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REITs, depreciation and FFO.

Sunday, November 7, 2010

The REIT business model is simple. REITs own real estate and they collect rent. For an investor to determine the investment potential of a REIT, one factor he would need to consider is earnings.

Asset value diminishes over time. Real estate is however a special class of assets because land and buildings are not like machines. Their values do not necessarily decline over time but tend to rise or fall depending on market conditions even if they are leasehold properties.

The concept of 'Funds From Operations' (FFO) gets around this problem. FFO excludes historical depreciation costs from net income. FFO has become the industry standard for measuring a REIT's operating performance.

Source: UOB Asset Management.

FFO is calculated by adding depreciation and amortization expenses to earnings, and sometimes quoted on a per share basis. The FFO-per-share ratio should be used in lieu of EPS when evaluating REITs and other similar investment trusts.

Source: Investopedia.

Related post:
Replies from AK71: REITs and their assets.

13 comments:

Drizzt said...

something similar to operating cashflow perhaps sans tax and working capital.

i got a pretty good explanation here >> Net Profit, EBITDA, Operating Cashflow and Free Cashflow in Dividend Investing

Drizzt
Investment Moats.com

AK71 said...

Hi Drizzt,

Yup, FFO is a measure of cash flow. Very similar.

Thanks for sharing the link. :-)

Anonymous said...

"Asset value diminishes over time. Real estate is however a special class of assets because land and buildings are not like machines. Their values do not necessarily decline over time but tend to rise or fall depending on market conditions even if they are leasehold properties. "

I disagree here - leasehold properties will see its fair value hit rock-bottom when the lease is up.

Nick

Anonymous said...

Hi ak, been reading yr blog for some time. I find some of the posts written by u and yr fellow financial bloggers enlightening and meaningful especially those that pertain to life in general. Maybe I'm around the same group as u guys so probably could relate to what u guys experiencing. Keep up the blogging.

James

AK71 said...

Hi Nick,

I agree that a piece of leasehold real estate will see its value go to zero when its lease is up.

However, barring this, real estate value is really a function of market forces. We only have to look at some of the "ridiculous" prices which very old HDB 3 room flats are being sold for recently to realise this point.

This is why I have mentioned that we could make good money on rather old leasehold real estate if we time it right.

So, for example, people who bought into the old MI-REIT in the early days got a bad deal but people who bought into AA REIT last December got a good deal. :)

AK71 said...

Hi James,

Thanks for the encouragement! :)

Do visit often and I look forward to more comments from you in future. :)

Derren said...

Hi AK71,

Kindly ask if you know about the gearing part on Reit. Does any Reit pay off its debt from its income, consider 90% income for distribution?

AK71 said...

Hi Derren,

It would depend on the size of debt. Using Saizen REIT as an example because I know it well, this REIT has resumed distribution to unitholders. Next year, it has a smallish loan which is maturing.

The management has advised that it will use internal cash resources to repay that debt in full if refinancing is not possible.

The way REIT works, if it is possible to refinance at a lower interest rate while revenue stays the same or improves, it is a better option. :)

Anonymous said...

Hi Derren,

Generally, REITs DO NOT use their cash-flow to repay their loans since they are bounded to pay 90% of their cash-flow to unit-holders. However, this only applies to REITs with local assets so REITs with overseas assets (ie Saizen) are not bounded by such rules and can chose to retain income to repay debt. Unfortunately, more often than not, it will be the unit-holders who will foot the debt bill in the end.

A good measure to value yield stocks will be payout ratio (dividend/ops cash-flow) to determine how 'safe' your dividend is. The smaller the ratio, the larger the buffer. At the moment, you will be hard-pressed to find any REIT with decent dividend paying history while at the same time paying down its debts. I don't think it exist (so if you find it, let me know :) ). I guess only business trust will have the flexibility to do both.

Cheers
Nick

AK71 said...

Hey Derren,

Nick is trying to tell you "Buy Saizen REIT"! ;p

Derren said...

Hi AK71 & Nick,

Thanks for your useful knowledge.

In that case, when the interest rate goes up, more fund raising would be held as it keeps refinancing on maturing debt.

Would start accumulating Saizen soon! :)

AK71 said...

Hi Derren,

Refinancing of loans is something REITs have to do regularly. If interest rates go up, distributable income would reduce. The managers will have to source for the cheapest funds possible. I would not worry about it for now because cheap loans would be around for quite a while.

What I like about Saizen REIT, if you read their latest annual report, is that all their loans are now amortising in nature. So, the loan quantum will reduce over time. It is a relatively long process but this REIT's numbers will surely look better in time.

Just make sure you have done all the research on Saizen REIT and feel comfortable enough to hold before jumping into it. :)

Anonymous said...

Hi Derren,

Despite what AK might say, I am not asking you to buy Saizen (or any other coys) haha !!!

REITs, as an asset class, have their own flaws and pitfalls so study them well. Essentially, this is an asset class which cannot repay its liabilities unilaterally and more often than not only own leasehold lands. Property valuation also fluctuate violently and this will hamper the Trust's ability to refinance in the loans. Saizen amd MI-REIT are a pretty good example of how a sharp drop in asset valuation can make refinancing very difficult.

Property business trust is also something to look at though there are only few of them in SGX. They entail higher risk since they develop their own assets. However the reward is larger - they can sell it for a profit to REIT etc. Yet, there are only 3 of them listed here at the moment with short track record so the jury is still out on this class.

Cheers
Nick

Disclaimer: Vested in REITs and Shipping Trust

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