Independence Realty Trust Is Poorly Structured, But The Value Is So Compelling

| About: Independence Realty (IRT)
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Summary

The external manager structure at IRT is a nightmare.

The fees paid to the advisor / manager are poorly designed.

The Core FFO calculations should be rejected by any decent analyst.

The adjusted value I find after recalculating Core FFO is still compelling.

Additions to the portfolio during later September and in the fourth quarter should drive FFO significantly higher.

Independence Realty Trust (NYSEMKT:IRT) is a very interesting apartment REIT. This one is a reader request, and I'll try to occasionally get reader requests done for companies that are lacking in coverage. There are a few things I found in my first inspection of the company that I believe should be very important to investors. I'll break each of those factors down in their own section.

External manager

If you've read several of my pieces on REITs, you may know how much I dislike the external manager structure. The structure is inherently conflicted and makes it more difficult for analysts and investors to get the information they should have when assessing the company. The benefit of the structure is that occasionally it creates a fairly clear cost structure which can be useful for forecasting. In my opinion, the cons outweigh the pros when considering a very long term investment.

IRT is utilizing an external manager structure, and it's a fairly complicated one. I spent a long time digging through several financial statements because occasionally important information was completely omitted from the statements.

I utilized the following documents:

10Q

10K

DEF-14A

All links go directly to the SEC database. Perhaps I'm being old school, but I like to go pull the original documents. I'll be talking about information from the 10Q and DEF-14A (aka the proxy statement). I opened the 10K looking for useful supporting information to the 10Q, but the information I wanted was either not available or not worded in a manner that would make it easy to cover.

Who is the external manager?

The external manager is a subsidiary of RAIT Financial Trust. RAIT is listed under the ticker (NYSE:RAS). As far as I can tell, there are multiple subsidiaries to RAIT which complicated issues. From reading the 10Q, you'll find that the external manager is RAIT and that there is an unnamed "Advisor". I thought surely the 10K would explain the relationship with the advisor, but it does not. The proxy statement lists the advisor on page four as being another subsidiary of RAIT.

In my opinion, the way the information was presented makes it deliberately harder to determine that RAS is effectively the manager and advisor to IRT.

How does the external manager get paid?

This is a question every investor should ask when they are considering investing in a REIT with an external manager. Understand what management is compensated to do and you will find yourself rarely surprised.

RAS gets paid (through a subsidiary) for several things.

Advisor fees

The advisor portion of RAS gets the management fee. I know, it seems like the management fee would be in the management agreement, but it is in the "advisory agreement" instead. The management fee is payable quarterly and equal to .1875% of gross real estate assets under management excluding the 8 properties that IRT owned prior to August 16th, 2013. Note that this says gross real estate assets, so depreciation is removed from the calculation. I don't mind depreciation being removed and I don't mind that the 8 properties that were already owned by IRT are excluded from the agreement, though I can find no clear rational for excluding those properties which are investments of IRT just like every other apartment building.

Because those 8 properties were excluded, they may inflate past operating results. When IRT grows, every new property pays this fee; therefore, new investments should be less profitable for shareholders than the first 8 investments.

The advisor is also paid an incentive fee. The incentive fee is equal to 20% of the amount that (pre-incentive fee) "Core FFO" exceeds 1.75% (quarterly) of "the cumulative gross proceeds from the issuance of equity securities we have obtained". Core-FFO is a non-GAAP measure; I'll come back to this later on.

Property manager fees

As a property manager RAS gets paid "property management and leasing fees on a monthly basis of an amount up to 4.0% of the gross revenues from the property for each month". I'm not a big fan of the standard property management agreement because those agreements can contain compensation structures that make it profitable for the property manager to see higher turnover rates of residents. I do not expect to ever be given access to the exact compensation structure agreed upon between IRT and RAS.

Non-competes clauses are non-existent

The CEO and chairman of IRT is also the CEO and chairman of RAS. I doubt the negotiations on the compensation structure were very intense.

Bad incentives

The structure of the agreements creates an immediate conflict of interests. The first major source of money for RAS is the fee on assets under management. That's a problem for shareholders. Whenever the company increases assets under management, compensation goes up. If the company issues shares at an unfavorable price and uses the proceeds to buy mediocre investment buildings, the fee still goes up. I'm not saying that management would do that, but it remains a very clear possibility under the existing agreement.

As a property manager, RAS gets paid again relative to gross revenues. The nature of the "leasing fees" is not disclosed, but may provide an incentive for management to create more new leases rather than keep existing renters. If you were buying rental properties on your own, you would place a very high importance on finding long term reliable renters that would occupy your property for several years. However, "leasing fees" provide property managers with an incentive to find short term residents so they can collect the fee more often. The individual investors in my circle have all been opposed to hiring a manager to handle their leasing activities because they wanted to avoid this problem.

Core FFO

Investors need to understand that Core FFO is a non-GAAP measure and should never be used in place of measures computed in accordance with GAAP. The definition and computation of Core FFO depends on who you ask, which immediately creates problems as Core FFO is not a comparable metric between companies.

Here is the description of Core FFO from the 10Q:

"Core FFO is a computation made by analysts and investors to measure a real estate company's operating performance by removing the effect of items that do not reflect ongoing property operations, including acquisition expenses, expensed costs related to the issuance of shares of our common stock, gains or losses on real estate transactions and equity-based compensation expenses, from the determination of FFO. We incur acquisition expenses in connection with acquisitions of real estate properties and expense those costs when incurred in accordance with U.S. GAAP. As these expenses are one-time and reflective of investing activities rather than operating performance, we add back these costs to FFO in determining Core FFO."

In my (professional) opinion, there is absolutely nothing about stock based compensation expense that is non-recurring. There is absolutely no rational basis in accounting or economics that would cause stock based compensation to be added back for any calculation. Stock-based compensation is every bit as real as paying compensation in cash and issuing new stock to recover the cash that was just paid to the manager.

Fortunately, stock-based compensation is a very small amount which is largely immaterial in the context of the financial statements. Generally, there is no need for stock-based compensation in an external management agreement because the management agreement already pays for the services of the manager.

Unfortunately, neither stock-based compensation expense nor executive compensation occurs as a line item on the income statement. It was lumped under "General and Administrative Expenses". As an analyst, I don't like that choice.

The Core FFO for the first 9 months was $.52 per share. The FFO for the first 9 months was $.60 per share. Given that Core FFO makes reasonable adjustments, except for stock-based compensation, I prefer looking at Core FFO minus stock-based compensation as a reasonable measure of the productivity of the company. On a per share basis, that amounts to $.50 per share. Annualized, that would be $0.665 cents per share. Because additional properties came on line in September and more are being added during the fourth quarter, I expect Core FFO minus stock-based compensation to be higher next year than this year.

Conclusion

The management structure is a very complex beast for any new investor to dig though. The payments in the agreements between RAS and IRT promote behavior that is not in the best interest of shareholders. However, the amount of FFO that can be produced on a per-share basis makes a very compelling case for IRT as an investment.

I'll do a little more digging and fundamental analysis on the company and see what I can find. The ratios for the company look very appealing for growth and the conflict between the great ratios and the poor structure leave me conflicted. I don't' believe that the buildings have depreciated. If I add back depreciation to the book value of equity, the resulting value is slightly above the current market price. Combine that with the strong FFO, and this is going to be an interesting stock.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.