When it comes to a discussion of real estate investment trusts (REITs), I do get comments on both sides of the spectrum.
The beginners to wealth building can easily relate to the benefits and the pitfalls of using them as an investment (you can read about these in depth in my FREE REITs Training Center).
At the same time, I do get feedback from more savvy active investors telling me REITs are financial engineered vehicles, they are low return, a dumping ground for parent companies. We should steer clear of them.
Are these savvy investors correct?
I think the primary basis of sustainable investment is adequate respect given to price you pay versus the intrinsic value.
There is always a value to different kinds of assets, it is whether you have the data and competency to value them well.
A Discussion of Berkshire Hathaway’s Purchase
Given this, I am intrigue to hear the point of view from investors who take more of the value approach.
The hypothesis is that in most cases, these investors will not touch REITs.
Last Saturday, I came across a mastermind group discussion at The Investors Podcast. The Investors Podcast is a podcast that reviews investment books, brings good investors on to explain what they think of the current investing climate, their investment process and some nuance to investing.
Periodically, they host a mastermind group where each of the participants (4 to 5) will give their case study of a stock they have prospected and the rest will attempt to tear it down.
In this episode, one of the participant, Hari lays out his case for STORE Capital.
STORE Capital is a USA REIT with 1000 plus properties that are single tenanted lease to single tenant.
On Jun 25, 2017, it was announced that Berkshire Hathaway took a private placement worth US$377 mil in STORE Capital. That is roughly a 9.8% stake.
The narrative is: Berkshire Hathaway, managed predominately by Warren Buffett and Charlie Munger, is made up of shrewd managers who takes more of a value approach in evaluating investments.
Their annual compounded rate of return (CAGR) in the past should exceed that of REITs, if REITs are financially engineered vehicles that are meant for sponsors to offload their assets at fair or expensive value.
If we look at the Vanguard REIT ETF, since the financial crisis, the REIT sector have recovered very well.
Given this run, would value still exist in this sector for Berkshire Hathaway to find opportunities that are large enough to invest?
This podcast allows us to explore:
- how they look at the business model and capital structure
- what they considered as the investments strengths and weakness
- the strategy they have to make use of the nature of REITs in their overall wealth strategy
I have cut the portion of the podcast that has the discussion below:
Here are some of the discussion points.
The Nature of STORE Capital
STORE Capital(STOR) is not a very big REIT, in the context of United States.
Its market capitalization is US$ 4.9 bil. Simon Property Group is probably the largest REIT in the world. Its market capitalization is US$48 bil.
STORE is short for Single Tenant Operating Real Estate.
STOR was just listed in 2014, which means its very young.
They own 1770 real estate properties and the portfolio is diversified across United States.
Single tenant operation is pretty similar to our single user asset that are usually purchased via sale and leaseback.
In the Singapore context, sale and leaseback get a very bad rap because it became an avenue for the owners to sell the asset at a great price by leasing from the REIT for 3-5 years at a good rental rate. Thereafter, the owner/tenant can then vacate the property. The REIT will find it hard to lease to another tenant at such a good rate.
In the case of STOR, they see single tenant as an advantage. However, the way they approach it is different.
Rather than buy a portfolio of asset from some private funds, or owners who owns a chain of retail shops, they cold call to ask owners whether they are willing to sell and leaseback from them.
This provides them with a group of prospective properties at good Cap Rates.
Because these businesses tend to be service based instead of retail, they tend to be sticky and resilient against downturns.
One of the manager’s risk management is that the tenants will need to provide STOR with their annual financial statements.
In this way, STOR can assess the risk of the tenant so as to better anticipate for possible vacancy.
The weighted average lease expiry (WALE) is long at 14 years.
There is also built in lease escalations.
The rental are triple net leases, this means that all the costs are borne by the tenant. STOR just collect rent (Similar REITs in Singapore like this is First REIT and PLife REIT)
STOR pays a 4.8% dividend yield. That looks low by Singapore standards (I heard investors who won’t touch anything less than 6%) It is only when you realize their dividend payout is much less than their AFFO.
AFFO stands for adjusted funds from operations. This is similar to your free cash flow or in Singapore REIT’s case the income available for distribution.
Most if not all the REITs pay out near 100% of their income available for distribution. Not the good REITs in the USA.
John Huber’s Take on the REIT Model
Hari highlighted that he felt very privileged that one of the mastermind group member was John Huber of Saber Capital Management and the investor who runs the famed value-centric site Base Hit Investing.
John, through Saber Capital, follows the philosophy of identifying wide moat, high quality businesses and purchase them at attractive prices. This is more tuned towards the Buffett approach.
What many might not know is that John actually applied this value approach initially to build up his real estate business. His father was a good investor in both stocks and real estate, so he learned from his father’s experience.
Then he bought small properties, small apartments and dabble in commercial properties. The objective for the properties is to build up enough capital so that he can start an investment partnership.
Most people who are successful in properties and build up a portfolio of them in the USA most often sticks to it. And seldom do we have someone who does things very well on both aspect.
Even rarer that they turned out to be someone who is able to explain things so clearly.
John’s take is that real estate is a low return on capital business.
To gain a decent return, it requires that we engage in some form of leverage.
Due to this, it is likely the return on incremental capital will be low.
The nature of the business is that we see in the statements of cash flow that the operating cash flow to be positive, follow by very negative cash flow in the investing section, follow by positive cash flow in the financing section.
REITs take in capital from various means, be it equity or debt.
This model for REITs is to take advantage of capital sources so as to grow.
John emphasis that as business owners, we should think about the return on the capital we generate from the business. For example, single tenant operation generates this cash flow, and through debt and equity raising, STOR has these capital. However, what is the return on capital, in this case the CAP Rates that they are getting, relative to the historical?
John’s worry also highlights his experience from his real estate investing days.
His worry is that the market cap rates have narrowed a lot and that the incremental capital that the REIT raised are invested in assets that have low cap rates.
Market CAP Rates are computed by taking the net rental income of average properties divided by prevailing market prices. It gives us an idea of the net cash flow that the market average property would yield taking into considerations expenses assumptions.
In property investing, your asset must at least earn a decent after expenses cash flow:
- against the opportunity cost of capital
- against the historical CAP Rates
This is probably John’s value perspective going to work.
John thinks that looking at how REITs work, it is likely Berkshire Hathaway’s purchase thesis is looking at STORE Capital as a pseudo bond.
John also made a comment that STORE Capital looks like a high quality portfolio of properties.
His comment gives us an idea what is his opinion of high quality: Tenant mix is diversified and single tenant do not take up a large proportion
REITs as a Placeholder for Capital
Hari highlights that he is looking at STORE Capital as an investment that the upside is limited.
However, given the current price versus the specification of the business we are getting, it becomes a good place to deploy your excess capital in an environment where the risk free investments is low yielding.
Preston echos John’s point that given how the cash flow statement looks, as well as the WALE, the ideal way to measure STORE Capital is by their dividends.
The Inference of Interest Rate Direction Going Forward
The group also explores Berkshire’s position versus the operating environment we are in.
They stated that for interest rate sensitive assets such as REITs, if rates are on a secular rise, the value of the property should correct downwards.
Given this, the deployment actions of Berkshire Hathaway may show that their idea is interest rate is not going to go up for a prolong period of time.
John highlights that in a recent Berkshire Hathaway meeting, Buffett talks about the valuation of S&P 500 to be reasonable. The S&P 500 valuation then was at 22 times. If Buffett expects interest rate to rise, he wouldn’t have called 22 times as “reasonable”.
Thus we might have an idea how he looks at the longer term operating environment.
Berkshire’s Motivation in STORE Capital
We won’t know the real investment idea for STORE Capital, unless Berkshire held it long enough and people in there started talking about it.
We also won’t know this is whose idea (Warren or Todd Combs or Ted Weschler)
John and Hari have already explain perhaps they look at this investment as a bond.
Hari highlights that this might be a way for Berkshire to deploy their capital.
REIT is essentially taking in capital and then investing in short or long term assets. Their operation risk is that sometimes in the short term, they might not be able to rent out, or rent out well.
However, over time, given quality management with good competency, they should do ok, if the property is situated in an area of bright future.
The problem is that, in the times of tight credit, they might fail to find financing, be it equity or debt at reasonable rates.
This is where having Berkshire Hathaway or some reputed private equity firm’s borrowing and equity helps. It provides certainty.
The injection by firms such as Berkshire, Blackstone and Oaktree, firms that most know are more shrewd with their capital, also inevitably creates a Halo Effect over the REIT.
John highlights that this is not the first time Buffett have invested in a REIT. However, it is in contrast to his narrative.
Buffett have explained in the past that he prefers to own properties outright, as owning it through these structures, there will be slippage.
Yet he highlights in the 1990s that there is a change in tax, such that we can convert an S-Corp to a C-Corp, and pass the cash flow to the owners tax free if 95% of the income comes from real estate.
Buffett did purchase some of these REITs and sell off as the value rise.
Essentially, these could be like the preferential shares he subscribed to Goldman Sachs. They are a very good reward for the reasonable specification of business and risk they are getting themselves into.
Over time, they will sell off these stuff as the value rises.
It should also note that the current amount of $377 mil is a drop in the ocean for Berkshire Hathaway.
Oaktree Capital and STORE Capital
What is not part of the discussion is how STORE Capital came about.
In one of the news publication, there is a short article on the collaboration between STOR and Oaktree Capital.
Oaktree Capital, for those who are unfamiliar, is a giant alternative asset investment firm that focus on distressed asset. It is inevitably linked with its chairman and famed investor Howard Marks.
When you are in the distressed space, you need to assess risk, value much better than others.
Oaktree probably look at the partnership with STORE from a value perspective that the net lease segment exhibits more risks, but the risks are displayed out in the public and thus essentially is less risky.
And a fertile ground for hunting a good quality specification of asset at good prices.
It should also be pointed out that they decide to partner with someone who they are aware are genuinely experienced and have competency in this area (which again highlights one of the 3 important metrics when selecting a REIT for buy and hold)
One other note is that Oaktree at IPO exited this investment completely.
Basically this is a unlisted fund/trust exiting and getting returns by selling to listed fund.
The general thinking here is that the winner here is those in the unlisted fund.
This is often because private equity or funds are marketed with a good internal rate of return (IRR). This is the hurdle that the fund manager aims to hit, to exit the fund so that it is satisfactory for the investors in the fund.
This means that the asset listed during IPO, or sold to a listed REIT, are likely less to be valued.
The loser here is the shareholders who bought the listed REIT during IPO or at IPO prices.
This bears quite a fair bit of similarities to owners selling to REITs, developer sponsor selling to their listed REIT, and in recent days Cromwell Property’s IPO of Cromwell European REIT.
Berkshire Hathaway’s Purchase, in Context of Oaktree Capital’s Exit
The timing between Oaktree Capital’s exit and Berkshire Hathaway’s purchase is a 3 year difference.
STOR’s portfolio has grown in this period.
STOR IPO at $18.50. The placement price for Berkshire Hathaway is at $20.50.
If we are not talked about Oaktree and Berkshire, the inference may be the one who subscribe to the placement is buying something dear.
Oaktree and Berkshire are both based on value approaches. But Oaktree’s sale is a matter of mandate, rather than long term value.
Berkshire purchase, whether it is they are seeing it as a bond place holder, or speculative, points that they do see price below intrinsic value or with some margin of safety.
In most cases, IPO means its probably overpriced.
However, the devil is in the details. We can still gain a good return on our capital, or XIRR out of REITs (in this article, I highlighted some past internal rate of return (XIRR) of Singapore REITs).
The objective of this article is not to give you the idea that if Oaktree Capital, Berkshire Hathaway and investors like Hari is looking at REITs, then it is the right financial asset to invest in.
What we want to do is to listen about their considerations, what they think could go wrong, what kind of environment REITs can function well or poorly in.
And a lot is pretty similar to what I consider as the important metrics when selecting REIT to hold in a portfolio for longer horizon:
- Valuation versus the Current Price
- Good Management that showed sound capital management, ability to gain access to different capital, prospective tenants and prospective acquisition assets
- Property portfolio that is quality versus the current narrative
Overall, what is also important is given the nature of REIT as a financial asset, what is its role and objective in your wealth building strategy. That will guide your buy, sell and hold decisions, and how much you have of it.