Analyzing REITs property acquisition
When a Trust acquires a Property, a natural conflict of interest is ignited from the very beginning. The seller(Developers or Sponsors) wants to inflate the property value as high as possible. Whereas, it is in the buyer’s (REITs) best interest to acquire properties as low as possible to achieve a “Yield Accretive” outcome.
Which brings us back to this question: “are the property that the trust acquired any good?”
where was Property acquired?
There are Primarily, two ways REITs can acquire new Property.
- External Developer
The commonality of these two sellers is, both sellers want their property portfolio to be valued as highly as possible.
There is advantages/disadvantage, from acquiring properties from the different sellers.
Property Acquire from Sponsor.
Sponsor-backed trust, especially if the sponsor happens to be a developer, has access to a high-quality property pipeline because of “Rights to First Refusal”. This relationship between the sponsor and trust is mutually beneficial. As Sponsors sell their property to Trust, they can recuperate their finances and rechannel the funds to their core business; While the Trust is too able to grow in terms of “AUM( Asset under management)” and property revenue. To add-on usually, Sponsors have high stakes in their Trust. Thus, sponsors would also benefit greatly from the Trust Capital Appreciation.
Pressure to acquire overpriced Property or Low-quality property. In theory, Sponsors can artificially enhance properties’ financial value/returns for a period of time and “forcefully encourage” the trust to absorb those properties. Inexperience Investors, might not be able to spot these red flags.
Property Acquire from External Developer
*Trust without Sponsors are also subjected to more risk*
Not at Risk of forceful injection of properties that aren’t beneficial to unitholders.
Trust needs to actively seek out new acquisition opportunities.
*Trust without Sponsors are also subjected to the following risk:
- Harder to negotiate a better interest on loans/bonds
- Does not have the financial backing of a strong sponsor during a time of financial turmoil.
Red Flags in Property acquisitions?
As we established, each party involved in the property acquisitions has the interest to guard. For REITs investors like us, our concerns are to ensure that the Trust:
- Acquire the property at a fair value or better
- The property can generate sustainable revenue
- Add value to the Trust Portfolio(AUM)
Red Flags to look out for when the property is bought from a Sponsor
Income support agreements
This form of agreement is fairly common. However, it is risky for inexperienced investors because an Income support agreement has the potential to distort the Figures of the Rental income of the Property.
What income support agreements are…. Basically, a way for sponsors to inflate the price of the property but not the actual value.
When an income Support agreement is drawn out, it means that
- The Property was most likely acquired at an unfair value by the Trust
- To support the property revenue( artificially boost the Revenue income of the property), the Sponsor would assist financially; By supplementing the Property Income.
- Results, in the appearance of a yield Accretive acquisitions, were made by the Trust.
- The “Supplemented Income” will also be used to support the dividends payout.
- Everything will appear to “fine”. Until the Income Support agreement ends and the Property is still unable to organically produce the desired income.
Red Flags to look out for when the property is bought from a Sponsor/External Developer
“Capitalization Rate” or CapRate is defined as “the rate of return from property assets”.
In other words, CapRate is used to measure how fast a particular property asset will fully pay off itself.
CapRate=Annual Net Property income Current Property value ×100%
How to use CapRate?
There are three ways CapRate could be used to analyze REITs
- For Trust Managers, CapRate could be used to compare with the Cost of Borrowing. It is then possible to generate an earning spread to assess the profitability of the property in the future.
- The CapRate of a Property could also be used to compare with the Weighted CapRate of a similar Asset class. For example, if the weighted CapRate for Hotels is 4%, the acquired Property(a hotel) HAS A CapRate of 6%, It can be said that the Trust acquired a high yielding property.
- CapRate could also be used to evaluate the existing property in the trust Portfolio. For this Instant, we must twig the formula to this:
CapRate=Annual Net Property income cost of Property acquired× 100%
The change is from “Current Property value” to “Cost of Property acquired”. With this change, we will be using the Property’s Price tag when the Trust bought it. Meaning this is always Constant. With a Raising CapRate, it implies that the Property is income is increasing yearly.