REITs: Internal Vs. External Growth
Summary
- Two ways REITs can raise cash for investment are by selling stock or by retaining earnings.
- Each can, in the right circumstances, produce a large rate of growth.
- Too often ignored are the risks of growth fueled by issuing shares and the opportunity to grow enabled by retaining earnings.
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During the research for my most recent article on EPR Properties (EPR), I found myself impressed with their transition in business model across the pandemic. They are now driving growth of cash earnings based on retained earnings and rent growth.
EPR transitioned from retaining 5% of Funds From Operations, or FFO, to retaining more than 30%. What seemed remarkable was that their post-pandemic model supports a 6% growth rate of cash earnings, which is a stellar number for any REIT.
That high rate of growth is before headwinds, which do exist and often will. But it motivated me to focus more broadly on the tradeoffs between growth using the sale of stock and growth using retained earnings and rent increases.
That led to this rather theoretical article.
At least it has lots of pictures (well, graphics). I worked hard to make the math simple and transparent, but if you find the going too tough, skip down to those.
Types of Growth of Cash Earnings
In detail, net cash earnings must be thoughtfully considered. For REITs with very simple financials, such as National Retail Properties (NNN), one finds Cash from Operations, or CfO, comparable to FFO and to Adjusted FFO, or AFFO. But even AFFO, which is supposed to be the best measure, can mislead for many REITs.
The present article will not split hairs on these distinctions, instead writing in terms of cash earnings. When you are lucky, this is AFFO.
It seems to me that authors on REITs overall write in confusing ways about the types of growth of cash earnings. Let’s take a systematic look at sources of growth. Here is my list.
- Internal growth (a.k.a. internally funded growth)
- ..... “Organic growth” from increased rents, involving no new properties
- ..... Growth using retained earnings to fund new properties
- ..... Growth using sale of properties to fund new properties (i.e., capital recycling)
- External growth (requires accessing capital markets)
- ..... Growth using sale of stock to fund new properties
Taking on Debt is not listed because REITs may take on debt in association with any of the other sources of growth. For any specific REIT, Debt over time tends to be in a fixed ratio to Total Assets.
Everyone seems to agree that growth based on increased rent can be described as organic growth, and we use that below. Everyone seems to agree that growth based on selling stock to raise capital is external growth.
But authors often do not mention retained earnings — a big mistake, as we will see below. They also often do not mention capital recycling, used to great effect by several Multifamily REITs in particular. And they often seem to think that what distinguishes external growth is whether or not one is buying (or building) properties.
This way of arranging things does not make sense to me. The increase in cash earnings per share is quite different for properties purchased with capital raised by selling stock than for properties purchased with capital from retained earnings or capital recycling.
To my mind the sensible way to distinguish types of growth is based on whether or not they require access to capital markets.
In the following we will ignore capital recycling because it would just add too much complexity. Maybe later.
As said above, the motivation here is Net Lease REITs, which do little capital recycling. We will compare as well to Shopping Center REITs, who tend to recycle little unless they are seriously reworking their portfolio.
In contrast, Multifamily REITs often do a lot of capital recycling. So we will leave them out.
Investment Yield
Both internal and external growth depend in part on the investment yield, defined as the cash earnings produced by an investment of new equity in properties. So we take that up first.
Any REIT has revenues and property expenses that net to give Net Operating Income, or NOI. But NOI does not include various costs that reduce the net cash earnings to the owners, such as General & Administrative costs, recurring capex, and interest expenses. We first seek the ratio of Cash Earnings to NOI, which we will call CashToNOI. Here and below the boxes shaded blue convey the main point.
CashToNOI is a slight generalization of what I have previously called the V-factor, devised by Chris Volk.
One may have to do some work to determine the actual Cash Costs for specific cases. Even so, there is a significant difference in Cash Costs between the Net Lease sector and the sectors that operate properties. There are some differences amongst the REITs within each sector; we will ignore these here.
The Net Lease sector has quite small Cash Costs. We will use 7% of NOI as a representative value for the Cash Costs for this sector.
The Shopping Center REITs have a much larger fraction of NOI as Cash Costs, mainly from recurring capex. (Property taxes are generally included as part of property expenses and so have been taken out of NOI.) We will use 15% as the ratio of Cash Costs to NOI.
The ratio of interest expenses to NOI or InterestFraction, does vary with the REIT sector and the individual REIT, but tends to be in between 20% and 30%. The easiest calculation depends on whether one is looking backward or forward. Looking backward, one can take the interest expenses from the 10-K and the NOI. Looking forward, it works better to use Interest Rate, Cap Rate, and Debt Ratio as shown.
As mentioned above, I treat debt as riding along with new equity and not as independent. Most REITs target some level of their Debt Ratio (Debt to Total Assets), which changes little and slowly. We will use 40%, which is typical. We will consider interest rates and cap rates further below.
Once one knows CashToNOI, the cash yield of newly invested equity is straightforward. This is the bang for your buck on new capital that you invest.
The prefactor here is the ratio Cap Rate to equity fraction, where equity fraction is (1 - Debt Ratio). This ratio is also the ratio of NOI to new equity.
Multiplying that by CashToNOI, the ratio of cash earnings to NOI, gives you the ratio of cash earnings to new equity, which is the investment yield. This prepares us to look at internal growth and then at external growth.
Numerical example: Using 25% as the ratio of interest expenses to NOI, one gets a ratio of cash earnings to NOI of 68% for Net Lease REITs and 60% for Shopping Center REITs. For a Debt Ratio of 40%, one finds an Investment Yield of 7.4% for Net Lease REITs at a 6.5% Cap Rate and 5% for Shopping Center REITs at a 5% Cap Rate.
Internal Growth
What is meant here by internal growth is growth of cash earnings per share enabled by reinvesting retained earnings and by rent escalators, ignoring capital recycling as discussed above.
Here is the formula for the Internal Growth Rate. We will unpack it just below.
The first term on the right is quite simple. As an example, if we retain 30% of cash earnings and invest it at an investment yield of 10%, we increase cash earnings by 3%.
Now we turn to the organic earnings growth. What is known is most often the increase in rent as a percentage. As typical values, we will use 3% for Net Lease REITs and 4% for Shopping Center REITs, whose shorter leases enable faster adjustments.
(These numbers include a bit of a tailwind from inflationary rent adjustments when leases renew, a new element recently. There could be a much longer story here, but it does not seem worth going there today.)
This table shows the steps we will discuss going from escalation of rent to escalation of cash earnings. For specific REITs the results can be scaled by the escalator.
The third row (shaded orange) shows the ratio of NOI to rent for escalations. Assuming that the rent escalations are mostly inflationary, the property operating costs will also increase. The impact is a lot larger for REITs that operate properties and that pay property taxes.
Here based on looking at a few examples (and experience) we use 95% for the Net Lease REITs and 65% for the Shopping-Center REITs. The escalation of NOI is the product of the second and third rows in the table, shown in the fourth row (shaded blue).
But we are not done, as only a fraction of the new NOI adds to cash earnings. The escalation produces no new interest expenses. But the Cash Costs do increase.
We will use the ratios of Cash Costs to NOI discussed above, seen in the fifth row (shaded gray). The final row then shows the fractional increase of cash earnings
Now we have all the pieces that make up internal growth. Let’s set some parameters and make some plots.
Numerical example: Now apply this to the example above. For Retained Earnings of 30% and 10%, the Net Lease REIT has an internal growth rate of 4.9% and 3.4%, respectively. For Retained Earnings of 30% and 10%, the Shopping Center REIT has an internal growth rate of 3.7% and 2.7%, respectively.
Graphics on Internal Growth
First we will compare internal growth rates for two Net Lease REITs under certain assumptions. These are notionally if not precisely EPR Properties (EPR) and Realty Income (O). Today they are operating under very different business models.
The Interest Rates and Cap Rates used for these REITs are representative, not specific at some time. The point will be that the change in the rough value of the numbers produces qualitative changes in behavior.
EPR is at the end of the spectrum with high cap rates. Between rent escalators and lease renewals, they correspond to the escalator shown in the table above. Realty Income has lower escalators in consequence of their focus on investment-grade tenants. I used a number 100 bps lower than the EPR value.
Here are the numbers in the models.
The rows labeled Current are based on recent filings and presentations. The rows shaded green are for Net Lease REITs. The notional numbers for EPR suppose that they face increased interest rates, for comparison.
[It seems worth noting here that the 6% Cap Rate for Realty Income is based on their current Investor Presentation. This average is smaller than the rates that Wolf Report, whose work I generally appreciate, quotes for a specific transaction.]
When we apply the above math and parameters, this is what we get for the internal growth possible to two Net Lease REITs:
Notable is that EPR used the pandemic to shift from an external-growth model to an internal-growth model. The result is that EPR can generate an earnings growth rate near 6% by retaining and reinvesting between 30% and 40% of cash earnings. Increases in interest rates have a relatively small impact on this.
This rate of increase is before various headwinds discussed in the article. The headwinds related to interest rates will impact both EPR and Realty Income to similar degrees. Those related to tenants will be worse for EPR.
In contrast to EPR, the growth rates Realty Income can produce from retained earnings are much smaller. Their retained earnings are small (near 10%) and they cannot increase this without cutting their sacrosanct dividend. The business model for Realty Income is almost entirely one of external growth in the sense defined above. We will look at that below.
Now consider Shopping Center REITs. Here is the plot.
There is some nuance here in the Cap Rate. The Cap Rate of 6.5% corresponds to what these REITs get from properties they develop.
In addition, when they buy properties, often at lower Cap Rates, such REITs often redevelop them or otherwise mark rents to market. This rapidly pushes the Cap Rate measured from current NOI and purchased price up to a larger value.
The case shown in blue, with lower Interest Rates and higher Cap Rate, represents that recent reality. As you can see, retaining 30% of cash earnings can get you an earnings growth rate above 4%.
Increased Interest Rates and lower Cap Rates decrease this (shown by the black line), but slowly. It would take a lot to push it down to 3% for large fractional Retained Earnings.
The bottom line is that Shopping Center REITs that can retain near 30% of cash earnings can grow earnings by 4%, give or take. Once again, this is before headwinds. This year the headwinds from Interest-Rate increases, often applied to Floating Rate Debt, have suppressed these earnings growth rates to near zero for many in this sector.
Within the sector, Regency Centers (REG) and Brixmor (BRX) have been running with high retained earnings. In contrast, Federal Realty (FRT) has not, and has been more dependent on access to capital markets.
A final point relating to Internal Growth is how often it is ignored. You can see above that the resulting growth rate can be large under some circumstances.
Note also that WACC (Weighted Average Cost of Capital) has nothing at all to do with growth achieved by retaining earnings and reinvesting the cash. The Interest Rate matters but is subsidiary, appearing only in the V-factor.
The implication is that those tables of WACC you find in many articles are telling an incomplete story. Looking good on such a table does not imply that a REIT can in fact grow faster.
External Growth
We now take up the other side of earnings growth for REITs. This is external growth that involves raising capital by selling stock.
The key to external growth is to buy something more cheaply than you sell it. In any business, doing that repeatedly will grow your net earnings. Here the “something” being bought and sold is cash earnings.
One can view capital recycling through this lens. But here we focus on doing the selling in the stock market.
The way a REIT sells cash earnings is by selling stock, The way it buys cash earnings is by buying (or developing) new properties. If this produces a net gain, then the REIT can issue stock to grow.
If you issue new stock that is 10% of your current shares outstanding, you sell 9% of the current earnings to the holders of those new shares. You also correspondingly dilute existing owners, which we must account for.
Here is how this fits together:
Previous articles, including this one, have discussed this relationship at some length. It is worth noting that the WACC appears nowhere here. The spread that matters is that between buying and selling cash earnings.
We can connect the YieldFromSales to other useful quantities and simplify the expression for the external growth rate. First we note that the ratio of cash earnings to stock price equals the ratio of the dividend yield to the payout fraction.
Knowing this and a bit of algebra lets us write the external growth rate in terms of the fraction of shares issued, Investment Yield, Dividend Yield, and fractional Retained Earnings, as follows:
Some graphics can show us how this goes. Here is one for our notional EPR, showing the dependence on Dividend Yield.
The Interest Rate and Cap Rate represent current values. The solid curve is for Retained Earnings of 5% and the dashed curve is for 30%.
What you see is that, at today’s Dividend Yield above 9%, EPR could not generate earnings growth by issuing stock and buying properties, even if their Retained Earnings were at their pre-pandemic level of 5%.
Then as the yield drops any growth depends on how large their Retained Earnings is. So for a 30% Retained Earnings, once the dividend drops below 7% accretive share issuance is possible.
[If you look at this plot more deeply, Dividend Yield and Retained Earnings are taken to be independent. In reality they may be linked.]
Now let’s look at a similar plot for a notional Realty Income:
Mainly because of their lower Cap Rate, Realty Income needs significantly lower Dividend Yield to be able to accretively issue shares. Historically, their Dividend Yield has often been below 4.5%. With their low Retained Earnings, this has usually supported accretive share issuance.
Now we can combine the external growth and internal growth to find the total growth rate of cash earnings. The new wrinkle is that the dilution from issuing shares also dilutes the internal growth. So we have:
This gives us another way to see the interplay of retained earnings and dividend yield in the impact on growth from share issuance. Here is the Total Earnings Growth for EPR:
In the pre-pandemic era EPR was running roughly at 5% Retained Earnings and a 6% Dividend Yield. The solid curve in the plot shows this case. During that period, issuing shares in modest quantities produced strong earnings growth.
EPR exploited that in the 2010s to generate such growth. Challenges related to tenants arose in the late 2010s and reduced the growth, as discussed in my recent article.
In contrast, post-pandemic EPR is running at more than 30% Retained Earnings and a 9% Dividend Yield. The dashed curve in the plot shows this case. Any share issuance today reduces their earnings growth.
The story is different for our notional Realty Income, shown here:
Realty Income has been running roughly 10% Retained Earnings and a 4.5% Dividend Yield. The solid curve in the plot shows that issuing shares in modest quantities produces earnings growth (though less than that of EPR from Retained Earnings).
However, the dashed curve shows that an increase in the Dividend Yield to 6% would kill the external growth model. Now if cap rates went up enough, the model might still work. But historically cap rates have moved much less than dividend yields and interest rates.
My view is that at some point the external growth model will break for REITs like this, whenever earnings multiples in the markets move back toward or below their long-term averages. (The only way this never happens is for earnings multiples to stay near historic highs indefinitely.)
At that point Realty Income will be genuinely stuck. They could maintain their dividend and grow it very slowly, so their shareholders steadily lost ground to inflation.
Or they could cut the dividend by about a quarter and put themselves on an internal growth path. This would enable them to generate total growth rates between 4% and 5%, based on the numbers above.
Here I am just picking on Realty Income because it is so beloved and nobody discusses this risk. There are a number of REITs who will face similar challenges whenever earnings multiples do drop significantly. And many retirees will have to live with the results.
What upsets me is that pretty much the same story applies to Federal Realty. I admire much about them and their CEO Don Woods. But their Dividend King status and high payout ratio has them pretty much stuck as well, unless increasing stock prices (or maybe capital recycling) bail them out.
Takeaways
The discussion above puts some quantitative meat on my long-standing preference for REITs running internal growth models. They are far more robust against variations in Dividend Yield (i.e., market pricing of the stock).
Internal growth, powered by rent increases, Retained Earnings, and capital recycling, can produce substantial earnings growth rates even when dividends are high. WACC has no relevance to this and therefore discussions based on WACC typically miss an important element of potential growth.
External growth, powered by the issuance of shares of stock, can produce substantial earnings growth rates only when the Dividend Yield is low enough. Ironically, having higher Retained Earnings (for a fixed Dividend Yield) reduces and may eliminate the possible growth. REITs cannot have their cake and eat it too beyond certain limits.
Articles emphasizing low WACC and making predictions of solid growth of earnings on that basis alone rarely emphasize the potential for that earnings growth to disappear. All it takes is for earnings multiples, such as P/FFO, to return to the values they had from early in this century to several decades earlier. Failure to discuss this risk seems significant to me.
Beyond that, few REIT articles actually address forward earnings growth. This seems to me a significant oversight. And those that do so, to some degree, often omit any contribution from Retained Earnings. This seems to me a larger oversight.
The investing implication is to always identify and think about the payout ratio on cash earnings (perhaps AFFO, often not FFO). Payout ratios are large when above 90% of cash earnings (which is often 80% of AFFO).
Any REIT with that large a payout ratio is riding the wrong side of the history of long-term variations in earnings multiples from the markets. Their ability to grow earnings without cutting their dividend is at the mercy of the stock market.
In my opinion, retirees should care about this a lot.
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This article was written by
Paul brings substantial experience in research, and in understanding and developing models of uncertain systems, from his decades working as a physicist. He wrote his first Monte Carlo model aimed at investments in 2006. He has intensively researched and modeled a wide variety of portfolio options. Among other degrees, he holds a doctorate in physics and a bachelors in philosophy. His career began with running large projects for a major research laboratory, and continued with a long, and award-winning run as a professor at the University of Michigan. He has authored nearly 300 articles published in formal academic journals, and two editions of a textbook.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of EPR either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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