Investors are divided into two camps.
There’s camp A, we’ll call TEAM STRIKE FORCE. These investors look to buy stocks that are either undervalued or that have good growth prospects (at a reasonable price). They like getting paid a dividend to wait for their investment to recover/grow, but it’s not necessary. Depending on the situation, a dividend could get in the way of the company’s plans, like paying off debt or investing in new infrastructure to help grow sales.
Then there’s camp B, which we’ll call TEAM DISCOVERY CHANNEL. These investors care about getting paid, getting paid, and, oh yeah, getting paid. Any investment without a growing dividend stream is relegated to a pit of dirty diapers, which apparently they have around for some reason. These investors are left choosing between about 90 different stocks, which are mostly dominated by the largest of the large blue chips. When asked, these investors will often say things like it’s only the income stream that matters, and they don’t really much care at all about the principal. It exists just to create income.
I was researching REITs the other day (specifically Dream Office REIT, which I’ve talked about a couple of times before). And I got to thinking about REIT accounting, because I am a boring individual.
You all probably know that REITs are designed to pay very little in taxes. They pay out more than 90% of the money they make to investors in exchange for hardly paying a dime in tax. That income is then taxed in the hands of investors.
When it comes to investors paying tax on the income, it’s not as simple as just a straight dividend. The distribution might be made up of things like other taxable income, capital gains, and reduction on adjusted cost base.
Let’s take a look at Dream’s 2013 tax form from its website as an example.
Because so much of the company’s distribution is return of capital and capital gains, you’re looking at a pretty attractive tax bill. 53.7% of the distributions aren’t taxable at all, and just about half of the rest are taxed as capital gains.
Don’t sweat knowing too much about this, or worrying about this come tax time. You’ll get a slip from your broker that separates out the actual amounts of cash for you. All you’ll need to do is copy the numbers to your tax form, and actually mail that puppy in.
The other thing you need to know about REIT accounting is why you can’t use net income as a method for valuing REITs.
Most businesses don’t bother revaluing assets on the balance sheet on a regular basis. If a business bought a building for $1 million back in 1952, there’s little incentive for listing that building on the balance sheet for the current value. For that to happen, a business needs to book that as earnings at some point, and the business would have to pay income tax on those earnings. It’s dumb to trigger a taxable event for no reason, so they don’t bother.
(This is one of the reasons why companies will often trade at a huge discount to the value of real estate on their balance sheet, like Hudson’s Bay Co. which has been around a million, billion years. Companies lately have been trying to monetize these assets by packaging them up as REITs and reissuing them back to the market. Aside over.)
Since REITs don’t pay tax, they don’t have this problem. Using Dream as an example again, let’s take a look at its “net income.”
As you can see, Dream’s net income got pretty close to surpassing its revenue back in 2010 and 2011.
Because it doesn’t have to worry about paying tax on the gains of its property, the company is constantly looking at the value of its portfolio. If it can book a gain, it will. Why? Because it can then distribute that “gain” back to shareholders as a capital gain. Everyone has a low tax bill this way, and presumably everyone is happy enough to not TYPE IN ALL CAPS.
This is also why REIT investors use a value called funds from operations to determine the stability of the payout. Essentially, FFO is just operating income less interest.
Continuing to talk about Dream, let’s take a little closer look at its valuation. Valuing REITs is pretty easy. Since the company continually readjusts the value of its properties, we can assume that the value on the balance sheet is pretty accurate. There’s not a lot of other stuff going on, so it’s essentially an easy equation.
Value of properties+minimal assets-mortgages-minimal liabilities=book value
I’ll save you the work, and tell you that Dream has a book value of $35.72 per share with a loan-to-value ratio of its properties and mortgages in the neighborhood of 50%. Meanwhile, the stock trades at $27.54. That’s a discount to book of nearly 30%.
There are a couple reasons for that. Toronto, which is one of Dream’s biggest markets, is awash in office space right now. Projections are that vacancy rates will jump somewhere into the 8% range by 2018 or so. Dream, meanwhile, is struggling a bit, with vacancy rates approaching 5%. It still makes enough to cover the distribution, but the market is skeptical, hence the company’s overly generous 8.13% dividend yield.
I’m also pretty sure that there are Canadian real estate bubble fears entering the picture here too. Most REITs don’t trade for such a discount to assets. Most don’t trade for a huge premium to assets either, which is pretty much what you’d expect.
Philosophy stuff kinda
Let’s talk about why companies trade at either a discount or premium to book value.
A company might trade at a premium to book value because:
- Book value is old, and the value has gone up (like with real estate)
- The assets are able to generate a dependable return of, say, 20%, which make them worth more than cost
- A company’s competitive advantages make it worth more than just the sum of its parts
- Investors excited about a company’s ability to generate income or potentially grow bid it up to an elevated level
You see this all the time. A company like McDonald’s or Coca-Cola isn’t worth the sum of its parts. They’re worth far more, because of all sorts of factors. Consequently, these companies have very little in terms of book value. They’re not priced that way, they’re priced on the income they can generate on those assets, which is also known as earnings.
Companies might trade at a discount to book value because:
- The company is struggling to earn money
- The market thinks the assets are overstated
- The company is out of favor with investors, even though it continues to be profitable
- The company is so small and unfollowed that there’s little demand for the shares, causing it to trade at a huge discount
You see this less often, especially when the market is doing well. Since these companies struggle to earn income, they’re priced on the value of their assets. Especially when there’s debt involved, they’ll sometimes trade at a huge discount to the value of those assets. The company will continue to get punished until income is reliable enough to value it on that, or it goes bankrupt, whichever comes fist.
Back to REITs
This all got me to thinking.
As a real estate investor, I’m interested in two things:
- The value of my property
- The value of the cash flow coming from that property
REIT investors should be worried about the same things, I’m assuming.
We’ve already established Dream Office REIT’s value above. It trades at a discount to book because the market is nervous about the future of its biggest market. Instead, let’s take a look at a favorite holding of U.S. REIT investors, Realty Income.
I have to give Realty Income all the props in the world. These guys know who butters their toast, and they cater to that group almost exclusively.
That group, of course, is dividend growth investors. Realty Income does its part by expanding and giving the DGI crowd regular dividend increases from its relentless expansion and any slow rent increases because of inflation. The DGI crowd repays the company by continuing to give it positive press. Everyone is happy.
Because of the benefit dividend growth investors see from the company, shares have been bid up pretty high. The company pays just a 5.34% yield, and it trades at a 56% premium to book value.
Realty Income compares pretty favorably to Canada’s largest REIT, RioCan. Both primarily own retail space. RioCan has a yield of 5.5%, albeit without the stellar dividend growth. Still, RioCan did raise its dividend this year.
The difference? RioCan trades at a premium of just 4.5% of its book value.
It’s not just a Canada/U.S. difference either. American Realty Capital Properties is one of Realty Income’s largest competitors. In fact, it has a little bigger market cap. It trades at a discount of approximately 10% compared to its book value, and offers investors a yield of 8.46%.
There are a million more examples. Finding REITs in the U.S. that pay 7-8% dividends is as easy finding NFL football on a TV on Sunday.
Why does Realty Income command such a premium to book value? Because investors are overvaluing its consistent rising dividend stream.
Over the past 5 years, Realty Income’s dividend has rose 5.6% a year. Most REITs can’t do that, because they’re generally a little more stable. They don’t care about rising dividends.
The big risk with Realty Income is what happens if the dividend increases stop. Based on just about every other REIT in North America, I’d say it would crash down to pretty close to book value.
There lies the risk of paying a premium for ever increasing income. By doing so, investors are turning a company that should be valued at close to the value of its assets (because, let’s face it, there’s no special sauce when it comes to buying retail space), and valuing it because of its rising income stream. Eventually, the growth will stop, and you’ll be left holding the bag of a company that’s valued more than 50% more than the value of its properties.
That’s bad. And that’s why you should never pay a huge premium to book value to own a REIT. Even one with a rising income stream. If you want a rising income stream so badly, use the REIT’s dividend reinvestment plan to keep buying more units. More units = more income, assuming all else stays the same. You’ll get a lot of the same benefits, with not nearly the same amount of risk.