The term ‘cash cow’ originates from the incredible investment characteristics of a dairy cow. Despite only needing to feed a cow inexpensive hay, it can produce around 20,000 gallons of milk in a lifetime, and then be sold for meat. Used in a matrix designed by Boston Consulting Group, cash cows are products or companies that generate more cash than it costs to maintain them, but are mature and slow-growing. The recommended strategy is to ‘milk’ them with as little investment as necessary until they become obsolete.

As shown in Figure 1, it’s difficult to lose money over a ten year period with an investment in commercial real estate. If the property owner can ‘milk’ a growing cash flow from the property and somehow defer obsolesence – or even increase the terminal value of the property – the investment could be much better than a cash cow, with similarly little downside risk. In this hypothetical example, principal loss is only evident if the exit capitalization rate (or ‘cap rate’, defined as the initial net operating income yield of a property) rises to 7% (from 6%) and the property experiences 4.5% annual declines in Net Operating Income (or NOI).

We believe that the current pricing of public REITs at a discount to the private market indicates that investors believe cap rates will increase in the near future. We believe that the obsession over what the current cap rate should be can draw attention away from two rare characteristics that are exhibited by high quality commercial real estate: predictable growth in cash flow and the potential for price appreciation, assuming the property is well-located and properly maintained.

Mind the GAAP

Generally Accepted Accounting Principles (or GAAP) requires companies to depreciate buildings over a 30-40 year useful life. Though it is essentially only applicable as a non-cash tax shield, the concept that a building depreciates in value over time can be true…sometimes. For GAAP purposes, a brand new $100 million building will depreciate by $2.5-3.3 million per year, thus providing an annual tax shield of $2.5-3.3 million multiplied by the corporate tax rate. And, at the end of the ‘useful life’, the ‘book value’ of the building will be zero, thereby causing the company to pay taxes on the entire sales price should the property be sold at that time (the gain is equal to the sales price minus book value).

This GAAP equation implies that a company can spend $2.5-3.3 million per year on the property (and capitalize the costs, called capitalized expenditures or ‘capex’) to maintain a book value of $100 million. Some call this the ‘dirty secret’ of real estate. We argue that maintaining a high quality building is well worth the expense as it increases the certainty of the terminal value of a property. We also believe the opposite is true: neglecting to reinvest in a property can ensure that the building will be worth nothing more than the land value at the end of its useful life.

A Question of Time

This publication has often touted the many benefits of public REITs, especially when compared to their private peers. One of the more nuanced differences is the time horizon. While a private equity company may be using five to ten year time horizons due to their promises to return cash to shareholders, public REITs essentially have an infinite time horizon.

A key finance formula used by both public and private real estate investors alike, the ‘NPV’ (or Net Present Value) sums up estimated future cash flows and the terminal value, and discounts them back to the current period based on the risk (or lack thereof) of achieving such estimates. In simple terms, the higher the discount rate and quantity of time, the lower the NPV. While the terminal value may be less influential as time increases, the discount rate becomes much more meaningful. For example, assume the purchase of a $100 million property at a 7% cap rate with annual NOI growth of 2%, no capital expenditures (or ‘capex’), and a terminal value of $100 million. The difference in NPV between an eight and a ten percent discount rate on a five year time horizon is only $7.5 million (or 8%), while the difference between an eight and a ten percent discount rate on a 15 year time horizon is $15.4 million (or 19%). Because the discount rate changes based on assessment of risk, public REITs are therefore incentivized to take less risk.

The lower appetite for risk shows up in multiple ways. Property quality, capital expenditures, price (or value), and leverage are the most important considerations that may differ between a public and a private real estate investment.

Quality Control

Why do some properties trade at 4% cap rates and other for 8% cap rates? Why wouldn’t someone pick the 8% cap rate property over the 4% every time given the annual cash flow per dollar invested will be double? The answer lies in the risk. We’ve discussed that certain investments carry different terminal values, discount rates, and cash flow streams. In practice, these assumptions are based on supply and demand at the location, tenant credit quality, and market liquidity, among many other items (ie. regulations, tenant diversification, construction quality, etc.).

Assuming that the market is correctly pricing in risk differences between the 4% cap rate asset and the 8% cap rate asset, the NPVs of each should be similar. And, assuming similar NOI growth and exit cap rates near the respective entrance cap rates, the 8% cap rate asset should outperform the 4% cap rate asset before adjusting for risk.

However, research from Green Street Advisors in Figure 2 shows that low cap rate and low leverage REITs have outperformed high cap rate and high leverage REITs over most trailing twelve month (or TTM) periods since 2002. Though Green Street Advisors is applying this theory to REITs instead of on a property by property basis, the results should be reprensentative of a fact that a casual investor may not appreciate: high quality outperforms low quality, and carries with it less risk. How is this possible?

Consider a $100 million investment in both the 8% cap rate property and the 4% cap rate property. If the 8% cap rate property is a 100% leased office building to an investment grade S&P 500 company in suburban Chicago with a lease maturity in 15 years and 1% annual lease bumps, the returns are certainly better than the 4% cap rate for several years. However, if the 4% cap rate building is located in midtown Manhattan, is 90% leased to 25 tenants, and can generate 5% annual net operating income growth over 15 years, the cash flow increases to almost $8 million by year 15. Still doesn’t sound more appealing than the 8% cap rate building, right?

Now assume the properties are brought to market for sale, one with a diversified tenant base and the other with a single tenant that will either leave or demand significant tenant improvements to stay. The reality is that a landlord (or potential landlord) for a building with a single tenant lease expiring in the near term will have little pricing power over that tenant, especially if it’s located in an area that isn’t ‘mission-critical’ for the company. Even assuming only one year of free rent and a new lease signed at the same terms as the expiring lease for the single tenant building, the multi-tenant building could sell at a cap rate up to 5.7% to achieve a similar NPV, assuming a 10% discount rate for the single tenant building and an 8% discount rate for the multi-tenant building.

To Defer, or Not To Defer Capex

Another important difference between a suburban property in a secondary market and an urban property in a gateway market is the necessary maintenance capex. Though the cost of labor and materials per square foot may be similar between the two areas, the cost of land and the revenue per square foot of space is much higher in the urban area. Thus, as a percent of revenue and a percent of dollar invested, the maintenance of properties in urban area tends to be much lower. Thinking about it slightly differently, owning a single property comprising 500,000 square feet (or sqft) that generates $7 million in NOI will cost less to maintain than five properties comprising 2 million sqft generating $7 million in NOI. NOI after maintenance capex is also called economic NOI, which is helpful when comparing two investments. For example, if the 500,000 sqft property costs $1 million per year to maintain, but the 2 million sqft portfolio costs $2 million to maintain, the single property is actually priced cheaper on an economic NOI basis, or ‘economic cap rate’, assuming equal purchase prices.

Interestingly, nominal cap rates (or cap rates before capex) still dominate the real estate market. Even if quoted nominal cap rates are actually achieved because of skimping on the capex, the property usually later sells at an impaired price due to ‘deferred capex’. Thus, the economic cap rate most often represents the true economics of owning a commercial property. Public REIT research departments were some of the first to discover this mispricing, and, because they are long-term oriented, they have been able to exploit it more than shorter-term competitors.

The Price Isn’t Always Right

We believe that the most common denominator of historical real estate cycle collapses has been too much speculative building at peak pricing. Capital (both debt and equity) is most freely available when prices are at a peak, and investors (and developers) tend to reach for returns by taking on too much risk, which ultimately leads to a loss of principal.

Historically, public and private real estate investors have reacted differently at cyclical peaks and troughs. While public REITs have proven their ability to raise capital at all points in the cycle, private funds rarely have the same luxury. Therefore, they are motivated to raise as much capital as they can when it is available. In addition, they are motivated to put the money to work rather quickly due to the fees that can be generated (transaction fees, property management fees, investment management fees, etc.), which highlights a major conflict of interest between the investor and the manager. In theory, an investor should want the opposite to be true.

As Warren Buffett wrote in his 2004 shareholder letter, a good investor is “…fearful when others are greedy and greedy only when others are fearful.” In the real estate world, this would be the equivalent of selling when prices are high, and buying when prices are low, which much easier said than done. A number of REITs in the Chilton REIT Composite seem to have proven their ability to adhere to this seemingly simple principle.

Figure 3 shows that public REITs as a whole (light blue line) have historically followed Buffett’s mantra, while private equity investors (orange line) have done the opposite. The best example of this was the leadup to the Global Financial Crisis (or GFC). From mid-2005 to early 2008, commercial property prices (dark blue line) soared before collapsing in late 2008. During this three year period, private real estate funds (orange line) were voracious buyers, growing by more than they had in the previous 20 years.

Simultaneously, public REITs (light blue line) were not so quietly cashing in their chips. Public REITs did not necessarily call the top of the market– they simply observed that the risk of buying a property at peak pricing far outweighed any potential returns, even if the cycle didn’t come to an end soon thereafter.

After prices bottomed in late 2009, public REITs had more cash on hand and were able to raise equity via secondary offerings, pushing aside their fear to greedily dominate the market for pristine properties from distressed overleveraged borrowers. Remarkably, the GFC only resulted in one public REIT declaring bankruptcy, while numerous private funds had their equity completely wiped out.

Leverage is Not the Answer

Finally, leverage is the ‘cure’ for making an investment appear attractive if the other aspects do not meet the required IRR. As mentioned above, the availability of debt is usually inversely related to when it should be used. While a private fund may gush at the possibility of using 70-80% leverage to transform a 7% unlevered (boring) annual return into a 25-35% annual return, public REITs tend to use only 30% leverage. Why? We believe that leverage is not the cure, but the disease that obfuscates all of the above-mentioned principles for real estate investing.

First, the ability to generate 25-35% annual returns means that the investor gets his/her principal back within three to four years. Thus, the terminal value, and property quality, is almost irrelevant – a ‘bonus’ if the property is still worth something.

Second, the lack of a terminal value and the small amount of ‘skin in the game’ dis-incentivizes reinvesting in the property, or even contributing the minimum to maintain the property. For example, if a $100 million property generating $7 million per year costs $1 million to maintain, the $1 million is much more significant as a percent of investment for a 75% levered buyer ($1 million = 4% of a $25 million equity investment) than a 30% levered buyer ($1 million = 1.4% of a $70 million equity investment).

Finally, price becomes less of an issue with leverage. While a 30% levered buyer may drop out of the bidding due to the higher cost of equity and the sensitivity to maintain a total returnabove the blended cost of capital, an investor willing to simply lever up to be the winning bidder may overpay. Broadly speaking, leverage allows for excesses and conflicts of interest in the market that are unhealthy.

Rest Easy with Public REITs

Though real estate has been around for thousands of years, it still can be the culprit for financial loss. It may be better than a cash cow, but it can catch a disease if done the wrong way. Public REITs have proven their ability to manage real estate cycles using moderate leverage and upgrading portfolio quality, while producing long term total returns above the S&P 500.

As we are seven years into the current real estate cycle, public REITs have been very cautious about making acquisitions, heeding the messages sent by the NAV discounts at which they have been trading. While implied cap rates (income returns) are as low as they have ever been, they still trade at historically wide spreads to private real estate cap rates and comparable bond yields. Balance sheets are in the best shape in REIT history, dividend payout ratios are at record lows, and portfolio quality has never been better. It is difficult to say whether or not this cycle has one more year or five more years, but we can be certain that public REITs will be prepared to weather any scenario, and investors should give them a premium for highly predictable rising dividends and low risk of loss of principal.

 

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Bruce G. Garrison, CFA bgarrison@chiltoncapital.com (713) 243-3233

Matthew R. Werner, CFA mwerner@chiltoncapital.com (713) 243-3234

Blane T. Cheatham, bcheatham@chiltoncapital.com (713) 243-3266

Parker T. Rhea, prhea@chiltoncapital.com (713) 243-3211

RMS: 1926 (4.30.2017) vs. 346 (3.6.2009) and 1330 (2.7.2007)

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An investment cannot be made directly in an index. The funds consist of securities which vary significantly from those in the benchmark indexes listed above and performance calculation methods may not be entirely comparable. Accordingly, comparing results shown to those of such indexes may be of limited use.

The information contained herein should be considered to be current only as of the date indicated, and we do not undertake any obligation to update the information contained herein in light of later circumstances or events. This publication may contain forward looking statements and projections that are based on the current beliefs and assumptions of Chilton Capital Management and on information currently available that we believe to be reasonable, however, such statements necessarily involve risks, uncertainties and assumptions, and prospective investors may not put undue reliance on any of these statements.

This communication is provided for informational purposes only and does not constitute an offer or a solicitation to buy, hold, or sell an interest in any Chilton investment or any other security.