The Price of Converting to REITs
Many listed property companies are converting or considering converting to real estate investment trusts (REITs) in South Africa since the April 1st new tax regime for list REITs was enacted. Other countries have gone down this road and one may ask as to how their share prices fared as a result of such action.
U.S.-listed real-estate investment trusts, or REITs, are on track to issue more new equity in the U.S. than in any year since 2001, according to Ipreo, a capital-markets data and advisory firm. REITs have raised $16.8 billion in U.S. IPOs and secondary stock sales so far in 2013, a pace that would top 2012’s record $36.6 billion.
During the last couple of years, REITs, aided by investors’ rabid appetite for income-producing investments, consistently have trumped the broad market. In 2011, while the S&P 500 was flat, the FTSE Nareit U.S. index jumped 4.3%. Last year the S&P was up 3.8%; the REIT index, 5.9%. No wonder, then, that companies in industries including digital-transmission towers, data warehouses, private prisons, and health-care facilities are seeking to convert to REIT status. And there are attractive opportunities to play this trend through the shares of companies likely to undergo a conversion.
In the US, for example, and much of the world follows the lead, a company seeking to become a REIT must satisfy two main criteria: It must derive at least 75% of its revenue from rents and other direct real-estate activities, and it must pay out at least 90% of its profits to shareholders as dividends. In return, those profits are untaxed at the company level, and the hope is that yield-focused investors will flock to the shares.
One of the most prominent conversions last year was American Tower, the leading owner of mobile-communication transmission towers, which moved to become a REIT soon after it had used up its tax-loss assets. The switch, effective last Dec. 31, immediately made American Tower the second-biggest publicly traded REIT. Its current market value is $26 billion. The stock gained 14.7% in 2011’s second half, after it started the conversion process, and last year added another 8%.
Now, American Tower’s smaller rival, SBA Communications (SBAC), is setting the stage for a conversion, already reporting adjusted funds from operations, or AFFO, as REITs do, alongside its usual operating-company results.
According to REIT commentators Online Barrons, Jeff Kolitch, portfolio manager at the Baron Real Estate Fund (BREFX), says that the average REIT fetches 22 times AFFO, a measure comparable to operating cash flow. At a recent price of around $50, SBA was trading at about 17 times this year’s forecast operating cash flow. At 22 times, the stock would be around $66.
Datacentre REITs are currently performing well and are popular among investors who are attracted by their high dividend pay-outs as well as by growing demand for datacentre real estate. The strength of the sector could push other datacentre companies to go public or adopt the REIT format. One example of this is Equinox, a company operating datacentres for the likes of AT&T and Amazon.
The following three datacentre REITs are good examples of REIT switching success stories;
• CoreSite Realty (COR), with market capitalization of $580 million, is most similar to CONE. COR is the smallest datacentre REIT, but its stock value has increased 33% since the end of October, and its dividend yield measures 3.6%.
• Digital Realty Trust (DLR) is the largest of the three data centre REITs with market capitalization of about $8.4 billion. Its stock value increased more than 16% since the end of October, and its dividend yield is 4.1%.
• DuPont Fabros Technology (DFT), with market capitalization of $1.5 billion, is the second largest data centre REIT. Its stock value grew 14.8% since the end of October, and its dividend yield measures 3.3%.
Finally Corrections Corp. of America converted to a REIT and is the nation’s largest operator of private prisons. The company operates 66 correctional and detention facilities, and has a total capacity of about 91,000 beds, yes, that’s real estate, in 20 states.
Correction Corp.’s funds from operations (FFO) per share, a key REIT cash flow metric, grew 7% to $2.34 in 2012 from $2.19 a year earlier. Corrections Corp. has provided guidance for a 16% rise in 2013 FFO per share to between $2.72 and $2.87. Some of this growth will likely come from a one-time tax benefit of between $115 million and $135 million from converting to a REIT. Corrections Corp. plans to pay quarterly dividends at an annualized per-share rate of $2.04 to $2.16 this year. At the mid-point of this range, shares yield almost 2%. In addition, the company will pay a special one-time dividend of at least $650 million to investors during 2013. The special dividend will be a combination of cash and stock.
The lofty valuations that REITs now command in the US might not be sustainable over the longer term, especially if interest rates rise, offering good alternative income investments. And the requirement that 90% of earnings be paid out to shareholders means earnings can’t be accumulated for future investment, necessitating that still-growing REITs sell equity or debt to buy or build additional properties. REIT conversions could boomerang down the road. But at the moment, the haste to be a part of the REIT club holds rewards for discerning investors.