Monday, May 18, 2015

Evaluating REITs

Dividend Growth Stock Blog Hello, this is Div4son,



Over the last several weeks, I spent some time researching how to evaluate REITs (Real Estate Investment Trusts). I had previously skipped over REITs because I wasn't fully aware of the tax implication. After brushing up my tax skills for last year's tax season, I think REITs can add further diversification to my portfolio. 

This article summarizes my evaluation process for REITs.




I have recently used this evaluation method to review three REITs (WPC, HCP and OHI). After the review, I've decided to add HCP to my dividends portfolio.

The HCP analysis will be published in my next blog post. 


What are REITs?
A real estate investment trust (REIT), which can be publicly traded on stock exchanges is a company that owns and in many cases operates income-producing real estate. REITs own many types of commercial real estate, ranging from office and apartment buildings to warehouses, hospitals, shopping centers, hotels etc.

Analysis Consideration

Due to the nature of real estates the normal use of GAAP ratios is problematic. Real estate depreciation is not the same as depreciation from regular companies. For example, if we apply deprecation to the Empire State Building, it be be worthless, whereas we all know that it is not the case. 

We need to add back the depreciation to the net income after preferred dividends (and remove any gains from real estate sold) to get the funds from operations (FFO). 

So, for analysis of REITs, we cannot use the regular ratios. We need to adjust based on the FFO.

Example:
  • EPS becomes FFO per share
  • Payout Ratio will use FFO
  • ROE will use FFO
  • Debt per capital need to be adjusted, or use a lower percentage etc

How to screen REITs?

The purpose of the screen is to reduce the number of stocks for analysis. 

I like to use the CCC dividend list from David Fish to screen for dividend stocks. 

For REITs, the standard payout ratio is not too useful. Therefore, I simple screen is as follows:

  • Yield over Avg Yield > 1.10
  • Yield > 4% (but less than 7%
  • Chowder > 8%
  • Dividend growth > 5 years

The yield over 5 year average yield gives a quick indication if a REIT is well valued. This is the same criteria I use for regular stocks. 
The yield >4% is from the Single Best investment book to look for yields in the mid range. 
I've lowered Chowder for the screen, but for the next step I still maintain 12% as a criteria. 
The YoY dividend growth is the key in this simple screen. I want a REIT that is consistent and the dividends will show this. The resulting list is ranked based on the companies with the longest streak of dividend growth. 

I plan to limit on 3-4 companies for the next step. 

Criteria List for REITs evaluation


The framework for my criteria is similar to my stock selection which is foundation is based on the SBI book:

Good quality + high yield + high growth (+ time & patience)

There are some differences but overall, I am looking at high quality companies that offers high yield and growth.

I also want to make sure I buy at a reasonable valuation. Since we are dealing with imperfect information, and Mr. Market is unpredictable, I am just trying to limit the downside risk. It is likely that I will not find a perfectly valued company, but with time and patience, I should be okay.

AreaCriteria
Quality Company
Dividend Growth>10 years
Rising FFOFFO rising trend
Payout Ratio (FFO)<85%
Steady ROE (FFO)Steady FFO ROE
P/FFO<15
M* & S&P
Credit Rating
> BBB+
Debt to Capital (Bal Sheet)<50%
M* & S&P Stars> 3 Stars for both
Dividend Growth
& Yield
Dividend Yield>4% 
Dividend Growth>5%
Chowder>12%
Valuation
Yield/Avg Yield>1.1
Dividend Yield Theory Mid PointBelow Mid Point
DDRM~10%
M* Estimate<M* est
S&P Estimate< S&P cap IQ est


Dividend Growth

My criteria is >10 years (which is more than the screen). For REITs, I will put a higher emphasis on longer dividend payout and growth  than regular stocks. I want to be very conservative with REITs.

Rising FFO

This is based on the SBI book's recommendation to seek for both rising FFO and yield. In my mind, this is similar to rising income that I look for in regular stocks - except that we are simply adjusting for REITs.

Payout Ratio

For REITs, the Payout Ratio is based on the FFO. Once I calculate the FFO, I divide by the number of shares to get the FFO/share and I use this with the dividends to get the FFO payout ratio. The 85% threshold is based on the Ultimate Dividends Playbook recommendation. 

Steady ROE

Again, I use the FFO basis to calculate ROE. Again, this calculation is based on the Ultimate Dividends Playbook where the equity is adjusted with the depreciation. The adjusted equity is used with the FFO to get the FFO ROE ratio.

Here, I look for steady FFO ROE year over year. This is a real estate business, and I am looking for around 10% range. The more the better, but is probably unrealistic to sustain.

Price / FFO 

This recommendation is from the SBI book to  seek a moderate multiplier of FFO. The book suggests,
ten or eleven times current FFO being a reasonable price for an average REIT and twelve or thirteen times for a rapidly growing REIT. So, for my evaluation, anything under 15 would be reasonable.

Credit Rating

This criteria is based on the Utimate Dividend Playbook to avoid REITs with subpar credit ratings (lower than Standard & Poor ’ s BB grade). For me, I've reused the BBB+ rating requirement from my general stock analysis.

Debt to Capital

The ultimate dividend playbook suggests avoiding a REIT if its debt/capital ratio is more than 60 to 65 percent on a market value basis or more than 80 percent on an FFO basis. 
SBI recommends 30% (I assume this is FFO or market basis) which is very conservative. 

My view is anything under 50% is probably okay.

M* & S&P Stars
 
I am noticing that the Morningstar and S&P Capital IQ recommendation stars are a good indication on when to buy. I am looking at 3+ stars from both. The more stars the better the indication to buy. I will continue to use this for REITs.


Dividend Growth & Yield

In this section, I want to make sure that the REITs would give me adequate yield with growth. However, with high yields and if I reinvest the dividends, a lower growth rate may be acceptable if the underlying company is established.

Dividend Yields

REITs return most of their income back as dividends so I expect a higher yield. However, I don't want the yield to be too high since this is an indication of a troubled company. This is in line with SBI's recommendation to select REITs in the mid range.

In general, I am looking at yields at greater than 4-5% range, but generally lower than 7%.

Dividend Growth

The following the same approach as my regular stock picking at >5%. For established REITs with long dividends paying history, a lower growth may be acceptable for security of the dividends.

Chowder

I haven't established if Chowder of 12% is reasonable. For examples, 8% chowder is normally okay for utilities. For now, I maintained the 12% rule, but this is flexible until I find a suitable number for REITs.

Valuation

I've reused my valuation strategy from regular stock picking. The DDRM model is adjusted to use the FFO basis. 

5 years Average Yield

This idea came from The Part Time Investor with his KISS strategy for dividend stocks with his PAAY (Percent above average yield) scheme. This method gives me a mid term (5yrs) comparison of yield for valuation. 
My threshold is 10% above average yield which is the same as my regular stock picking. 

Dividend Yield Theory

The book from dividends don't lie describes the dividend yield theory. 

Please see my previous post for more information. 

Again, I am using this scheme to find a midpoint and low point for valuation. Note that this is a 10 year view and with the Great Recession, the yields are heavily skewed during the 2008-2010 years. I think with the 5 year average yield method above and the 10 year view from dividend yield theory, I can get a feel on the valuation based on the yield. 

For REITs, I am looking for anything below the midpoint which is the same strategy for my regular stock picking. 

DDRM - Dividend Drill return model

The DDRM is from the ultimate dividend play book. The difference with REITs is that the calculations are adjusted with FFO basis. 

There is also a 'fudge' Free Growth percentage per the book which I have also included as part of the calculation. 

I am okay with a return in the 10% range. 

M* and S&P Capital IQ estimates

I use these as sanity checks to make sure that the valuation are in line. 

I basically want current price to be below these reports fair value. 

Risks 

I will also look at risks associated with the REITs using seeking alpha, reports and other blogs. 

I want to understand if there are underlying issues outside of fundamentals. 

Conclusion

I think with these set of criteria, I can evaluate a REIT to determine if it is a quality company, and to have a good sense when to buy. 

A Word of Caution

I used the Ultimate Dividend Playbook a lot for the recommendations. However, the example the book used DDD showed excellent fundamentals and they still succumbed to the Great Recession when they cut their dividends. 

Therefore, I will make sure that my REIT selections are fully diversified and only a small portion of my overall portfolio. I will try to be conservative in my selection. 

That's all for now!

Div4son

Disclosure: Long HCP


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