Wednesday, June 30, 2010

Coverage Myopia
The broker / dealer community's focus on distribution coverage ratios is myopic.   Coverage ratios are important and a clear sign of a REIT's health, and a harbinger future distributions, but they are only a piece of a larger puzzle.  Most non-traded REITs have ideas to one day list on an exchange (or merge or even sell their portfolios outright).  If a REIT is going to list on an exchange and hold its value, not only does it need adequate distribution coverage, it needs growth in its Funds from Operations (FFO).  Broker / dealers need to expand their analysis and start looking at FFO growth in addition to distribution coverage ratios.  REITs are stocks, and stocks trade on future growth.  It is not enough to cover a distribution from operations, the distribution and underlying FFO needs to grow for a REIT to hold its value.

I know that many non-traded REITs have appalling coverage ratios that require immediate attention, and some coverage ratios are telegraphing unsustainable distributions.   But for REITs that are fully invested and have sufficient coverage ratios, FFO growth needs to be the focus.  A portfolio of properites with flat long-term leases may look appealing from a safety and coverage ratio standpoint, but over time a REIT with this type of portfolio will trade at a lower FFO multiple (and lower valuation) than a similar REIT that has lease rate growth.   

Another way to view FFO growth is to look at in context of a REIT's estimated time horizon.  A REIT that has a five-year window to list or pursue other liquidation options will likely extend the hold period without FFO growth.  This is because the market will discount this non-growth REIT.  Even the most avaricious REIT sponsor will think twice about listing a REIT that will trade at a significant comparative discount to its initial share price due to limited growth potential.

2 comments:

Kurt said...

Growth of FFO is a very important objective for any REIT. However, broker-dealer focus on dividend coverage is not irrational. First, a broker dealer must be satisfied that the price of the security being offered is reasonable; a history of dividends in excess of cash flows calls this assertion into questions. Second, consistent FFO shortfall versus dividends dilutes the net asset value per share, militating against any portfolio growth related to increasing FFO. Finally, dividend policy reflects on the prudence of management, and distributing more than is earned does not promote confidence. Taken together, these factors suggest that dividend coverage is a VERY effective and efficient screen in considering whether to sell or continue selling a REIT offering.

Rational Realist said...

I agree, a focus on FFO coverage is not irrational, but at some point, a REIT has to have growth in FFO or its share price will be discounted v. REITs that have FFO growth. Your comment on price is a HUGE can of worms and is topic all in itself. It is easy to to use an FFO multiple, like a P/E ratio, to figure out a price, but no non-traded REIT sponsor will like the resulting value.