A recent article about Senior Housing Property Trust (SNH) brought to the forefront the issue of depreciation and dividends in real estate investing. In my view, depreciation is a real expense, which is to say, it has significant economic substance. In some industries, assets can be depreciated for years with little in the way of maintenance capital expenditure needed, while in others the impact is felt more quickly. However, in all cases, the amount of yearly depreciation will roughly capture the deterioration of the asset in question and in return the reinvestment needs.
In the property world, capital expenditure can be quite lumpy and the cash generated by depreciation can be used for a number of years to service debt, pay dividends or reinvest in new properties. An example from my own professional experience is Tishman Speyer which owns property around the world, but has a strong focus on property in Washington D.C. Tishman used its D.C. properties as collateral to obtain a term loan and other financing in the late 2000s, in part to renovate certain properties, which had become outdated. Specifically, the property at 1730 Pennsylvania Avenue, originally completed in 1972, was renovated with a new façade and foyer. Without sharing the specific financial details of this renovation, it should be clear to most from the pictures that such a renovation was extremely expensive in relation to the historical cost of the building, not just in terms of construction costs but also lost rents. In essence, Tishman had used a very significant number of years of depreciation to "pay for" the renovation.
Further evidence can be found in the words of a CEO that should command a great deal of respect in his line of business: Steve Wynn of Wynn Resorts (WYNN). During the financial crisis of 2009, I began researching Wynn because its first mortgage bonds were trading at 80 cents on the dollar and looked like a good investment opportunity for the firm I was working for at the time. We ended up becoming investors and I began listening to the conference calls on a regular basis. Mr. Wynn gives great conference calls and never pulls any punches but I was fairly amazed when he started poking holes in the concept of EBITDA as it relates to casino companies, which are essentially just collections of property, especially when they have a hotel attached. From the 3Q09 conference call:
So many people on this call, our competitors who are on the call and the press focus so intensely on top line numbers, market share, EBITDA -- we forget for a moment with all the rhetoric that it doesn't really mean a thing. What matter is how much money is left. You've got to pay interest. You've really got to pay depreciation. In our business, the carpets wear out, the equipment has to be replaced. Depreciation is a real expense in our business and when you don't spend it, you are hawking the future. You are losing the kind of environment that gives these businesses their franchise.
REITs are not significantly different in most cases than casino companies. The expenses in each case will be different - some need to focus more on the exteriors of the buildings then the carpets, and like the prior example showed, in some cases the renovations are lumpy, while at a casino, the reinvestment is more frequent, but in either case it is real expense.
Digging deeper into Senior Housing, we can see that depreciation is a real expense for them as well. In my view, the company does not present its financial statements (2011 10-K) in a way that is friendly for investors, which makes digging out the information more difficult. Specifically, on the company's cash flow statement, it does not separate out capital expenditure on existing property from new acquisitions, instead calling them all "acquisitions" (Page F-6). However, the company disclosed that in relation to its short and long term residential communities, "Depreciation expense increased as a result of our purchase of approximately $65.2 million of improvements made to our properties" (Page 66). The company also discloses that this part of the business has $71 million of depreciation expense (63% of the total company's depreciation). Therefore, in 2011 the company essentially reinvested all the cash flow generated from depreciation, at least in this segment of the business, into maintaining the current properties. The prior year 10-K does not appear to have the same disclosure; therefore, it is difficult to know how lumpy the expenditure is, but with nearly 400 properties, the company will likely always need to be making investments in a subset of them.
Because Senior Housing pays out all its net income and depreciation in dividends, it has been issuing new debt and equity to pay for these capital expenditures on existing properties. Therefore, while investors are getting a 7.1% yield, they are trading cash flows to debt investors and being diluted by new equity to pay for these improvements (the company has done both in each of the last three years). REITs are not required to pay depreciation to equity holders. The company could just as well use the cash generated from depreciation to make these reinvestments in their property. Because we don't know the exact amount of capital expenditure made to existing properties, and in reality it would need to be a long-term average and subject to judgment as to how much is needed to keep the properties competitive, we cannot figure out the exact yield this would leave the company with. In my view, a sustainable dividend that did not require new equity or debt issuance would be in the mid-5% range.
However, there is nothing wrong with Senior Housing's financial policy with respect to its dividend. Many REITs make a similar level of payouts and rely on bringing in new capital to fund capital expenditure. In a sense, this gives investors more control of the company because they have a bigger say in the reinvestment of cash flows. However, the important part is that investors need to understand that a portion of the dividend needs to be reinvested in the business and it is not free and clear return.