investing. I’m just too lazy to go the actively managed route.
There are a few reasons why so many retail investors love real estate. They can use small amounts of money to get into the market. There’s seemingly endless investment possibilities, especially if you live in a larger market. It’s passive enough an investor can scale pretty easily, too.
Ultimately, it comes down to real estate being a pretty easy business to understand and execute. Or, as someone once put it: “Think about the stupidest rich guy you know. There’s a 100% chance he made his money in real estate.”
God, I love that quote. I’m just going to pretend I came up with it from now on.
Keeping with the simplicity theme, one of the nice things about buying individual properties is they’re pretty easy to analyze, especially if you’re in the business. You know what a certain property will rent for. You subtract predictable operating expenses like insurance, property taxes, and maintenance, and you end up with a pretty good idea what operating income will be, which you then use to figure out cap rate.
Consider the following:
Property value: $200,000
Rent: $18,000 per year
Insurance: $1,000 per year
Property taxes: $2,000 per year
Maintenance: $1,000 per year
Operating income: $14,000
7% return on investment (AKA cap rate)
28% return on equity (assuming 25% down)
This is not an exhaustive list of expenses, of course. You may want to add contingencies for things like vacancy or property management. But it’s pretty close.
Compare that to analyzing the average stock, which can take up days of your time if you really get in the weeds. I’ve seen equity analysts get stuck on things like the amortization of intangible assets or some other nonsense on page 104 of the annual report, things that do not matter at all.
It’s not easy for real estate investors to make that jump. I personally know at least one hella smart real estate investor (hi, dad!) who could easily understand stocks if he put his mind to it. But he doesn’t, because he’s content to stay in his own circle of competence.
So even though many equity analysts make fun of real estate guys, there’s a certain beautiful simplicity in the way they invest. Here’s how you can borrow their strategies to make better decisions with REITs, including a few examples.
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Keep it simple, stupid
I know more than a few stock market investors who don’t venture into the world of REITs because they can be incredibly confusing for a rookie.
Here are just some of the things a halfway competent REIT analyst needs to keep in mind:
Management is constantly looking at properties and either increasing or decreasing their value based on these internal assumptions. Sometimes outside appraisers are used.
These increases (or decreases) in value end up on the income statement, making a REIT’s earnings basically useless
Instead, investors use terms like funds from operations (FFO), which essentially looks at income without any fair value adjustments
They also use adjusted funds from operations (AFFO), which factors in capital expenditures and is a replacement for free cash flow
Sometimes, total debt isn’t accurately reflected on a balance sheet because debt is held at the project level and the REIT only owns a portion of the total project
Fortunately, there’s a simple way to analyze a REIT that avoids most of this, a method that allows you to look at a portfolio of properties the same way a real estate investor looks at an individual property.
Enterprise value (market cap + total debt - cash)/net operating income = rate of return
Wait. That’s it?
That’s it. I told you it was simple.
This method allows an investor to easily calculate the rate of return generated by the current value of the assets. That’s because we’re using market cap and debt, rather than a company’s internal version of net asset value.
As you’ll see, REIT portfolios differ wildly in earnings yield, usually because the market is no fan of the assets.
One note before we get started on a few real life examples. This strategy isn’t foolproof. It’s just a real good place to start. Like anything, it’s only as good as the data you put in, meaning adjustments may have to be made. Trailing data doesn’t work if big changes are made, like a REIT selling a bunch of assets.
Let’s take a closer look at some residential REITs and see the difference in implied earnings yield. We’ll stick to one part of the overall REIT sector, since we want to use this method to compare alike assets. There isn’t as much value in comparing residential property to industrial property.
First up, Minto Apartment REIT (TSX:MI.un). Minto owns 32 high rise towers in Toronto, Ottawa, Montreal, Calgary, and Edmonton, consisting of 8,291 suites. The REIT also lends money towards certain developments, loans which have options to convert to ownership interests.
Let’s do the math. (Note that I’ve annualized Minto’s NOI since it hasn’t reported full-year 2022 results yet)
Market cap: $654M
Total debt: $873M
Enterprise value: $1.521B
Net operating income: $86.5M
Cap rate: 5.69%
Boardwalk REIT (TSX:BEI.un) owns 33,722 apartments across five provinces. More than 60% of its net operating income comes from Alberta, although it has been diversifying into Ontario and Quebec. Additionally, 26% of shares are owned by insiders.
Let’s do the math. (I’ve also annualized Boardwalk’s NOI)
Market cap: $2.90B
Total debt: $3.29B
Enterprise value: $6.17B
Net operating income: $285M
Cap rate: 4.62%
BSR Real Estate Investment Trust (TSX:BSR.u)(TSX:BSR.un) owns multi-family residential projects in the Sunbelt region of the United States. It owns 8,666 units across Texas, Oklahoma, and Arkansas. BSR reports in U.S. Dollars, so all figures below are in USD.
I’ve also annualized BSR’s NOI
Market cap: $545M
Total debt: $762.7M (including convertible debentures)
Enterprise value: $1.3B
Net operating income: $71.2M
Cap rate: 5.48%
Morguard North American Residential REIT (TSX:MRG.un) is a residential REIT with 11,829 suits spread between 42 different properties. 26 properties are located in the United States, with 16 in Canada. The Canadian assets are heavily weighted in the Toronto market.
Full year 2022 results came out on Tuesday, so we don’t have to annualize partial year results.
Market cap: $733M
Total debt: $1.5B
Enterprise value: $2.23B
Net operating income: $151.2M
Cap rate: 6.78%
Canadian Apartment Properties
Now’s a good time to talk about the granddaddy of them all, the largest residential REIT in Canada. Canadian Apartment Properties REIT (TSX:CAR.un) owns 47,300 apartment suites and an additional 12,383 manufactured home community sites across every province except Manitoba. Some 45% of assets are located in the Greater Toronto Area. It also manages and owns a portion of an apartment portfolio in the Netherlands.
NOI has been annualized for CAPREIT.
Market cap: $8.48B
Total debt: $6.9B
Enterprise value: $15.3B
Total operating income: $648M
Cap rate: 4.24%
InterRent REIT (TSX:IIP.un) owns a total of 13,180 suites across 127 different properties across Canada. Approximately 60% of its NOI comes from Toronto and Ottawa area properties, with the rest coming from other Ontario (whatever that means), Montreal, and Vancouver regions. The company also just finished converting an office building to residential suites in Ottawa, which will start contributing to NOI in 2023.
I’ve also annualized InterRent’s NOI.
Market cap: $2.05B
Total debt: $1.64B
Enterprise value: $3.69B
Total operating income: $137M
Cap rate: 3.71%
Last one. Killam Apartment REIT (TSX:KMP.un) owns 203 apartment buildings, 39 manufactured home communities, and 7 commercial properties. It translates into 19,527 apartments and 5,974 manufactured home sites. More than 50% of the company’s assets are located in Atlantic Canada.
I’ve also annualized Killam’s NOI.
Market cap: $2.13B
Total debt: $2.18B
Enterprise value: $4.3B
Total operating income: $204.9M
Cap rate: 4.77%
Let’s summarize before we go any further. As you can see, there’s a pretty big gap between the best cap rates and the worst ones.
Remember, this is only the start
It’s not enough to simply pick the cheapest REITs based on cap rates and buy. You gotta lift the hood up and see what’s going on.
For instance, both InterRent and Minto have some pretty good development programs in place. Those tend to add to NOI over time, meaning forward yields should be higher than today. An investor might want to try to project next year’s earnings as new assets come online and value the stock today accordingly. This is often easier said than done, but it can be a valuable exercise.
Some investors like Morguard because it has more properties in the U.S., located in places without rent control. And some don’t because despite the various Morguard REITs being dirt cheap for years (seriously, check out MRT.un sometime) the parent never seems to do anything about it. K. Rai Sahi is content to sit back and grow his awesome moustache.
I also have to do more work in Minto because I have no idea why it’s so cheap. There must be something hidden I haven’t seen yet, because a REIT with exposure to Toronto, Ottawa, and Montreal should not trade at a lower valuation than one with most of its exposure to the Maritimes.
Sorry in advance, Nova Scotians. But not really.
The bottom line
Most investors look at a price-to-FFO ratio when buying REITs, but I don’t think that tells the whole story. Each of the REITs featured have differing levels of debt, which means looking at just the equity isn’t the right way to go about it.
Say we have two REITs that both have $1B in assets and generate $50M in NOI, for a 5% cap rate. One has zero debt, so it trades at a price-to-FFO ratio of 20x. The other has $900M worth of debt, meaning it trades at a price-to-FFO ratio of 2x. One has superb balance sheet strength and is likely looking to expand the portfolio. The other is essentially insolvent.
Looking at a REIT like a real estate investor eliminates this. It simplifies a complex portfolio into something more resembling a single property. Sure, there are downfalls to the method, but that’s okay. It’s only meant to act as a start, as a way to find the more interesting assets. The rest is up to you.
Now if y’all will excuse me, I’m off to do more work on Minto Apartment REIT.
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