The idea that all REITs are not created equal might seem obvious, but Chilton Capital Management LLC has taken steps to identify those REITs that stand head and shoulders above their peers.
The Houston-based wealth management firm has tagged these companies as “REIT Elite”—a catchy moniker for sure, but the numbers behind the REIT Elite prove they have as much substance as style.
NREI caught up with Matthew Werner, a portfolio manager and analyst with Chilton Capital Management, to talk about the genesis of REIT Elite, the companies that deserve such a title and what sets them apart from other REITs.
An edited transcript follows:
NREI: Can you explain the whole concept of REIT Elite?
Matthew Werner: The REIT Elite is our way of segregating REITs that have a distinguished record of producing above average total returns to shareholders over a long period, and we believe have the best chances of continuing to do so going forward. These are the blue chip, core quality holdings that an investor should buy for his or her grandparents, parents and children. They are the “sleep at night,” confidence-inspiring companies with management teams and operational expertise that REIT investors can rely on for above average earnings growth over long time periods, despite changing economic conditions.
The idea behind the REIT Elite was to respond to the flow of money we have seen go into high quality dividend paying stocks. We started thinking about a portfolio of REITs that would be able to be put on autopilot for the next 10 years without having to worry about what direction interest rates are moving in or if they were going to miss a consensus quarterly earnings estimate by a penny. Instead, the REIT Elite give investors the peace of mind that they will manage through each scenario as well as they possibly can, acting in the best interests of shareholders.
NREI: Investors are familiar with the idea of blue chip stocks. Does the idea of REIT Elite take the idea of blue chip to the next level?
Matthew Werner: The term blue chip has traditionally been reserved for industrial companies with distinguished records. We have not seen it used in the REIT space. In the REIT space, our version of blue chip is usually referred to as core. Like blue chip industrial companies, core REITs have a favorable track record, strong credit ratings, and a product that has been, and will continue to be, in demand.
Of the 123 equity REITs as of June 30, 2012, we have classified 28 as core. However, analysis of these 28 companies found that 11 of them created total returns for shareholders far above the average for their competitors, and they had many characteristics in common. Importantly, the average REIT Elite member produced a total return of 725 percent for shareholders over the 10 year period ending July 19, 2012, while the MSCI US REIT Index produced a total return of 214 percent.
NREI: What metrics did you use to identify the REIT Elite?
Matthew Werner: In addition to producing above average total returns for shareholders, the REIT Elite can be identified by looking at the income statement, balance sheet and the management team. Specifically, we looked at metrics surrounding the capital structure, predictability of the dividend, management team track record and operational excellence.
Each member of the REIT Elite stressed having the most flexible balance sheet. They maintain a manageable dividend that leaves room for growth. Management teams have established a track record of smart capital allocation and transparency with investors, tenants, their boards of directors and fellow employees. Last, they have a focused effort on finding the best properties in the best locations, and then growing cash flows at the property level at a rate above the average for the submarket.
NREI: Your firm highlighted 11 REITs that qualify as REIT Elite. What do they have in common?
Matthew Werner:The 11 companies we found that excelled in the metrics were: AvalonBay Communities, Federal Realty Trust, Simon Property Group, Ventas, Eastgroup Properties, Essex Realty Trust, HCP Inc., Public Storage, Boston Properties, Taubman Centers and newcomer American Tower Corp.
Each one of these companies consistently trades at above average multiples of Funds from Operations (FFO) and Adjusted Funds from Operations (AFFO), and commands a premium to net asset value (NAV) under most market conditions. They trade at these high valuations due to the metrics cited earlier: flexible balance sheets, low dividend payout ratios, consistent same store net occupancy income growth, and management teams whose reputations are second-to-none.
NREI: Many investors would consider these REITs to be pricey. And your own firm doesn’t own all of these stocks either. What can you tell us about valuation?
Matthew Werner: As a group, these 11 REITs trade at a price/2013 FFO multiple of 20.0x and a price/2013 AFFO multiple of 23.1x as of July 19, 2012, which are well above the REIT averages of 16.1x and 20.1x, respectively. Additionally, they trade at an average of 21percent above their consensus NAV.
The market has ascribed a premium valuation to them due to confidence that the management teams will continue to make value-enhancing decisions on multiple fronts. Also, the REITs included in the REIT elite own mostly core properties, which are the most sought after by institutional investors.
The flight to quality by institutions looking for yield and liquidity has driven up the valuations for the REIT Elite relative to the rest of the REIT universe even more than normal. Lastly, their size and presence in indices (both REIT and non-REIT) keeps them in high demand as “must-own” for many institutions that have mandates to maintain exposures.
NREI: An important differentiator for the REIT Elite is the predictability of the dividend. How do the REIT Elite compare to the REIT universe at large?
Matthew Werner: A high percentage of REITs cut their dividends in the 2008-2010 time period. Remarkably, eight of the 11 REIT Elite members did not cut their dividends (AMT did not pay a dividend and was not classified as a REIT until January 1, 2012).
Despite frequent dividend raises and lack of dividend cuts, the average payout ratio for the REIT Elite is 65 percent of AFFO today, far below the average for the REIT sector of 74 percent. This gives investors confidence that the dividends will be increasing over the near and long term.
NREI: The value of a REIT’s management team is difficult to determine, yet your evaluation includes this qualitative element, as well as other hard-to-measure components. Why are these components an important part of your equation?
Matthew Werner: An outsider looking into the REIT landscape could easily make the assumption of think¬ing a REIT is merely a collection of buildings, instead of a company with employees and future value creation potential.
We argue that a strong leadership team is as, if not more, important in the real estate business as in other sectors for several reasons. First, there is constant cash flow coming into the business, which requires prudent capital allocation deci¬sions. Second, real estate is characterized by high leverage so a CFO must be disciplined to maintain relatively conservative targets. Third, the risk and return associated with develop¬ment is alluring and should only be attempted if there is a favorable track record to assure shareholders there will be value added.
NREI: What about the balance sheet of the REIT Elite? Is there a measureable difference in the way the balance sheets are managed that propels them to REIT Elite status?
Matthew Werner: To measure balance sheet flexibility, we look at several metrics, which include the debt/ total market capitalization, debt/gross asset value (GAV), and net debt/EBITDA ratios. As of March 31, 2012, the REIT Elite average debt/total market capitalization ratio was 28 percent.
PSA leads the way with a 2 percent ratio. The average REIT has a debt/total market capitalization ratio of 38 percent. The debt/GAV ratio average for the REIT Elite stood at 31percent, which again is much more conservative than the average REIT at 40 percent. Lastly, the average net debt/EBITDA ratio for all of the REIT Elite members was 5.5x, versus a REIT average of 7.0x as of March 31, 2012.
NREI: From an investor standpoint, what would I miss out on if I invested only in the REIT Elite?
Matthew Werner: You would miss all of the REITs that could potentially become members of the REIT Elite of the future! Each member of the REIT Elite had to come from somewhere.
Though there is higher risk associated with these companies, the commensurate return that comes from spotting a REIT that is not yet recognized for some of its elite qualities can add significant value to a portfolio. Some companies may never become Elite, but there are still times when a REIT is mispriced by the market and there is the potential for outsized returns relative to the risk.
If you had to pick 11 REITs in a portfolio and were not planning on making any trades for the next 10 years, these would certainly be the first 11 we would recommend. However, we believe we can add value over a static portfolio of the REIT Elite bucket by taking calculated risk where appropriate. And we are more than happy to oblige when a member of the REIT Elite is priced to produce a total return that is acceptable for the low risk.
NREI: Is there anything else that differentiates the REIT Elite?
Matthew Werner: The management teams of the REIT elite have realized that high leverage does more harm than good, so their liability management skills have been superior. The capital allocation prowess of many REITs was very notable in the 2006/2007 period when REITs were huge sellers of property at record high valuations while private funds were buyers only to see a 30 percent to 40 percent drop in value in 2008/2009.
Many of these private funds used leverage which ended up destroying the equity. This period turned out to be a defining moment for the REITs in the modern REIT era.
In the past 20 years, the best REITs have improved the quality of their assets, lowered debt leverage, and brought dividend payout ratios down to record low levels. We look forward to seeing how the REIT Elite will perform over the next 20 years that will surely be filled with equally surprising economic shifts and market movements.