Real Estate Investment Trusts (REITs)
Value investing is defined as a systematic process of buying high quality stock at an undervalued market price quantified by intrinsic value and justified via financial analysis; then selling the stock in a timely manner upon market price recovery.
Real Estate Investment Trusts (REITs) are considered excellent long-term investments. There are two underlying reasons. First, under the Internal Revenue Code, they are considered income tax free investments. To comply, the REIT must distribute at least 90% of all net income earned to shareholders. The shareholders pay income tax on those dividends received. Because of the dividend distribution requirement, REITs have excellent dividend yields. This is why REITs are considered perfect investments for widow and orphan funds whereby cash is necessary to fund the monthly payments to annuitants.
Secondly, similar to any real estate investment, time is beneficial to the overall value of the REIT’s fixed assets. No differently than owning a home, time allows the underlying asset to increase in value. Thus, the normal pattern for a REIT’s market price should be a slow and continuously positive increase over time. Long-term resale of the stock should provide capital gains for the investor. Putting the two financial benefits together creates an excellent long-term return on one’s investment in the stock.
With value investing, the concept is to own quality stocks at good prices. This matches the primary concept of business – ‘Buy Low, Sell High’. When the price returns to normal, proceed to sell the stock and continue the pattern. The long-term outcome is significantly greater returns than many of the common market indicators (DOW Jones Industrial Average, S&P 500, Russell 2000, etc.).
REIT’s are generally high-quality investments. Their financial statements are moderately difficult to read due to two uncommon financial measurement indicators of 1) funds from operations (FFO) and 2) normalized funds from operations. However, with an understanding of basic accounting reporting information and how FFO is quantified, a reader of REIT financial reports can quickly ascertain overall performance of the entity.
Analyzing and evaluating REITs is similar to owning residential property as a landlord. However, the scale is exponentially greater; practically eliminating variances. In effect, there is improved predictability and reliance on the information provided. Intrinsic value is tied to market value of the respective apartment complexes. There are several articles within this section explaining and illustrating how to determine and apply fair market values for apartment complexes.
With REITs, investors look for three key financial indicators of performance. First, is the dividend yield percentage. This matches the landlord’s desire for cash flow from their investment in real estate. Secondly, holders of rental property desire positive net income in order to assure adequate proceeds to make the principal payments on any mortgages associated with the property. Finally, landlords want to ensure that their rents charged mirror the economic conditions of the property’s location. With publicly traded REITs, this is evaluated with the fixed assets turnover ratio.
Earning a good return on a REIT investment requires a long-term view. Rarely do REIT investments recover quickly; it takes several quarters to reaffirm to shareholders the company’s performance. Thus, there is a longer outlook required with this type of investment. Adherence to the fourth principle of value investing, patience, is definitely required.
Within this section of the Value Investment Fund, you must be a member of the Value Investment Club to access the articles, spreadsheets, resources and respective buy/sell model.
Real Estate Investment Trusts are corporations, trusts or associations that act as agencies in real estate and associated mortgages. This is a specialized tax segment and it requires recognition by the Internal Revenue Service to operate as a Real Estate Investment Trust (REIT). In general, the REIT pays little to no income taxes and acts very similar to a pass-through entity for tax purposes. All REITs must comply with Code Section 856 which addresses compliance for this privileged tax advantage. Typically, REITs file Form 1120-REIT for tax purposes.
A secondary advantage for REIT status is the ability to raise capital via syndication. Section 856(a) and (b) require a minimum of 100 shareholders or owners of interest in the business entity. This allows for a more advantageous management situation by having a more formal elected board of trustees or directors. In addition, it allows for greater ease of transfer of ownership with the respective investors.
To fully appreciate the Real Estate Investment Trust, you should become acquainted with the history behind REITs. From there, there are unique advantages associated with REITs and an investment in one. As with all business situations, there are some disadvantages and you should be aware of them. The following sections cover these three topics and I’ll finish off with my own conclusion.
Real estate syndication is how apartment or office complexes are financed? A typical complex will have 80 to 100 units and the cost of construction will approximate $7,000,000. Where does this money come from? Your average person will think it is financed by a mortgage of some sort. Well, this is partially true, but mortgage companies will not finance 100% of the cost of construction. More like 75% maximum financing is used in constructing complexes. The balance has to come from private money.
This is where the value of real estate syndication comes into play. The arrangement is usually a two tier relationship whereby an operating partnership is created that actually owns and operates the asset (the complex). The second tier is a silent partner in the operating partnership. The following sections explain these two tiers in more detail.
This post is to record the value investing fund's purchase of 192.12296 shares of Equity Residential, a real estate investment trust (REIT) for the value investment portfolio.
A second purchased made at close of business yesterday is 48.9644 shares of Essex Property Trust, another REIT investment. The total cost per share including transaction fees is $204.23 per share (closing price is $203.23).
When selling PUTs in the market, value investors cover their position by purchasing a similar position in an existing low price to book stock. In effect, the position acts as a bank account in case the PUTs are activated, thus the existing stock is sold and the proceeds are used to cover the PUTs financial obligation.
At close of business today, 10/26/2020, the REIT pool of the value investment fund purchased 606.9803 shares of UDR, Inc., United Dominion Realty Trust, at $32.95/Each including transaction fees of $1 per share.
Real Estate Investment Trusts (REITs) are considered excellent long-term investments. There are two underlying reasons. First, under the Internal Revenue Code, they are considered income tax free investments.
Intrinsic value of stock is a company's realistic value per share at any given moment. Intrinsic value is not book value; it is the most likely dollar amount a reasonable person would pay for the underlying net assets. In most cases, an investor would include some value for the near-term future earnings of the investment; but the core amount in determining the intrinsic value of a share of stock is tied to the net assets at fair market value.
The intrinsic value formula is different for every sector of the economy and for the respective industries within that sector. Equity based real estate investment trusts (REITs) consist of six different types. One of the types of REITs are apartment complex based operations. In effect, they are apartment rentals. With real estate, specifically those in the home rental industry which includes apartments, condos, townhomes and traditional individual homes, intrinsic value is strongly tied to the fair market value of the rental properties less the assigned associated debt (mortgage). In addition, some value is included for future near-term earnings and the other assets on the balance sheet. It is really no different than how your traditional home rental operation would value their investment.
With Essex Property Trust, this REIT has been around for almost 30 years. It owns 246 apartment complexes with 60,272 units. There are an additional 1,853 units under construction. To determine intrinsic value, one would simply appraise all 246 complexes, determine the full fair market value and then deduct the total debt to get net assets value. Add to this value, the other assets on the books, get a full net assets value at fair market value. In addition, you would simply add about three years of profits. With this cumulative sum, divide by the number of shares and determine an approximate intrinsic value per share.
This appears relatively simple. For Essex, assume each unit can be sold for $350,000; seems like a reasonable value per unit. Total fair market value would approximate $21.1 Billion. The other assets on the books are equal to around $900 Million, thus total assets at fair market value would approximate $22 Billion. Total debt and current liabilities on the books are approximately $7.2 Billion. Once the liabilities are satisfied upon the sale of the units, the net remaining amount available to all shareholders results in $14.8 Billion. There are 67.5 Million shares outstanding. Thus, each share has a net worth of about $219 tied to net assets value at fair market value.
Currently, the company's net operating income is just a little over $8 per share. Using three years of net income, the investor would add about $24 to the net assets value outcome to get total intrinsic value. Three years of net income is used as this would be a reasonable and normal time period to dispose of all the complexes, i.e. it would be the time period to negotiate an arm's length transaction (fair and normal). Thus, Essex Property Trust's intrinsic value is approximately $243 per share.
Of course, there is more to it than this simple approach. But the core idea is there; the intrinsic value should be in the neighborhood of $243 per share. As a value investor, you should anticipate that the intrinsic value isn't going to deviate greatly from this simple quick calculation. In effect, a value investor would expect the actual outcome to end up within 20% of this quick calculation. Thus, the final intrinsic value should end up in between $195 per share (20% less) and $292 per share (20% more). From Lesson 7, there is no definitive intrinsic value calculation for any stock. Intrinsic value has a range; the key for value investors is to narrow this range as much as possible in order to determine a reasonable intrinsic value for any potential stock investment. Ideally, getting the range down to plus or minus 3% is the goal. In effect, the final intrinsic value calculation is somewhere between the two given outcomes and the value investor's goal is to have a high level of confidence with the final outcome.
What is important here is that if you end up with a really conservative outcome (tending towards $195/share), it is likely the market price will never dip this low (the last time was in November 2014) thus eliminating opportunities for the value investor. If the end result is too high (tending towards $292/share), you end up with more opportunities but the end result with the investment is less gains from the respective buy/sell turnovers and therefore the overall return for a value investor decreases. In effect, it defeats the purpose of value investing which is to buy low and sell high. Thus, it is extremely important to walk through the exercise of calculating a reasonable intrinsic value that results in reduced risk and adequate opportunities to make buy and sell transactions assuring an excellent return for the portfolio, i.e. the pool of similar investments.
Given this, how do you determine a REIT's intrinsic value to plus or minus 3%?
Today, the Value Investment Fund purchased a second tranche of Essex Property Trust. After calculating the intrinsic value of Essex Property Trust at $256, the REITs Pool allocated $10,000 for a second purchase of Essex once the price dipped below $230 per share.
On June 18, 2021 at 2:56 PM, Essex Property Trust share price dropped to $304 per share triggering a stop-loss order purchased a month earlier.
