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Here's the math on why REITs have been
hit so hard
If you own real estate stocks, you might be a little perplexed by what's
happening to your investments. The S&P/TSX real estate index is down
about 25 per cent in the past year. Sure the credit market has rolled over,
but rents are stable, so how can buildings' values fall by that much? The
answer is that it's all in the delicate math.
To illustrate, we turn to a research note from National Bank Financial's
man on real estate, Michael Smith. The name of the report says it all:
Higher Spreads, Lower Property Values: The Simple Math.
Part of what makes it interesting is that the analyst used a real example
- the sale of a building before the credit crunch hit - and recast the
transaction using today's economic realities.
Before we get to the example, we have to define a couple of concepts.
Real estate investors often use internal rates of return to decide what to
pay for a property. There's a technical definition but think of it as the
minimum return the investor will accept for laying out cash on a building.
The cap, or capitalization rate, is sort of like a price-to-earnings
multiple in reverse. The lower the cap rate, the higher the price. Loan to
value is the amount of debt as a percentage of the price paid for a
property.
Back to the example. The building in
question was bought by a REIT in mid-2007 for $10-million. The cap rate used
to value the property was 7.8 per cent, the loan was 65 per cent of value
and bore interest at 5.6 per cent.
Today, the analyst figures that although
government bond yields, oftentimes the benchmark for other loan rates, have
fallen a lot, the borrowing costs would be higher (and so, therefore, would
the spread between the two rates - a sign that lenders are more cautious).
Another assumption, which makes sense, is that the loan would be smaller
relative to the sale price (see Table 1).
Size up the changes before and after and
they don't look too spectacular, do they? But they are. Table 2 shows the
effect of these changes in more detail.
The first thing you'll notice is that
interest payments are actually lower. The rate is higher, but remember that
the loan is smaller. The investor had to put in more of his own money.
If you're baffled as to how lower
expenses - more free cash flow - can lower the value, keep in mind that
investors judge property (all investments, in fact) based not on how much
cash they get back but on how much they get compared to what they put in. So
while the numerator - cash flow after interest - is higher, the denominator
- the equity invested - is also higher, and as the arithmetic would have it,
the return is lower.
The cash yield using first-year numbers
works out to be 1.7 percentage points lower. But remember that many real
estate buyers look for internal rates of return, and here's where it gets
interesting. If you assume that investors want to earn the same return after
the credit crunch as they did before - about 15.5 per cent - then the value
of the property has to drop about 6.5 per cent so that the equity invested
can come down, too.
But debt at the REIT level - that is,
debt above and beyond mortgages tied to specific buildings - compounds the
effect of this math. Assuming 50 per cent, the REIT average, then the
property's value has to fall by about twice as much, or 13 per cent.
And if you want to assume that higher
risks - from an economic slowdown, for example - are pushing investors to
demand even higher returns, then the property value falls even more. If the
desired internal rate of return is 115 basis points higher - about the same
as the lender's - then the property has to fall about 10 per cent, meaning a
20-per-cent drop in a typical REIT.
And finally, if you assume that real
estate investors are demanding two times the increase that lenders are, or
230 points, then the property value falls by 12.7 per cent, and the average
REIT by about 25 per cent.
As always, there are assumptions behind
this analysis, but they seem perfectly reasonable.
So if you want to know why real estate
stocks are down so much, take a few small numbers and start multiplying.
You'll have your answer in no time.
- 2008 March 7 GLOBE
& MAIL
| Real
estate analysis |
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Then |
Now |
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| Loan to value |
65% |
55% |
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| 10-year gov't |
4.5% |
3.6% |
|
| bond yield |
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|
|
| Loan cost |
5.6% |
5.87% |
|
| Spread |
1.10% |
2.25% |
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| Debt |
$6.5-million |
$5.5-million |
|
| Equity |
$3.5-million |
$4.5-million |
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| S&P/TSX real estate index |
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| INDEX, DAILY CLOSE |
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|
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| Yesterday's close 182.32, down 2.89 |
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| Valuation analysis |
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Then |
Now |
To
get same IRR |
| First year net operating income |
$780,000 |
$780,000 |
$780,000 |
| Net operating income growth |
2.5% |
2.5% |
2.5% |
| Interest |
$364,000 |
$323,000 |
$301,000 |
| Equity income |
$416,000 |
$457,000 |
$479,000 |
| Equity invested |
$3,500,000 |
$4,500,000 |
$4,201,200 |
| Building cost |
$10,000,000 |
$10,000,000 |
$9,336,000 |
| Year 1 cash yield |
11.9% |
10.2% |
11.4% |
| Internal rate of return |
15.5% |
13.1% |
15.5% |
SOURCE: THOMSON DATASTREAM, NATIONAL BANK
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