REITs and expense ratios

[Packer16]

I have put together an analysis that appears to imply that lower expense ratio REITs outperform higher expense ratio REITs in all categories except retail.  I have also estimated the impact of lower costs on P/FFO and in most cases the lower fee funds are undervalued at today's prices.  The only exception is NNN REITs, which appear to be undervalued in general due to P/FFO being lower than the other sectors but they have longer lease terms.  Just wanted to get folks feedback on this as I have not seen REITs examined on an expense ratio basis before.  Thanks.

 

Packer

REIT_Expense_Ratios.xlsx

[Read the Footnotes]

Packer,

 

I can't claim to be a REIT expert and I have never undertaken a systematic study as you have begun, but your thesis makes a lot of sense to me. First, let me clarify that my REIT experience is pretty much limited to the following:

 

Academic study, general reading, and 10-k's

Studying with some REIT managers in graduate school who were very successful, at least on their own behalf

Interviewing with a few large REITs

A few successful investments in REITs when P/AFFO didn't seem to make any sense.

 

With that said, I have a few observations. First, there seem to be a lot of unsophisticated retail investors in REITs who buy for yield. Many of these retail investors probably don't access metrics regarding valuation or management cost the way they might for a mutual fund. As a result, REITs may add a level of inefficiency in the pricing of securities and the rewarding of managements.

 

To add a couple of more anecdotal observations. Through talking to REIT managers, I learned of instances in which a REIT could be motivated to turn it's portfolio for institutional, or career reasons rather than for sound investment reasons. It would seem this sort of behavior would increase costs and simultaneously depress potential future returns. A REIT with a superior culture and incentives structure might be able to reduce costs and improving results by limiting these sorts of behaviors. Maybe someone from the board with experience in the industry could address this issue?

 

When interviewing with a few REITs I couldn't see a relationship between the record of returns to shareholders and the opulence of the offices or the compensation offered. In fact it seemed there was a negative correlation.

 

One very successful retired REIT manager I got to know made a fortune in REITs and was well known for his philanthropy. He told me that much of his fortune he made through the timing of trades in shares of his own REiT. He was adamant that the outside shareholders in his REIT had no idea of the true value of REITs or their likely future value and that outside shareholders typically bought in and sold out at exactly the wrong moments. He seemed gleeful when telling the story of how he could legally use his informational advantage to trade in opposition to the prevailing asset flows.

 

I believe that REITs are an area where a specialist would have a much greater ability to make good investments than a generalist, including the chance to improving results through identifying superior management. If real estate is a less efficient market, then excellent management should have an even greater chance of producing superior returns, but there is always the risk that management will capture the majority of the economic rents. So as always you are looking for management that treats investors well.

 

Clearly there are some great business people and asset managers in real estate and REITs. If REITs do have a greater degree of informational asymmetry and limits to management accountability then costs might be a great way to screen for managements. In fact, low cost may be a brilliant way to identify the managers that are in the game for the right reasons and are shareholder friendly.

 

You also might want to try to control for the size of the REIT in your analysis.

 

RTF

[thepupil]

I have put together an analysis that appears to imply that lower expense ratio REITs outperform higher expense ratio REITs in all categories except retail.  I have also estimated the impact of lower costs on P/FFO and in most cases the lower fee funds are undervalued at today's prices.  The only exception is NNN REITs, which appear to be undervalued in general due to P/FFO being lower than the other sectors but they have longer lease terms.  Just wanted to get folks feedback on this as I have not seen REITs examined on an expense ratio basis before.  Thanks.

 

Packer

 

Hi Packer, can you explain what you mean by "expense ratio"? I'm sorry if I missed it being defined somewhere. thanks!

[Packer16]

Since REITs for the most part are managing properties, the expense ratio is the total costs (except D&A and impairments) divided by the total assets.

 

Packer

[LC]

Thanks for the analysis, still digesting your conclusions.

[BG2008]

I have put together an analysis that appears to imply that lower expense ratio REITs outperform higher expense ratio REITs in all categories except retail.  I have also estimated the impact of lower costs on P/FFO and in most cases the lower fee funds are undervalued at today's prices.  The only exception is NNN REITs, which appear to be undervalued in general due to P/FFO being lower than the other sectors but they have longer lease terms.  Just wanted to get folks feedback on this as I have not seen REITs examined on an expense ratio basis before.  Thanks.

 

Packer

 

Packer,

 

Thanks for putting this together.  I'm still digesting this.  I think it's important to take into consideration major trends in real estate in the last 10-15 years. 

 

1) Overall compression of cap rate leading to higher valuation for REITs.  If you the REITs just kept on buying and holding, they should've have done quite well unless their category was getting killed.  15 years back would be circa 2001, that's right around the time when 9/11 happened and the US instituted massive easing of monetary policies.  This has been a massive tail wind for the real estate sector. 

 

2) Urbanization/cities getting safer - Any REIT that owns dense urban properties should have done quite well.  SLG has a decent long term CAGR, but in reality, they would've done much better had they just sat on their properties.  Doing too much can be detrimental.  Hence  you can't really look at all apt reits the same way.  You should probably separate out the urban versus garden styles in suburbs

 

3) In favor and out of favor asset types - Apartments are valuable, anything urban has become valuable, suburban offices have been getting killed.  Class B malls are dying left and right (likely structural) in the long run.  If you own Class A retail, you've likely done well.  If you own Class B retail, it's nothing but heartache. 

 

Food for thought 

 

 

[frommi]

Thanks, interesting conclusion. But it looks like it doesn`t work that way for healthcare REITs?

I didn`t look at the numbers in depth, but is there a reason that expense ratios are high in that sector?

[Packer16]

I do not know specifically but maybe due to the specialized nature of the facilities they cost more to manage.

 

Packer

[constructive]

This looks like a smart thesis Packer. Are you looking to invest in any other REITs besides Broadstone and which do you see as most attractive?

[JEast]

A little off subject, but how long will the tailwinds of cheap capital remain? 

 

For a historical side note -- after the Romans conquered Egypt and were able to reap the benefits of abundant grain stores that Egypt had, disposable income increased significantly and interest rates dropped from 12% to 4%.  What subsequently happened?  You guessed it, property values went up. 

 

As Howard Marks advises: where are we in the capital cycle presently and will the tailwinds continue?  It appears the end is not in site yet as interest rates proceed into negative territory — ha ha.

 

[CorpRaider]

Sounds bit like Bogle's "low cost hypothesis".

[james22]

I do expect the Vanguard REIT Index Fund Institutional Shares (VGSNX) to outperform the Admiral Shares (VGSLX) and ETF (VNQ) by .02% and Investor Shares (VGSIX) by .16%...

[Packer16]

In terms of tailwinds, we are 35 years into this cycle.  The last time we had similar conditions, peace and globalization, after the Napoleonic wars the tailwinds lasted 80 years from 1820 to 1900.

 

Packer