When considering investing in a private real estate investment trust, an investor should be aware the overall return on their investment will be linked to both the distributions they receive from the REIT and the change in the value of their initial investment.
The latter of these is normally measured by the change in the REIT net asset value (NAV).
When looking at the distributions provided by a REIT, investors should be asking if the REIT’s adjusted operating cash flows are sufficient to at least cover the REIT’s cash distributions. If they are not, the investor should enquire as to how the cash shortfall is funded.
For instance, is it funded by simply returning the investors’ own principal back to them? Regardless of the answer to the shortfall funding question, paying out more in cash distributions than a REIT can generate is unsustainable.
If a REIT is relatively new, it is common its early cash distributions will exceed its adjusted operating cash flows. In these situations, the investor should ask when, if ever, the REIT will be cash-flow positive, and when, if ever, will the REIT generate excess cash flows.
Questions to ask re: cash flows
For an investor to feel comfortable that a REIT’s distributions are sustainable, they should also ask if the REIT is in an accumulated cash-flow deficit or excess position.
This will assist the investor in ascertaining whether the REIT is building up a buffer to ensure that, in the event of an unexpected operating setback or an unforeseen capital expenditure, the REIT could still meet its current distribution commitments.
Graph 1 shows the typical progression and outcome of a REIT with a conservative approach to cash flow management as it relates to cash distributions.
During the first few operating years of a REIT, due to start-up costs and the timing of property purchases, an investor will normally find that the REIT’s current adjusted cash flows from operations (dark grey bars) do not cover current distributions (light grey bars).
Because of this mismatch, the REIT will accumulate a cash-flow deficit during the first few years of operations.
In Graph 1, this accumulated deficit is depicted by the first part of the orange line, which represents the accumulated adjusted cash flows after distributions have been deducted.
As additional properties are purchased and their income streams are included, the REIT should become and remain cash-flow positive on an adjusted-operating cash flow basis (light grey bar).
The orange line, which represents accumulated adjusted cash flows after distributions, shows that the REIT has recouped its initial cash-flow deficit by year four and it continues to build a very healthy cash flow buffer over the next few years.
A REIT should consider its current cash flow position before making any adjustments to its distributions. Any increases in distributions should not have a significant negative impact on the REIT’s cash flow position.
If a REIT increases its distributions before its cash-flow deficit has been fully recouped, the time to recoup the remainder of its cash-flow deficit may be extended.
A note about total returns
A REIT investor’s total return is not solely dependent on the annual distributions they receive from the REIT, but rather a combination of their annual distributions and their share of the increase in the value of the REIT.
The increase in the value of the REIT is basically the anticipated market value of the REIT’s properties less the debt/mortgages associated with the properties.
Since the REIT must “mark-to-market” its properties, for accounting purposes, the REIT does not have to sell the buildings to recognize the increase in value.
Therefore, the unrealized changed in value of the REIT’s properties will be reflected in its NAV.
Graph 2 shows an example of the relative importance of a REIT’s accumulated unrealized change in value (black bars) versus its accumulated distributions (orange bars).
It is very clear that the REIT’s total return potential may be significantly influenced by the additional value associated with property appreciation.
When considering investing in a REIT, or for that matter any investment that pays a distribution, ensure the cash flows generated by the investment can at least cover its cash distributions. If they cannot currently do so, how soon will they be able to?
Also remember to look past the “shiny” distribution percentages to see if there is any potential for your original investment to grow and, if so, at what rate.
Greg Placidi, MBA, CFA: Chief Investment Officer & Portfolio Manager, Equiton Capital: Greg is an accomplished investment professional with significant experience managing a wide array of investment portfolios. Over the last 30 years, Greg’s career has centred around global financial services and he has held senior roles in investment management, strategy consulting, insurance, real estate and financial services regulation.