By Jim Luckett, Ph.D., economics
If you want to invest in REIT preferred stocks, as suggested by Ralph Block in the accompanying article, then you’ll need the information below about risks, returns, call provisions and how to trade these odd ducks.
First some basics: Read more…
Being overly optimistic doing the numbers for a planned rental housing investment is like taking off for a trans-atlantic flight with too little fuel in the tank.
Rental housing is a long-term investment. Once you’ve built it or bought it, you’re committed. If you didn’t budget realistically at the outset, when you discover that fact your alternatives won’t be good. This is a detailed how-to article for developers or investors.
As we go through the steps below, bear in mind that the pressure to cut corners will be immenses from the worser angels of your nature and from people you deal with in connection with the transaction. I’m going to be the angel sitting on your right shoulder saying “scale back your revenue assumptions,” and “increase your expense projections” and “don’t underestimate future capital needs.”
Your own eagerness to do the deal, the broker trying to sell you the building, and/or the public funding sources you seek subsidy from (if applicable) will be whispering in your other ear: “Don’t listen to that old fuddy-duddy. This baby is a gusher. Your numbers are too conservative. Increase your debt level.”
The goal of doing the numbers is to predict your bottom line. To know your future annual profit or loss, you need to predict your potential gross revenue, and then subtract:
- vacancy loss,
- collection loss (deadbeats),
- promotional discounts on rent (“concessions”),
- operating expenses (accounting, admin, legal, repairs, maintenance, cleaning, utilities, taxes, etc.) ,
- mortgage payment and
- recurring capital expenditures.
And then each of the above have to be projected far into the future, going 15, 20 or even 30 years out. With each step in this process, there is the opportunity to sow the seeds of your own destruction. The opiate of excess optimism will be urged upon you at every turn. Don’t smoke that stuff!
Gross Potential Rent
The top line in your pro forma is the revenue you would earn in the nirvana world in which every apartment was occupied every month, you gave no concessions (discounts) to entice tenants in, every tenant paid the rent and every rent subsidy source paid the subsidy. (This article is for both subsidized and unsubsidized housing projects.) That world does not exist, but we’ll subtract the vacancy and collection losses and discounts in the next 3 steps. Right now, let’s focus on getting a realistic projection for potential.
The arithmetic of calculating gross potential rent is easy: Just add up the rents on every apartment. But what will those rent levels really be? Here is your first opportunity for self-deception.
[More to Come -- This is a Work in Progress. One of the issues I will address is the chronic underestimating of future capital needs -- big expenditures for things that last more than a few years, like carpet, roofs, counter tops, etc. Throughout the rental housing industry, and indeed throughout commercial real estate, this is a prime area for self deception. During my 27-year career the rule of thumb for budgeting capital needs, sometimes called replacement reserve, went from $275 per unit per year to $360 per unit per year. In other words, from one inadequate figure to another inadequate figure and even if you believed $275 was right in 1983 how could you then believe it would be only $360 27 years later given what has taken place with inflation in that time period? Every responsible actual study of the future capital needs of an actual housing project that I have seen has returned an estimate above $600 per unit per year. And, wall street analysts have finally caught onto this issue now that there are a substantial number of publicly-traded apartment owning companies. Wall Street calculates a figure called "adjusted funds from operations" which, roughly speaking is cash flow available to support dividends or expansion of the company after meeting all expenses and deficit and doing everything you should to maintain and update your existing properties so they don't lose value. The apartment companies had always suggested a figure in the $300 area for recurring capital needs, and then every year was an exception. Capital needs just happened to exceed $300/unit because bla, bla, bla but that won't happen again. The analysts caught on and started coming up with their own allowance for routine capital needs based on the actual spending history of each firm and they tend to be in the $600 area or even higher, as of last time I checked. I have seen perfectly good housing development where the right figure was north of $1,000 per unit per year, based on a careful analysis done system by system and building by building. The drivers of this high figure were the fact that the development has large units, with carpeting rather than more durable floor finishes like wood, and exterior siding and trim that required periodic repainting, which is very expensive.]
If you are eager to see the completion of this article, give me a nudge using the comment box below or my direct email address at Jim@SailboatsToGo.com. Thanks for your interest.
The story of how well-intenioned public policy and greed destroyed the Jewish community in Grove Hall. Highly recommended by Jim Luckett. Click in the box below to read more (you are not committing to buy)
By Jim Luckett, Ph.D., Economics
It amazes me that people will clip coupons to save 35 cents on a roll of toilet paper and then waste hundreds or even thousands of dollars on fees and commissions when they invest. Why? Could be:
(a) they don’t see these costs, and/or
(b) they believe the myth that you get what you pay for (not true in investing) and/or
(c) they see the fee but since it’s expressed as a tiny percentage like 1.5% they think it’s trivial.
Look for the fees: Before you buy a mutual fund, for example, find out the “load” and the annual operating expense. These have tobe prominently disclosed. The load is a sales charge. It should be zero (see next paragraph), but often it is not. The load may take a slice of your money going into the fund, or a slice when you
by Ralph Block
[Note: The following essay, written some time ago, has been modified and updated for QuickReference.Info as of January 2011. Ralph Block is an expert REIT investor and author of several books on the subject.]
A couple of years ago Andrew Bary wrote an article in Barron’s about preferred stocks – specifically those issued by financial institutions, e.g., Bank of American, Citigroup and others. The essence of his article, entitled “It Only Looks Like a Wipeout,” (Barron’s, February 9, 2009), was that many banks’ preferred stocks, while not without risk, “appear to offer an attractive alternative to the banks’ common shares, owing to super-high yields and a higher standing in their capital structures.”
Mr. Bary has written about REITs on occasion. But they are not his specialty, and he made no mention of REIT preferreds in his article. I, on the other hand, spend many of my waking hours – perhaps too many – on REITs and the REIT industry. Furthermore, commencing several years ago, I became a big fan of REIT preferreds. At a time when many chastened investors are looking for yield, perhaps a brief discussion of these income stocks might be of interest.
REIT common stocks have long been odd ducks. Are they equities or real estate? Are they owned for income, or for total returns? Should their investors look at GAAP net income, or supplemental measures such as “FFO,” “AFFO,” and “CAD?” How do we value them – like other equities, or on the basis of their net asset values? Are they interest-rate sensitive, or economy-sensitive?
In many ways REIT preferred stocks are even odder ducks. They are not debt obligations of a REIT, and thus are junior to REIT debt, but are senior to REIT common stock (with respect to dividends and liquidation preferences). At times their prices are interest rate-sensitive, but not at others. As there is no maturity date, unlike bonds, there is no “date certain” at which our investments must be repaid to us. They are quite illiquid, and must be bought with the care that Sammy, my Golden Retriever, uses when walking near the neighborhood pit bull. They bear high dividend yields, but have little capital appreciation potential. (continued below the link)
Many REIT preferreds today are intriguing investments, due to their substantial current dividend yields, ranging from 7% to 8%. These yields are higher than all but the junkiest of junk bonds. Some lesser quality preferred issues yield even more. There is a yield for every risk appetite. These current returns are very competitive with the total returns we should reasonably expect from REIT common shares or, indeed, from large- and small-cap equities. And they offer greater protection from deteriorating cash flows if space markets weaken again. They are also less volatile than REIT commons, making for a good investment soporific when markets are volatile.
As many REIT preferreds today trade at prices close to, and some even in excess of, their call prices (normally $25/share), we need to be aware that they may be called away from us and extinguishing our dividend streams at inopportune times. On the other hand, they also trade at healthy spreads and risk premiums over the yields on US Treasury notes and bonds; this is (continued on page 2)
Here are some tips on how to shop Amazon that could get you a better deal. We’re going to post some links to Amazon to illustrate the points and you are free to click on them to see what I’m talking about. You won’t actually be buying anything, though you could if you decide to:
Trick #1) Get over the free-shipping goal line. Sometimes you need a $1 or even just a 1-cent item to get your order over $25 so your order total qualifies for free shipping. For example, Adding a $1 item to a $24.99 order could save you say $8 on shipping, so you have a net gain of $7, even if the $1 item is worthless to you. (Note: Not all items on Amazon qualify for free shipping or count toward the $25 but most do and the info on whether an item does is always disclosed by the phrase “Eligible for FREE Super Saver Shipping “). Read more…