REITs: Value idea?

I always like to sift trough sub indices of the market and see what are the poorest performing and under stress sectors and sift through them to see if any value ideas can be generated. I was going through the TSX sub groups and I can find two sub indices that performed badly: REITs and Energy Trusts. I will focus this post on REITs and I will tackle energy Trusts some other time.

Real estate businesses in general have performed badly this year. REITs in particular have been hammered this year for several reasons among them credit crises, expectation of economic slowdown, rising interest rates and rising defaults in the US housing markets.

The Canadian REITs space is no exception. Real Estate is one of the poorest performing indexes in the TSX composite index, see figure. Canadian REITs have returned -15% for 2007. However, Real Estate is very local and diverse in its categories that a recession in US housing might not mean a any thing for retail real estate for example. I believe you can find value in some areas of real estate that can do well while the US housing markets corrects itself. Even in the US housing market, there are areas that doing quite well right now. Take a look at North Carolina, Seattle, and Texas home price appreciation this year in the midst of housing slow down; it is impressive.

I would like to look at the retail REITs in Canada for several reasons:

• Canadian Economy and housing market are not experiencing the same woes of the US. Canada did not experience the high level of speculation in houses and more importantly lending practices are conservative and more traditional. there is no subprime here.
• retail locations are getting dearer in high growth urban markets. therefore established retail centres have competitive advantage by virtue of its irreplaceable locations.
• retail space owners have a competitive advantages over other types of real estate, that I will go through later in the post.
• the Canadian retail development did not go through a building boom like in the office and apartment sectors.
• National retailers including Wal-Mart have big appetite for large chunks of properties, Lowes is entering the Canadian market as well, so demand for retail stores remain strong across Canada. Retail transactions volume and price have appreciated steadily in last few years based on CB Richard Ellis statistics. However, if the economy slows down this demand will be curtailed and real estate prices will slow.

A listing of Canadian retail reits can be found here. A sift through that list and screening through the assembled metrics I have chosen to analyse RioCan Reit. RioCan is one of the oldest reits in Canada and therefore it has accumulated better and cheaper properties than its rivals. In addition, it is the biggest, more conservatively financed, has better cash yield and lower payout ratios.

RioCan Real Estate Investment Trust (RioCan) (Google Finance):

... is a Canada-based, closed-end estate investment trust (REIT) trust. At December 31, 2006, the Company had ownership interests in a portfolio of 196 shopping centers. RioCan’s income properties are comprised of two components: long-lived income properties, including leasing costs and intangible assets, and properties held for resale, including properties acquired or developed directly and indirectly with partners.

Competitive Advantages

• RioCan is one of the oldest reits in Canada. It began purchasing properties in the later half of the 1990s. No other public reits began operation until the early 2000, s that gives RioCan a leg on competition. It allowed RioCan to buy primer locations at lower prices.
• Retail Reits in general have a competitive advantage in its ability to lock tenants into long leases, therefore securing steady cash inflow over longer periods of time compared to, for example, apartment or storage reits. RioCan, in particular, has, in addition to 97.6% occupancy rate, long term leases with tenants as more than 60% of its leases expire after 2012.
• Moving out of an apartment can be a hassle, can you imagine moving a retail store. Retailers have invested heavily into their locations from advertising and logistics infrastructure, so moving a retail outlet is no easy task. This is one of the most important advantage of retail real estate owners is the high switching costs tenants can incur compared to rent increases.
• RioCan have a financial scale and debt capacity that is larger than its peers. It is conservatively leveraged and has adequate size to take advantage of large opportunities and to withstand market deterioration.
• RioCan properties are located in high population growth areas mainly: Toronto, Ottawa, Montreal, Calgary, Edmonton and Vancouver. There is a strong migration trend toward urban centres around the world and Canada is no exception. RioCan's properties will benefit greatly from that.
• Stable large chain retailers occupy the majority of RioCan locations. RioCan generate 50% of it revenues form these retailers. So credit risk of tenants is small.
  

Financial Quality

Metric	RioCan	Comment
FFO/LTD Debt	9.74%	FFO (Funds From Operations) is a measure that adds back depreciation and gains from property sales to come to a figure that represents cash flow generation. RioCan has above than its peers average coverage of 7.91% and its closest competitor CWT.UN of 6.47%. However the level of coverage is low compared to a globally accepted coverage of 15%.
Ltd Debt/ Market Cap	69.9%	Another measure for debt quality shows the company is conservatively financed less than the average reit at 108%
Ltd Debt/ Ent. Value	41.8%	group average is 51.5%. under 50% is positive and acceptable sign for investment grade reits.
FFO/ mortgage pmts(interest+ principal)	1.15x	The figure is adequate but not high enough to provide me with extreme comfort level. I would liked to see at least 2x mortgage payments.
FFO Growth/ Distribution Growth	5.46%/ 3.82%	over the last 10 years FFO and dividends growth have averaged 5.46% and 3.82% respectively, which is a good growth rate over 10 years. The long period assures me that it has covered several real estate cycles and at least one economic rescission.
Cap rate	8.97%	Current cap rate (NOI/ property book value) for the the entire portfolio is on the high range of market rates. CB Richard Ellis market survey of Ontario cap rate is 5.75-7.25% in late 2006, while management estimate market cap rates to be 5.5-6%. Although cap rates have been coming down as indication of higher real estate prices, RioCan should not be affected as it did not do any major acquisitions in 2007. This is a testament to management capability to wait for value; a quality I admire.

The only concern from the analysis above is RioCan's coverage of payment obligations. I stress test the RioCan's coverage of its obligations by assuming expiring leases would not renew and a decline in the rental revenues for the reits as a result. The following table plots total obligations by year as well as lease expiry percentage. I assume no renewal to calculate how much income will the reit generate and if it is enough to meet its obligations. The result is enough coverage in this extreme scenario.

Mortgage pmts		$ 36,492.	$ 270,750.	$ 267,591.	$ 286,129.	$ 108,809
Debenture	pmts		$ 110,000.	$ 110,000.	$ 100,000.	$ 200,000
Total pmts		$ 36,492.	$ 380,750.	$ 377,591.	$ 386,129.	$ 308,809.
Lease expiry		1.40%	6.90%	10.30%	10.40%	11.80%
Rental revenue	$644,383.	$ 9,021.36	$ 44,462.43	$ 66,371.45	$ 67,015.83	$ 76,037.19
No renewal revenue		$ 635,361.	$ 590,899.	$ 524,527.	$ 457,511.	$ 381,474.
Coverage times		17.41	1.55	1.39	1.18	1.24

Overall RioCan has on better than average leverage but not so spectacular debt service coverage. Its FFO quality is excellent with steady growth rates and good cap rate compared to current market conditions.

Management Quality
The lack of transactions in 2007 and for the major part of 2006 indicates RioCan's management capability and quality. Reits should be patient enough to take advantage of miss pricing and low prices opportunities, which were not available in 2007 and 2006, so RioCan management did nothing. While capitalization rates were coming down, indicating higher prices, management stayed on the side lines. Making low cap rate transaction is a sure way to destroy value. If a reit cost of capital is around 6-7% and they make a transaction with cap rate of 5-6%, then there is no value added by management to its shareholders. As discussed above RioCan overall cap rate is about 8.9% and their cost of debt is 6.1% and management is cognitive that creating value in the long run is more important than focusing on deals and short term growth in earnings.

The Reit's ROIC (FFO return on invested capital) is higher than group; it stands at 7% while the group average is 4.89%. ROIC have shown a steady trend over the last few years indicating the quality of management decisions for investing prudently rather than doing deals for the sake of doing deals.

Management, other than directors, owns 643,625 units of the trust; an approximate ownership of .31%. On a diluted basis management owns 2.14% of the trust accounting for their options. You want reit's management to own a little bit more than that to ensure that their actions are aligned with shareholders interest. Although 2.14% is not a small ownership given RioCan size, I would have been more comfortable with an insider ownership position of 5%.

Insiders have been net sellers over 2007 to the tune of $20 million, in fact in dollar amount RioCan management tops all Canadian insiders in share sales. Not an encouraging sign, which can be an indication of continues price pressure on the units. The mere selling can be attributed to several reasons other than RioCan's financials but there were only two buys throughout the year for only $156,000. Not a ringing endorsement of what management sees in the future for the trust.

Valuation

The most critical piece question is does the valuation make sense. I will be using several measures to value RioCan. I will use comparative valuation multiples both to the industry and to RioCan historical averages. In addition I will use a discounted cash measures and asset valuation measures. These host of measures have advantages and disadvantages, but combining them can give me a good yardstick for the true intrinsic value of RioCan.

Metric	RioCan	Notes
Dividend Yield	6.2%	dividend yield is comparable to the group average, although you can get higher yields in this space it will be of lesser quality. The yield itself is not a good valuation tool even if it is high compared to others as it can be distorted. The good aspect of RioCan dividend yield is its payout of about 90%. The payout ratio is considered good for a reit as long as it does not exceed 100% on a long term basis. RioCan in its 10 year history exceeded the 91% level only once in 1998 its first year of operations.
FFO Yield	6.81%	The FFO yield is an alternative to earnings yield and it is the inverse P/FFO. It indicates that RioCan has a slight premium over the group average of 7.6%.
Entp Value/ FFO	24.5x	RioCan sells at a discount to the Canadian group average of 29.6x.
Div yield spread over 10 yr Bill	2.42%	The spread of dividend yield to 10 yr Bill give me an indication of risk premium as as valuation if compared to hostorical figures. RioCan current spread is lower than its 10 yr average of 3.3%. However the spread has widened over the last three years indicating favourable valuation for RioCan. see figure below. The company is rated BBB by S&P. So a comparison to similarly rated corporate debt yields a spread to 10 Yr TB of 1.7%, so a spread of 2.42% for a reit of the quality of RioCan is more than adequate.
FFO yield spread over 10yr Bill	3.02%	A similar situation in FFO yield spread over 10 yr Canadian bond. RioCan valuation is getting cheaper but not as cheap as its long term averages. by way of comparison CWT.UN has a dividend yield spread of 2.54% and FFO yield spread of 3.67%. Indicating a slight premium for RioCan, which I think stems from a better leverage and capital structure. Both RioCan and CWT.UN follow a similar trend in valuation indicating the retail space is getting cheaper from last 3 years.
Price/ NAV	.92	I have conducted a rough estimate of RioCan's properties market value to compare it to book value on their financials. I have done this by applying per sqr ft price of recent retail outlet transactions in similar geographic regions to RioCan's properties. RioCan has acquired 51% of its portfolio between 1996 and 2000, so a significant appreciation has occurred since purchase. RioCan's properties book value is $4.38 Billion, while my calculation has given me a value of $7.5 Billion. The price to net asset value (estimated market value before depreciation less total debt) of RioCan is .92 indicating that the current market price trade at a slight discount to the true breakup value of the reit. This would be my liquidation value safety net, if the company to go bankrupt tomorrow, I know that I will roughly get what I invested.
Discounted AFFO Value	$22.09	Reits should not be valued on breakup value alone, however they should be judged on their cash flow generation. I have assumed no growth in RioCan's cash flows (FFO less maintenance capital), a proxy for free cash flow, and I choose to calculate it on a perpetual basis using their cost of capital of 6.79%. The figure is a slight premium to the market price of $20.5.

Based on several measures RioCan appear to be trading less than its intrinsic value ever so slightly. Currently market price is equal to a non growth stream of cash flows and I am given more than adequate protection of breakup value. The dividend yield gives me an adequate spread over comparable bond and yields have gotten cheaper historically.

Although the units are selling at a discount, it can sell at a bigger discount going further. Experts are calling for 50% chance of a rescission in the US and Canada will not be far behind. In that case reits prices will come under pressure, however their intrinsic value will expand as reits like RioCan will be able to buy new properties with higher cap rates. More deals at favourable cap rates will lead to higher cash flow or FFO growth than organic growth.

Investment Conclusion

Although valuation measures are positive and management did a great job creating value, I will take my time to accumulate a position. Given a slowing economic situation and 2 year trend of reits valuation decline, retail reits will come down in price further creating better margin of safety and dividend yield. However, I will be buy at will at a price of $19.5 and under.

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Sources: Google Finance, Yahoo Finance, RioCan reports, Globe and Mail, CB Richard Ellis, Ink insider Research, Bank of Canada