Obviously REIT evaluation, like stock evaluation generally, is complex. There is really no end to the amount of data you can consider, analysis you can do, and so forth. Suffice it to say that I’m not going to be able to accurately or adequately sum up the entire process of REIT evaluation in a single blog post and it’s probably stupid to try. I’m going to do it anyway. Here’s why: If you’re making eight-figure investment decisions for a hedge fund, yeah, you’re going to need to do some analysis that goes well beyond the scope of what I’m talking about here. But most readers of the Dude’s blog probably aren’t doing that. Rather, I’m guessing that most of you are – like me – hobby investors looking for a profitable spot to park $500, $1,000, or maybe $5,000. You want to make good investing choices, and you probably enjoy investment research, but you’re also not going to spend the next 6 weeks doing a detailed breakdown of potential companies just to find the best place to park $500. The priority is just getting the money into the market – intelligently, but quickly – so that you can start earning some dividends and go back to playing MLB: The Show.
The goal of this post is to show you how to evaluate a REIT without spending more than a couple of hours. The format of this post will be a “think aloud.” A long time ago, before law school, the Dude worked as a math tutor. What I would do is show students how to solve math problems by doing the problem myself slowly and talking through each step of the process so that my “mental work” was completely transparent. That’s what I’m going to try and do here. I will pick a REIT at random, walk through the sorts of things I consider, and, at the end of the post, I’ll give you an up-or-down vote on whether I would invest $1,000 in that REIT today. (Note: I am not actually going to invest anything at the moment and I will be picking a REIT that I do not own, so this will be a hypothetical vote of confidence and not an actual disclosure of the Dude’s investments or planned investments.)
Today’s REIT will be Essex Property Trust, Inc. (ticker: ESS). Assuming that I had never heard of ESS until this moment, I would want to get a quick overview of their business, so let’s head over to Yahoo! Finance and check out their profile. According to them:
Essex Property Trust, Inc., an S&P 500 company, is a fully integrated real estate investment trust (REIT) that acquires, develops, redevelops, and manages multifamily residential properties in selected West Coast markets. Essex currently has ownership interests in 249 apartment communities comprising approximately 60,000 apartment homes with an additional 7 properties in various stages of active development.-Yahoo! Finance
Right away what we can see is that ESS is a residential REIT. I like that. With some kind of specialty REIT (say, data centers or timberland) I would need to ask a few questions about the health of that industry before looking at the underlying numbers. With an apartment REIT, I don’t need to bother. Sure, the residential real estate market will fluctuate from time to time, but I feel pretty confident that in 10, 20, or even 100 years people will still be renting apartments. It’s about as steady as business models come. (Unless, of course, robots take over and we all end up in a postapocalyptic hellscape confined to toiling away in salt mines at the behest of our evil robotic overlords, but Andrew Yang has assured me that there is, at worst, a 50/50 shot of that happening.)
Since I am confident about the basic viability of ESS’ business model, I will move on to looking at the numbers. There are three places that I like to go for this. The first is TDAmeritrade. (If you use a different brokerage, it should also provide research data for you when you punch in the ticker symbol ESS.) The second is SeekingAlpha. And the third thing I check are the company’s SEC filings from the past year.
The first number I’m going to check is “funds from operations” or “FFO.” FFO reflects how much money the REIT earns from its properties in a given period. This number is unique to REITs. If you’re evaluating a non-REIT stock, you want to look at earnings and the ratio of price/earnings. With REITs you use FFO instead, because the earnings number reflects artificial write-downs for things like depreciation and, thus, is not an accurate picture of how much money the REIT brings in. If you use earnings instead of FFO, every REIT is likely to look insanely expensive and every REIT dividend is likely to look endangered. (There is also something called “adjusted funds from operations” or “AFFO.” We will cover the difference between FFO and AFFO in another post. For now, just know that I prefer to look at FFO.)
What I see with ESS is that FFO for the 12 months ending December, 2019 was $936.4M. There has been a very nice upward trajectory. FFO for the 12 months ending December, 2016 was $654.1M and it has increased every year since. Meaning that the business churned out $282.3M more last year than it did just three years earlier. That’s very impressive growth for a big company. ESS’ FFO per share was $13.73 last year and is predicted to be $14.04 this year. At a current share price of $317.04 that works out to a P/FFO ratio (the REIT equivalent of the P/E ratio) of 23.09 for last year and (assuming the estimates are right) 22.58 for 2020 FFO. That’s a little bit high (I like to see a P/FFO under 20 as a general matter), but not high enough to scare me off when the company’s portfolio is solid and its FFO is increasing like crazy.
The next thing I want to do is look at the dividend. As an income investor, this is a big-ass deal to me. I’m looking for three things: (1.) Is the current yield attractive? (2.) Is the current yield safe? (3.) Is the dividend likely to grow? In this case, ESS’ current dividend is $7.80/yr (paid quarterly). Relative to the current share price, that is a yield of 2.46%. Frankly, 2.46% is a pretty disappointing yield for a REIT. REITs are required to distribute a substantial percentage of their earnings as dividends, so it’s not uncommon to see yields of 4% or higher even in this low-rate, low-dividend environment. That said, yields are usually a little lower for residential REITs, and 2.46% is not unreasonable when compared to ESS’ peers (i.e., other major apartment REITs).
Is that 2.46% dividend safe? Well, nothing is certain except for death, taxes, and the Marlins being terrible, but we can make an educated guess. It’s probably safe to assume that ESS will generate at least $13.73 per share in FFO this year. I say that because (a.) they did that last year, (b.) their FFO has been increasing substantially each year, and (c.) the bigwigs who make estimates about this sort of thing seem to think they’ll do better than that. That more than allows ESS to cover a dividend of $7.80. Relative to last year’s FFO per share, that is a payout ratio of only 56.8% (pretty low for the REIT world and well within the realm of what I’d consider safe.) So we can feel confident that that $7.80 dividend isn’t getting cut, but we don’t just want it to stay static, we want that motherfucker to grow. Will it?
Well, for the answer to this, we can look to ESS’ history of dividend payment, which is excellent. They have increased their dividend every year for 25 years, meaning that they even increased between 2008 and 2010 when the entire economy was basically an out-of-control tire fire. This is a great sign. The 5-year dividend growth rate is 8.83% and the 10-year growth rate is 6.59%. The dividend has roughly doubled every decade: It was $4.16 in 2010 and $2.80 in 2000. I would not be shocked at all to see that their dividend was $16/share (or even a bit more) in 2030.
In sum, ESS’ current yield doesn’t knock my socks off, but the dividend appears extremely safe and they have an amazing history of annual dividend increases, so the shares are likely to provide a reliable and constantly increasing supply of income for owners.
Finally, I like to take a quick look at the REIT’s balance sheet. I’m looking for something called “net asset value” or “NAV.” This is a very approximate, quick-and-dirty way of guessing at NAV, but, as I said, we’re looking for the quick approach here. Doing this for real would involve (among other things) getting appraisals of a whole bunch of buildings, and that’s just not cost-effective or reasonable for the average investor. What I tend to look at are two things: (1.) The total value listed for “property/plant/equipment” (“PPE”) and (2.) total liabilities. The first shows, basically, the total value of the REIT’s real property holding. The second is their total debt load. What you want to look at is whether the REIT is up to its eyeballs in debt or whether they have a nice-looking equity cushion.
In this case, looking at ESS’ balance sheet, I see PPE for 2019 of $14.038B and total liabilities at the end of 2019 of $6.485B. That’s a “spread” of about $7.55B. The REIT isn’t underwater or even close to it. If you were to sell off all their assets, pay down all their liabilities, there would be about $7.55B left to divide to shareholders. (Looking at the current market capitalization of $21.7B, ESS appears to be trading at a premium to its NAV, but that’s not out of line for a fast-growing REIT with a history of success.)
Finally, I like to move away from the numbers and go back to the big picture. I will look at the REIT’s website, get a sense of what kinds of properties they rent out, and do a bit of research on the old Google machine to see what people are saying about them. In this case, what I see is that ESS owns fancy-pants apartments in high-priced West Coast cities like San Francisco and Seattle. I like this, because (1.) people pay absolutely obscene amounts of money to live in those cities and (2.) the growth might level off, but I don’t see them ever being cheap. Additionally, San Francisco is out of space to expand, and it’s a difficult and cumbersome process to get a new apartment high-rise approved there. This helps to prop up prices by mitigating one of the biggest risks that REITs face: Over-building. (Whether that’s a good public policy, the Dude is skeptical, but the focus for now is just on whether it’s good for an investment in ESS.)
Final Verdict: If the Dude had $1,000 to throw into ESS right now, he’d do it happily. It isn’t cheap on a P/FFO basis and the yield isn’t amazing, but the history of dividend growth is phenomenal and their portfolio of properties is impressive.