This weekend, Jack Hough has written about REITs in the WSJ partly as a follow-up to his generally bullish piece last October. Now it seems residential multifamily landords are expensive, but industrial REITs may still be a bargain. Kudos to Hough; REITs have screamed higher since his October piece, and he’s written another good one about the need for REIT investors to be more discriminating. We, by contrast, have been (so far) incorrectly waiting for the publicy-traded property sector’s demise for a long time.
In the current piece, Hough uses NAV calculations to determine what’s expensive and what isn’t. He doesn’t quite spell out how NAV is calculated though, when he says it consists of analyst estimates of what underlying property portfolios are worth minus outstanding debt.
Well, of course a REIT, which is collection of properties, is worth the total value of the underlying individual properties minus outstanding debt. The question is how you come up with a valuation of the properties. A net asset valuation takes something called NOI (net operating income) that the properties produce, and applies a “cap rate,” which just means dividing NOI by a discount rate. Then you subtract the debt from that number to determine NAV. NOI is pretty straightforward (rental revenue minus basic expenses), but the cap rate isn’t. The fact is that cap rates are low, meaning investors are willing to accept low net operating income for the price they pay for properties or stocks of REITs at least partly because interest rates are generally low — which Hough mentions. But should you invest in something because it has a bigger yield than the roughly 1.5% the 10-year Treasury is giving you right now? Is that a margin of safety?
The equity market capitalization of Duke is currently $3.8 billion. If we apply a 6% cap rate to its most recent net operating income of $459 million we get a $7.6 billion valuation of the property. Then, when we subtract Duke’s debt of 3.85 billion, we come up with roughly the current market cap of $3.8 billion.
This means that investors are currently getting 6% of net operating income for owning the stock (or, effectively buying Duke’s properties or a part of Duke’s properties). That’s not unreasonable, especially if Duke were growing (alas, it’s not), but also not screamingly cheap. That NOI yield is also 4 times the yield of the 10-year US Treasury, but one has to believe that the 10-year US Treasury yield isn’t being manipulated by the Federal Reserve’s activities to have confidence in that spread.
Now let’s not try to guess what cap rate to slap on NOI; insead we’ll use funds from operations, a somewhat more stringent cash flow metric than NOI because it accounts for SG&A or the salaries that have to be paid to salespeople, etc….. Duke Realty has produced funds from operations (FFO) per share for the past four quarters of $.021, $.0.24, $.027. So its cash flow is declining. FFO isn’t a perfect cash flow metric because it doesn’t account for some depreciation that falls on the landlord, but it’s a decent metric.
So Duke has produced $1.01 of FFO per share for the past four quarters. At a recent price of around $14/share, investors are paying 14 times FFO. That’s not the 30 times FFO that multifamily REITs are trading hands for, but it’s not screamingly cheap either, especially for a REIT whose cash flow has been declining.
Finally, if FFO stays at around $0.21 per quarter, funding the $0.17 quarterly dividend (around a 4.7% annual yield based on the current stock price) will be fairly tight.
We’re not saying Duke is a short, but it’s not a long either by our judgment. The bullish REIT thesis depends on Treasury yields hugging the ground for a long time, as Hough mentions. That may be exactly what transpires, but we don’t want to have to count on that when we make a bet. A jump in rates without any meaningful growth or inflation will crush REITs, including Duke.