Last article covered the basics of some misconceptions of REITs. In part II we address how managers “add value” and dodge restrictions imposed on them.
The term “adding value” is short hand to justify management overhead. That value is supposed to be the profit, realized or not yet realized in a business that management created solely though its skill and expertise. The easiest way in the last 20+ years is to cut costs.
The “Do more with less” ethos does work. But at the cost of employee attrition rates and wide knowledge gaps from senior employees leaving. Customer service levels also suffer because of low moral and chronic understaffing.
The other most popular way is accounting slight of hand.
The transition from GAAP to IFRS accounting has enabled REITs to capitalize things like window cleaning, carpet cleaning, lawn mowing, and the labor that goes into those activities. All serving to increase the “value” of the properties. This practice is not endemic to just REITs, O&G companies can do this as well. When a geologist drills any hole in a piece of company land, the company can capitalize and add that cost to the value of the property.
Like the holes to nowhere, this is why no REITs ever get bought out and taken private if their market capitalization is lower than their net asset value. (Why they never want to is another article.) As the on paper asset value of the properties may correlate to market capitalization, but the underlying property values would not correlate to equivalent valuation on a standalone basis. The real value in REITs being the management fee stream derived from asset values. Which is why market watchers will only see hostile management swaps. They want the fees.
IF assets are diverse enough, capital cheap enough- the best way to add value is to buy land and build. REITs are prevented from building. So externally or internal management teams create a separate company out of the prevail of shareholders and board. This company, like any private company can then build. The executives the same. Then the REIT “loans” the money for free or a low interest rate to have the separate company build them a building. The executives charge the REIT 10%* on the price of the finished asset to be the general contractor- even if they outsource that role and build it into the price of the property. The REIT, being bound to buy the finished property seem to never report cost overruns.
Another way to add value is wait. Over time property appreciates naturally, and inflation can also step up paper values. Combined with large size these REITs are naturally able to lower their cost of capital this way- because their LTV or Loan to Value improves over time when the market is up. Thus they can borrow more and leverage higher than their stated leverage. Banks are wise to this because of external valuation reports, but can satisfy their customer with a supplementary line of credit not always subject to strict debt covenants.
*IF you have to invest in REITs do your homework. Fess like the typical 10% management building fee REIT managers charge can be found in the “declaration of trust” found on sedar.com.
Source: Trebuchet Research
This material is contains information from publications prepared by the Trebuchet Capital Partners and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of June 2015 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by Trebuchet to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Trebuchet, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.