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Real Estate Inv. Trusts: REITs
Hole in the Bucket

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By JimLuckett
August 3, 2005

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Green Street's Mike Kirby writes that he can't reconcile REIT's reported growth in same-property NOI with growth in NAV over the same time period. In the aggregate, NAV has not grown near as much as the NOI growth rate would imply, suggesting there's a hole in the bucket somewhere that's leaking out a lot of shareholder value.

The analysis corrected for change in cap rates over the period, retained AFFO, dividends, and other factors. Holding cap rates constant, retaining a dollar of AFFO should add a dollar to NAV. And holding cap rates constant and filtering out the effects of retained AFFO and dividends paid, a 1% increase in NOI should produce a 1% increase in asset value (and 2% growth in NAV at 50% leverage). But in his study he reports that the numbers don't foot, not even close. He says they are off by 2 or more percentage points. NAV is not growing as fast as it should, looking at the inputs (same property NOI growth rate, cap rate change, retained AFFO, leverage ratio). [Question to other subscribers: Is this the way you understand the article?]

He suggests the hole is probably largely that AFFO is overstated. A lot of what passes for retained AFFO actually is money that gets eaten up in capital expenditures that offset real depreciation of the properties rather than in growth in NAV. AFFO is supposed to be FFO minus enough capital expense allowance to offset real depreciation. But if real estate investors underestimate how much capex is needed to offset depreciation, then AFFO is overstated and total returns to real estate are lower than people think they are.

I have many reactions to this provocative piece, but they fall in two categories: (1) I am quite willing to believe that nearly everyone underestimates routine capex needs, (2) there are other logically possible explanations and I'd like to see some discussion of whether and how some or all could be ruled out.

Expanding on (2):

a) Maybe NAV growth is greater than GS estimates it to be. Maybe NAV was actually lower in the earlier period than GS estimates and or higher in the current period or both. In other words, maybe there is no hole in the bucket.

b) Maybe the hole in the bucket is poor capital allocation by REIT management. If you borrow a dollar or retain a dollar of AFFO and invest it in ways that turn it into 99 cents worth of assets (or 89 cents), that would explain why same property NOI growth, retained AFFO, and change in cap rates does not calculate out to the observed change in NAV. Of course, REIT management argues it creates value with its capital investments (Kirby notes), which makes the hole even larger: If management is believed to create value with new capital than the missing NAV growth is even greater. But Kirby does not explore the possibility that value destruction by poor capital allocation is itself the hole or a part of it. Perhaps he thought he was being disrespectful enough by implicitly plugging in 0% for value creation and didn't want to venture into negative territory for this variable. But I seem to recall other studies of corporate America generally that found very poor returns on retained earnings. [On the other hand, maybe Kirby has it right and these other researchers need to explore his theory -- it's not that the return on retained earnings are poor, it's that the investments financed with retained earnings were offset by existing capital becoming obsolete faster than reported depreciation, and the companies that underreport depreciation also tend to be the ones that retain a lot of earnings.]

c) He does explore briefly the possibility that same-property NOI growth is overstated.


Kirby says real estate investors expect unlevered real estate returns to be (typically) = current yield (adjusted for routine capex) + inflation . But if current yield is overstated by 2 or 2.5 percentage points because capex is underestimated by that amount, then the actual returns will turn out to be = current yield (incorrectly adjusted for routine capex) - 2 or 2.5 (for the unforeseen capex) + inflation. And, since inflation is in the 2 to 2.5% range, this just happens to equate to current yield (incorrectly adjusted for routine capex).

In today's low cap rate world, that means an IRR of about 4% to 7%. Why take real estate risks for an IRR no greater than that of a T-bond? And remember, if you can't borrow at less than the unlevered IRR, then the levered IRR won't be any higher. That's the challenge posed by his piece.

Kirby acknowledges that his study is broad-brush and aggregated, and that there are individual REITs where NAV growth exceeds that implied by NOI growth, retained AFFO and cap rate change. For example, KIM.

But before you switch your investment strategy to fill up on the best value creators, remember that the GS market-beating BUY/HOLD/SELL calls
do not tend to put the KIMs and the CNTs (proven value creators) on the BUY list and the value destroyers on the SELL list. In fact, KIM and CNT tend to be perpetual SELLs, while lowly-esteemed REITs like AEC are often BUYs. Anything can be a BUY or a SELL, or both on different days. It all depends on price -- are we overpaying or underpaying, given the value creating or value destroying habits of management, the NAV and the current stock price.

If Kirby's way of thinking about true prospective returns of the typical REIT takes hold in the investment community, then the REIT stock indexes should fall dramatically; if prospective returns are actually 2 or 2.5 percentage points lower than commonly expected, then investors will pay less for REIT stocks. But the fundamental idea in the piece -- that depreciation is real and the accountants get it about right in GAAP earnings, and nobody gets it right in AFFO -- is not new and has been advocated by other respected analysts before. Yet, REITs rise and rise and rise. Kirby's contribution in this piece is to show that, at least according to his NAV estimates -- the observed growth in NAV is not fast enough to validate the belief in AFFO [and the routine capex adjustment AFFO embodies], particularly if you add to this a belief that typical REIT managements create value.


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