Download REIT Performance Evaluation: A Case Study of Washington Real

REIT Performance
Evaluation: A Case Study
of Washington Real Estate
Investment Trust (WRIT)
Thanks to Jay Sa-Aadu
(University of Iowa) for
providing this case study.
Washington Real Estate Investment Trust (WRIT) -- diversified REIT

WRIT owns and operates 10 retail centers, 23 office buildings, 9 apartment
and 15 industrial properties, all in the Washington-Baltimore metropolitan
region. WRIT prefers to hold local assets rather than distant ones for which it
has a relative information disadvantage. It considers markets to be local if
they are within a two-hour drive time radius of its Rockville, Maryland
headquarters. WRIT investment strategy according President and CEO
Edmund B. Cronin, Jr., “is to acquire and manage real estate investments in
markets we know well and protect our assets from single property-type value
fluctuations through diversified holdings”. WRIT looks for property
investments to produce a return on invested capital (ROIC) of 10-15%. WRIT
hopes to achieve these returns by targeting strategically-located properties in
the Washington-Baltimore metropolitan region with value-added potential as
well as stabilized properties that offer future upside growth potential. To this
end, WRIT looks for well located properties, particularly those that they find
to be poorly managed and needing new mechanical systems, cosmetics and
so on, permitting them to reposition the property in its market place, raise
rents and reduce operating costs. The CEO further comments, “WRIT
acquires assets at an attractive price relative to replacement cost, and
putting these assets to new higher-valued uses than anyone had formerly
perceived”. WRIT typically seeks investment that vary in size between $5
and $25 million. WRIT is unique in that it is one of the only five publicly
traded US REITs that is A-rated by S&P and BAA-1 by Moody’s.
Exhibit 2: Washington Real Estate Investment Trust
Consolidated Statements of Income, 1999-2000
2000
1999
Real Estate Revenue ($000)
$134,732
$1118,975
Minus: Real Estate Expenses ($000)
38,316
35,281
Depreciation and Amortization of Real Estate Assets
22,723
19,590
Income from Real Estate ($000)
73,693
64,104
Plus: Other Income ($000)
943
732
Minus: Interest Expense ($000)
25,531
22,271
General and Administrative Expenses ($000)
7,533
6,173
Plus: Gain on Sale of Real Estate ($000)
3,567
7,909
Net Income per GAAP Financial Statement ($000)
$45,139
44,301
Earnings Per Share (EPS)
$1.26
$1.23
Go to Federal Realty Investment Trust Worksheet
REIT Performance Evaluation

Net Income (Earnings)
 Net
Income per share increased from $1.23 to $1.26, a
2.4% annual increase
 The net income is, on average, about 34% to 37% of
real estate revenues
 Net income is after depreciation, and therefore not a
good measure of how much cash flow a REIT generates
or consumes
 One way to fix this problem is to estimate the firm’s
funds from operation (FFO), as defined by National
Association of Real Estate investment Trusts (NAREIT)
 This procedure is shown in Exhibit 3
Exhibit 3: Washington Real Estate Investment Trust
Annual Funds Analysis, 1999 - 2000
2000
1999
Net Income per GAAP Financial Statements ($000)
$45,139 $44,301
Minus: Gain on Sale of Real Estate ($000)
3,567
7,909
Equals: Adjusted Net Income
41,572
36,392
Plus: Depreciation and Amortization of Real Estate Assets 22,723
19,590
Equals: Funds From Operation, FFO ($000)
64,295
55,982
Minus: Capital Improvement ($000)
(16,535) (18,721)
Plus: Rent Adjustment ($000)
1,265
4,605
Equals: Funds Available for Distribution, FAD ($000) $49,025
41,866
Funds From Operation per share
Funds Available for Distribution per share
$1.79
$1.36
$1.57
$1.17
REIT Performance Evaluation

Funds From Operation (FFO) and Funds Available for
Distribution (FAD)




WRIT’s FFO is about 126% to 142% its net income
This compares to a ratio of about 154 to 155% of adjusted net
income
This latter calculation implies that depreciation adds about (1.551.00)/1.55 = 35% to REITs FFO
However there are two problems here




FFO does not account for capital expenditures and amortization of
principal
FFO does not quite accurately reflect real estate revenues because
accountants straight-line rents
The solution is to calculate funds available for distribution (FAD)
For WRIT FAD is about 76% of FFO
REIT Performance Evaluation

Problems with FAD

Does not take account of the following:
 Capital spending on new investments
 Changes in REIT’s operating working capital
 Cash inflows due new debt (or new equity)


The latter reduces the firm’s cash flow to equity, which reduces the
REITs stock value
Free Cash Flow (FCF) to equity

It is easy to correct these problems by calculating the firms free
cash flow to equity (FCF), which is shown in Exhibit 5


FFC per share is about $1.27 in 2000
This equates to about 71% of FFO and 93% of FAD
Exhibit 4: Washington Real Estate Investment Trust
Free Cash Flow to Equity, 1999-2000
2000
$49,025
Funds Available for Distribution ($000)
(25,581)
Minus: Real Estate Acquisitions ($000)
(34,668)
Minus: Change in Working Capital ($000)
(778)
Minus: Principal Payments ($000)
55,000
Plus: New Debt Issued ($000)
3,567
Plus: Gain on Sale of Real Estate ($000)
100
Plus: New Equity Issued ($000)
Equals: Free Cash Flow (FCF) to Equity ($000) $45,665
Free Cash Flow to Equity per share
Ratio of Free Cash Flow to FFO
Ratio of Free Cash Flow to FAD
$1.27
0.71
0.93
1999
$41,866
(53,197)
(13,738)
(504)
58,720
7,909
496
$41,462
$1.16
0.74
0.99
Evaluation of REIT Financial
Health


Exhibit 5 shows the analysis of REIT financial health
Debt/Total Assets



The ratio of long-term debt outstanding to total capitalization is about
35% to 42% -- conservative debt policy by US standards
REITs typically use long term debt proceeds to repay advances on
lines of credit, finance acquisitions and capital improvement
Interest Coverage



Interest coverage is the amount of earnings available to pay interest
expense
It provides a sense of how far operating profits could fall before the
company would experience difficulty servicing its debts
WRIT’s interest coverage in 2000 was 3.4:1, which is extremely safe
Exhibit 5: Washington Real Estate Investment Trust (WRIT)
Balance Sheet, 1999-2000
2000
1999
Assets:
Gross Real Estate Assets ($000)
$698,513 $661,870
Less: Accumulated Depreciation
(100,906) (83,574)
Net Real Estate Assets ($000)
597,607
578,296
Cash ($000)
Accounts Receivable ($000)
Prepaid Expenses and other Assets
Total Assets ($000)
Liabilities and Stockholders’ Equity
Long-term Debt ($000)
Mortgage Notes Payable ($000)
Accounts Payable ($000)
Other Current Liabilities
Total Equity ($000)
Total Liabilities and Equity ($000)
Long-Term Liabilities/Total Assets
Short-Term Liabilities/Total Debt
Properties/Total Assets
$6,426
8,427
19,587
632,047
$4,716
6,572
18,896
608,480
$265,000 $210,000
86,260
87,038
13,048
44,421
7,525
8,310
260,214 258,711
632,047 608,480
41.9%
5.5%
94.6%
34.5%
15.1%
95.0%
Evaluation of Financial Health of
REITs

Profitability



Dividend Payout Policy



In 2000 WRIT’s Net Income = $45M, Total Assets = $632M, and
Shareholder Equity = $260M
Thus, ROA = 7.1%; ROE = 17.3%
In 2000 WRIT’s paid out about 95% of net income in dividends, or
$1.2 per share, which meets the 90% payout ratio for US REITs
In practice many US REITs pay more than their earnings in
dividends – HOW?
Dividend Yield



In 2000 the P/E ratio or earnings multiple for WRIT was 20x
This suggest a price per share of $25.2 based on 2000 EPS of $1.26
Hence dividend yield = 4.8% (1.2/25.2)
Do You Believe in Magic? The
FFO Magic !!!
How is it possible for REITs to pay more than their earnings in
dividends?
 The answer lies in FFO, which is calculated by adding back depreciation
and amortization to net income
 For WRIT in 2000 EPS = $1.26, while FFO per share = $1.79
 WRIT could pay 90% of FFO or $1.61 per share in dividends, which is
128% of earnings per share
 In this case the investor needs only report $1.26 for federal income tax
purposes
 The difference between the dividends paid ($1.61) and EPS ($1.26) or
$0.35 is considered recovery of capital (ROC)
 The ROC of $0.35 serves to reduce the cost basis of the share acquired
by the REIT investor
 This tax treatment allows the REIT investor to receive part of the
dividend ($0.35) “tax free” until the stock is sold