Robert Ruggirello, CFA is the Managing Director of Brave Eagle Wealth Management, a NY-based Registered Investment Advisor. We emailed with Robert about when to adjust FFO/AFFO figures, what factors receive too much investor attention and overcoming behavioral biases.
Seeking Alpha: How do you determine from a qualitative and quantitative standpoint what the market is missing in a stock, as you did this very successfully for Gramercy Property Trust (NYSE:GPT), which was acquired by Blackstone?
Robert Ruggirello, CFA: We start with the basic assumption that the stock is priced right. From a quantitative perspective, we try to extract what’s priced in, i.e., we solve for the expected growth rate given the current market price. Then we can compare our expectations vs. what we think market expectations are and this informs us to potential mispricings. Qualitatively we try to identify the driver of the mispricing. With regard to Gramercy, we estimated a very low growth rate priced in by the market and thought the company would grow at a higher rate.
After a tremendous amount of due diligence, we identified a very high-quality asset portfolio, in a sector with powerful tailwinds, and a strong management team, trading at a discount to NAV with a low implied growth rate. We couldn’t identify any logical reason for the stock to trade at such a discount. The fast pace of acquisitions and dispositions to reposition to an industrial REIT, along with the firm’s JVs, and non-relevant historical financial statements made the analysis complex. We were able to benefit from this complexity.
SA: Are there any industries or companies that stand out as likely targets for consolidation in the REIT space?
RR: I think we could see another acquisition in the Industrial sector. Industrial is in high demand given what appears to be a long-term secular runway of growth for e-commerce. At this point in the cycle, most of the public REITS are focusing on primary markets, recently illustrated by the announced Prologis (NYSE:PLD) acquisition of DCT. In my opinion Terreno (NYSE:TRNO) and Rexford (NYSE:REXR) are the most likely acquisition targets for public or private investors looking to tilt their exposure towards high demand last-mile locations. Both firms have asset portfolios surrounded by strong demographics (see my most recent article on Terreno) in infill locations.
We may also see a mall or shopping center acquisition if an acquirer sees a deep value opportunity. It will be interesting to see if Brookfield’s offer for General Growth Properties (NYSE:GGP) is accepted by shareholders.
SA: Can you walk us through the different ways you value REITs, including the advantages and disadvantages of each approach?
RR: We use cash flow valuation to estimate intrinsic value for any business including REITS. The advantage to cash flow valuation is that any stock is worth the present value of the cash flow to equity owners. The disadvantage is the difficulty in estimating the inputs, we address this by creating a valuation range using scenario analysis.
We also use a net asset value (NAV) analysis that estimates balance sheet items at market value. The advantage of this is that we can estimate the value of real estate using private market comps. The disadvantage is that the cap rate estimates that are required are just a rough estimate.
It is impossible to visit every building and assign an appropriate cap rate to it, even if we could, it would still be an estimate. Further, a cap rate contains discount rate and growth estimates, so in using cap rates, investors are indirectly making the same estimates necessary for a cash flow valuation. We prefer to create a range here as well, using best and worst-case cap rate estimates.
In the case of the Gramercy, the cash flow and NAV valuations were extraordinarily close. This gave us confidence in the valuation.
SA: FFO/AFFO are key metrics for evaluating REITs but you note instances where investors should disregard them – can you explain?
RR: There are several adjustments made to FFO, but by far, the most important is the add-back of depreciation. This is a huge assumption and only works if the properties aren’t depreciating. For example, investors using FFO to measure earnings for mall REITS need to revisit if this is a valid assumption. If malls have been depreciating in value, which the market is implying in stock prices, then investors and analysts have been vastly overstating earnings (FFO).
AFFO is mostly used as a cash flow metric. The problem is that it is not standardized, and company management has discretion to include or exclude certain items. Some companies go further and calculate Cash Available for Distribution or Funds Available for Distribution, CAD and FAD, respectively. If AFFO is cash flow then what is CAD and FAD and why are they necessary? If CAD or FAD is cash flow, then what is AFFO?
Investors using FFO should consider the depreciation assumption. Investors using AFFO should understand what is included and excluded to analyze if it is really free cash flow.
SA: For REITs, what factors do you think receive too much – and too little – attention by investors?
RR: There is far too much focus on yield. Companies declare dividends, but the market assigns the yield. High yields usually result from high risk, low growth, or a combination of the two. We believe a total return approach that is cognizant of yield is a superior approach.
RR: When a stock declines in value, investors often use heuristics like “back up the truck” and “double down.” This is quite dangerous and assumes that the market is always wrong. This could be a demonstration of overconfidence bias. Investors should always revisit their investment thesis to see if it is still valid and consider if they were wrong before investing more capital. This type of non-biased framework is a way for investors to avoid behavioral biases.
We like to have a target allocation on a stock, we buy back to the allocation and trim back to the allocation depending on market movements. Academics theorize that this type of “constant rebalancing approach” may earn a premium for providing liquidity. We also have individual position maximums and sector caps. This helps to remove emotion from portfolio construction.
SA: What’s one of your highest conviction ideas right now?
RR: We recently became interested in American Homes 4 Rent (NYSE:AMH) and published on Seeking Alpha to alert investors to a serious insider buy from Wayne Hughes. After the article was published, Tamara Gustavson, the daughter of Wayne Hughes, made an even bigger purchase, and we made a small purchase a few days later. This insider buying is occurring with the stock trading at about 80% of sell-side analyst consensus NAV.
Based on our estimates, initial research indicates that given the current price, the market only expects cash flow growth between 2.5% and 3.3% using conservative equity discount rates in a range of 7.5%-8.25%, respectively. This appears to us to be a low hurdle rate given the lack of new supply and the high cost of home ownership relative to renting. Since the IPO general and administrative expenses and net property expenses as a percentage of revenue have decreased to levels in-line with multi-family REITS, driving margins higher. The capital structure is appropriate, and the management team has a strong pedigree.
To summarize, you have strong insider ownership with buying at current prices, low short interest of approximately 2.2%, a low implied growth hurdle rate, and margin expansion in a sector with favorable supply and demand dynamics. We plan on writing a Seeking Alpha-dedicated article on AMH.
Thanks to Robert for the interview. If you’d like to check out or follow his work, you can find the profile here.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.
Additional disclosure: Check with individual articles or authors mentioned for their positions. Robert Ruggirello, CFA is long TRNO, GGP, AMH.