A tale of two REITs

When it comes to real estate investment trusts (REITs), Jeff Sayer follows a blueprint.

He screens and ranks portfolio prospects based on their current and expected valuations, funds from operation (FFO) and adjusted funds from operation (AFFO). He also analyzes their growth and dividend yields.

Sayer, vice-president, portfolio manager at Ninepoint Partners in Toronto, says he and his team then use heat maps to corroborate their findings and find hidden gems. These maps indicate the price changes for the various sectors and countries.

“For example, if you imagine an X and Y axis, we have countries along one side and sectors on the other. What this allows you to do is see which countries and sectors are working and which aren’t from a price-return perspective,” he says.

Sayer says he’s currently underweight the U.S., overweight Canada, and well-exposed to Europe—and when geopolitical issues have cropped up, he’s used them as buying opportunities.

He’s taken a few chances on U.S. real estate despite the threat of rising interest rates—a typical headwind for REITs. Two of the key performance drivers in the space last year were the specialty and industrial sectors, he says.

Here’s how two recent U.S. picks worked out.

HIT: Equinix, Inc.(NASDAQ: EQIX)

Equinix is a California-based company that provides, among other offerings, interconnected data centres to tech giants including Amazon and Apple. Equinix caught Sayer’s eye in fall 2016, after it had become a REIT the previous year, and it passed Sayer’s screening tests with flying colours. “It had a high growth multiple, reasonable valuation and it [was] paying about a 2% dividend yield,” he says. Sayer classifies it as a specialty REIT.

The company had been busy in the meantime: it launched data centres across the globe in 2016 as part of an expansion plan, and had closed two acquisitions the year before. By August 2016, Equinix had announced two consecutive quarters of revenue increases after a solid 2015 performance.

Company stats

Equinix, Inc.

Ticker: NASDAQ: EQIX

HQ: Redwood City, Calif.

What: Multinational provider of data centres and co-locations, and a specialized REIT. Equinix supplies approximately 8,500 different companies and more than 190 data centres globally, across five continents and 22 countries.

Sayer’s first purchase price and sell price: Between US$350 and US$360 in October 2016. He began trimming after Dec. 6, when Equinix announced a US$3.6-billion deal with Verizon. His final sales of this round were in February 2017, at an average price of US$375.

Sayer’s second purchase price: He started rebuilding the position after Equinix completed its equity deal on March 8, 2017 and closed at US$363.43—the company issued an additional 6.1 million shares at US$360 per share, for total proceeds of almost US$2.2 billion. Sayer started buying soon after that.

Current price: A close of US$409.88 on March 27.

MISS: GGP

Ticker: NYSE: GGP

HQ: Chicago, Ill.

What: Publicly traded REIT that invests in shopping centres and owns 125 retail properties in the U.S., across 40 states. In early November 2017, Brookfield Asset Management, which owned 34% of GGP at that time, started preliminary takeover discussions. A US$14.8-billion bid was rejected in December 2017, but a new deal reported as worth nearly US$15 billion, which valued GGP’s stock at US$23.50, was accepted on March 26.

Sayer’s purchase price: Average of US$24 in late October 2016.

Current price: A close of US$20.08 on March 27.

Sayer was convinced. He started buying Equinix in mid-October and added more shares for the next month or two. Between Oct. 11 and mid-December of 2016, the stock increased from US$352 to nearly US$358.

“Our original position was bought at a cost below US$360 per share. We liked it and held the position, and were seeing some good returns out of it,” he says.

Turning point

On Dec. 6, 2016, Equinix announced it was buying 24 data centre sites from Verizon Communications for US$3.6 billion. That gave Sayer pause.

It was a “very significant buy that was going to be accretive, but we could tell from their debt-to-EBITDA ratios that there was likely to be an equity issue coming,” he says.

“In the company’s corporate presentations, you could see that [those ratios] had moved to about 4.0 times once the deal was looking to close, and that was at the very upper end of its targeted range of between 3.0 and 4.0 times,” he adds. “In the presentations, [management] also suggested that permanent financing would be put in place once the deal closed, or between the signing and the closure.”

As a result, Sayer started trimming the position and, by February 2017, had dropped Equinix entirely. The final sale “was done at an average price of US$375 per share,” he says, but “we traded all the way up to US$385 per share. It was a reasonably good pass in that short time,” leading to a reasonable return over his original purchase price.

The story doesn’t end there. On March 8 of that year, Equinix offered 6.1 million common shares at US$360 for potential proceeds of more than US$2.1 billion to finance the Verizon acquisition.

“Once that deal hit the tape, we began rebuilding our position in Equinix,” Sayer says, since the purchase was complete and “here wasn’t any funding or financing risk.” Soon after March 8, when the stock hit a closing low of US$363.43, he starting buying it. The average cost of those buys was “higher than on the day of the stock deal but still at a reasonably attractive price,” he says. In March, the stock rose from US$377.99 to US$400.37, despite its dip early in the month.

For the rest of 2017, Sayer wasn’t worried about rising U.S. interest rates. Even through 2017’s three hikes (in March, June and December), Sayer says Equinix’s positives were enough to ease macro concerns. “We were expecting 20% revenue growth, almost 30% FFO growth and about 23% AFFO growth for the year, and those were extremely attractive growth metrics,” he says.

In mid-February 2018, the company reported 21% year-over-year growth for 2017, along with AFFO growth of 33%. It also reported adjusted EBITDA of 47% for all of 2017 and, between Q4 2016 and 2017, 29% growth—all was in line with Sayer’s expectations.

Result

Sayer doesn’t plan to drop Equinix again. On March 27, 2018, the REIT’s stock closed at US$409.88, which is above the price at which he started buying it the second time.

Still, he says, the company is “on the growthier side of the real estate space.” He’s monitoring quarterly to make sure it’s maintaining above-average growth.

The company’s guidance for 2018 is calling for 15% revenue growth, and 14% AFFO growth, “which is significantly better than the overall sector,” says Sayer.

MISS: GGP (NYSE: GGP)

Near the end of 2016, avoiding the U.S. retail space seemed wise, says Sayer. “It was facing pressure from Amazon and the sentiment was terrible, with bricks-and-mortar retail under pressure.”

That led him to be underweight in U.S. retail REITs, though he “didn’t want to be completely unexposed to the retail space,” he says. In particular, Class A properties—generally defined as properties built within the last 15 years that have high-quality amenities and/or wealthy tenants—were becoming destinations in the U.S. and elsewhere.

Sayer expected those properties would hold their value better than Class B and C properties. So he chose to invest in GGP, formerly General Growth Properties, Inc. (GGP), a REIT that owns, leases and redevelops what it refers to as high-quality retail properties.

Out of 126 properties that GGP held in 2017, Sayer estimated about 75 were Class A. Further, GGP had, and continues to have, a powerful player in its corner: in Q3 2017, Brookfield Asset Management upped its stake in GGP to 34%, from 29%, by exercising all of its outstanding warrants.

“When you have a very large, well-funded parent company holding the number two mall operator in the U.S., you feel comfortable in your decision to buy that REIT,” says Sayer.

He added to the GGP position that already existed in the Ninepoint Global Real Estate Fund that his firm manages (the same fund that holds Equinix). In total, the fund holds only 30 names.

While there was a “tiny position on GGP, we liked it and thought it was going to be the one name that we were going to buy in the U.S. REIT sector,” says Sayer. In late October 2016, “we increased the weighting to about a 2% position immediately, at an average cost of about US$24 per share.”

Turning point

One year later, the situation had changed. Throughout 2017, GGP’s stock had largely remained below Sayer’s average purchase price.

There was, however, a significant rise in its trading volume on Nov. 7, and the stock closed at US$22.20—up from its close of US$19.01 a day earlier.

That was because news broke that Brookfield Property Partners had begun early talks to take over the remaining 66% stake of GGP that it didn’t yet own—and it planned to take GGP private.

GGP confirmed Brookfield’s takeover bid on Nov. 13, when it was reported that Brookfield was offering US$14.8 billion, or about US$23 per share. The good news, says Sayer, was the offer “represented about a 21% premium to where the shares of GGP had closed on Nov. 6,” meaning Brookfield was valuing GGP closer to Sayer’s own net asset value call of between US$27 and US$28—higher than what was being reflected in the market prior to the bid.

“When the news came out, we actually took our position up,” says Sayer. “We were buying on the news of a pending deal because we believed that the takeover would be concluded, and that there was a high probability the bid would be increased.”

Sayer held that view based on Brookfield’s past bids for real estate entities, where he says the initial bids have often come in at a discount before being bumped up by around 9%.

If that were to happen with GGP, it would imply a price of US$24.80 to about US$25.30 per share, “which would make our GGP investment of US$24 profitable.”

In early December, media reports said GGP’s special committee rejected the US$23 bid. However, “there was never an official announcement from the company,” says Sayer, so he was confident that the negotiations would continue and conclude.

Result

The deal came through on March 26. Brookfield offered US$23.50 per share (up from the US$23 offer in November) and US$9.25 billion in cash (up from US$7.4 billion) to gain control of the two-thirds of GGP it doesn’t own. Bloomberg values the deal at nearly US$15 billion.

On March 27, GGP’s stock closed at US$20.08. While Sayer bought GGP at an average price of US$24, hoping it would rise to US$28, he’s not disappointed in the company. “If you look at GGP relative to the benchmark, or GGP relative to [Brookfield] from the date the deal was announced to today, GGP has outperformed by a wide margin,” he says, despite a near-term real estate correction.

GGP will be delisted when the deal closes, which is expected to happen early in the third quarter, so Sayer will no longer hold it. Shareholders will be able to either take cash (US$23.50 per share), Brookfield shares, or shares in a new REIT Brookfield is offering (BPY U.S. REIT). The deal is subject to proration, Sayer says, with the cash-to-stock ratio at 61% to 39%.

He’ll watch how Brookfield trades over the next few days or weeks before deciding what to do. A rally “would actually make the deal more attractive from a GGP shareholder perspective,” he says.

Unless that happens, he says he agrees “with what seems to be the market’s disappointment” with the deal as announced, since it doesn’t account for the slide in Brookfield’s units since November. Like GGP, Brookfield closed lower on March 27 at US$19.19, compared to trading around US$23 in November.

Real estate definitions

FFO (funds from operations) and adjusted FFO (AFFO): In addition to International Financial Reporting Standards, REITs use FFO and AFFO to measure financial performance. The Real Property Association of Canada suggests calculating FFO by taking the IFRS-defined profit or loss and adjusting for 20 non-cash accruals (e.g., depreciation, non-cash taxes, realized and unrealized gains and losses, and goodwill impairments). AFFO takes FFO and adjusts for items such as capital expenditures and leasing costs. AFFO is considered a better proxy for cash flows than FFO.

Class A, B and C properties: Class A properties tend to have high-quality amenities, wealthy tenants and low vacancy rates, while Class B and C properties are older buildings that may not be professionally managed; rental income is lower, as is the quality of amenities.

Retail sales per square foot: One metric used to evaluate the quality of both publicly and privately owned real estate.

Net asset value (NAV) of a REIT: The book value of a REIT, as determined by the fair value of the property portfolio less debt. A REIT can trade at a discount or premium to the NAV.

Sources: Real Property Association of Canada; “Insights on the Retail Real Estate Sector” by Brookfield