Published November/December 2013
In late August Taubman Centers (NYSE: TCO) announced a program to repurchase up to $200 million of its outstanding common stock. With REIT stocks trading well off their highs, many at very substantial discounts to estimated net asset value (NAV), will more REITs announce similar programs? Should they?
Because REITs must pay 90 percent of their pre-tax net income to shareholders each and every year, they cannot retain much of their earnings. And, yet, today’s REITs are active businesses, continually needing capital for growth. Sure, REITs can, and do, borrow; but, as we learned in 2008-2009, debt leverage has its limits. Furthermore, equity capital is sometimes prohibitively expensive, and property sales are often counterproductive. Accordingly, the use of equity capital has always been a major focal point for REIT investors.
REIT organizations deploy their earnings in a number of ways, including dividend payments, property acquisitions, developments and debt reduction. But buying in company shares may, at times, be the best use of precious capital. This is standard fare at non-REIT companies (albeit with uneven success), but REITs don’t often avail themselves of this practice. Should they do more of it?
Whether REIT stock buybacks are the best use of equity capital is a complex issue. An obvious principle is, “buybacks are smart when they produce the best returns on a REIT’s capital.” But determining “best” is problematic – future returns are always uncertain.
"The use of equity capital has always been a major focal point for REIT investors."
Consider a REIT with a 45 percent debt-leverage ratio, where its shares are trading at a 15 percent discount to its estimated NAV. Should it be conservative and use available retained earnings to reduce debt? Or is acquiring properties in its markets or in promising new markets a better use? Or should the company develop new properties that are expected to provide a stabilized initial yield well above existing cap rates for similar properties in the same markets? Or is buying in shares the best alternative?
Let’s add another dimension and consider risk-adjusted returns. Reducing debt is riskless, and it may augment the market value of the REIT’s outstanding shares – investors are often willing to pay a valuation premium for a less-levered REIT. Property acquisitions entail only modest risk – unless property values are about to decline. Development, of course, offers greater rewards, but comes with significantly more risk. And stock buybacks at prices below NAV create immediate NAV accretion – unless NAV declines because of market forces beyond the REIT’s control.
Thus, it would seem that the wisdom of any capital deployment choice is only as good as the REIT’s risk and return assumptions. And those, in turn, can be proven erroneous by poor execution or by unforeseen changes in the space and capital markets. Just as investing, itself, is more art than science, we must recognize that determining the “best” risk-adjusted returns on invested capital will always be an educated guess.
So, there is no free lunch. Each use of capital has its own unique risk and potential reward profile. Accordingly, REITs might seek to determine the kinds of investment returns that their shareholders are seeking and how much risk they are willing to assume. Existing and future space and capital market conditions affecting acquisitions and developments should also play an important role in such decisions. How cheap – or expensive – are debt and equity capital, and what’s the trend? How debt-levered is the REIT, and how large is the NAV discount at which shares can be repurchased?
In short, there are plenty of trade-offs and no certainty. I can only state the obvious: Investors will award higher valuations to those REITs that consistently allocate capital, through whatever means, to create the most shareholder value with the least risk.
Ralph Block is the author of “Investing in REITs” and “The Essential REIT” blog. Views expressed are solely those of the author.