The REIT Emperor has No Clothes
Introduction
To start this article I should fully disclose that I believe that the commercial real estate industry and the
REIT industry are systemically mispriced and therefore present opportunities to exploit the mispricing
and create above market returns. This article will address one REIT in particular but it is indicative of the
overall mispricing of the REIT industry.
Recent Parkway Stock Performance
Parkway Properties (ticker PKY) has been on an acquisition spree over the past several years and Wall
Street apparently has thought highly of this as the company’s stock outperformed the Vanguard all
equity REIT ETF (ticker VNQ) by 11.0% in the previous three months. As such, it is worth investigating the
source of this recent outperformance to determine if it is warranted.
1
REIT SG&A Expense
When a property is acquired by a REIT, there are non-property level expense that will be incurred which
are classified as SG&A expenses. These are equivalent to asset management fees for privately owned
real estate assets. We can get an estimate of what these expenses are as a percentage of the value of
the properties the REIT owns by looking at the historic ratio between the SG&A expense as a percentage
of the enterprise value of the REIT. Depicted below are the SG&A expense as a percentage of the
Enterprise Value of both Parkway and Highwoods for the previous 5 years. Highwoods is presented for
comparison purposes as it owns properties in many of the same markets that Parkway does. What we
see is that the SG&A expenses for both REITs have been similar and a reasonable estimate of future
SG&A expense is 75 bp of Enterprise value. What this means is that any property that is acquired will
cause a REIT to have an estimated marginal 75 bp of SG&A expense.
Enterprise Value
SG&A Expense
Year Parkway Highwoods Parkway % of EV Highwoods % of EV
2014
4,156
6,069
32.7
0.79%
36.2
0.60%
2013
4,114
6,224
25.7
0.62%
37.2
0.60%
2012
3,421
5,249
16.4
0.48%
37.4
0.71%
2011
1,951
4,566
18.8
0.96%
35.7
0.78%
2010
1,508
4,070
15.3
1.02%
33.0
0.81%
average
0.77%
0.70%
Capital Expenditures
One of the most overlooked factors that affects a property’s economic performance is the capital
required to maintain the property. For anyone who has ever owned a house, they will be familiar with
the expense associated with replacing a roof, the HVAC equipment other major capital expenses. Tucked
away in the statement of cash flows for Parkway is a line item called “Improvements to real estate”
which reflects the cash expenditure to replace buildings’ capital. In Highwoods’s statement of cash
flows, these are further broken down into “Investments in tenant improvements and deferred leasing
costs” and “Investments in building improvements.” This capital expenditure represents the economic
cost to sustain the operating income generated by the properties.
Shown below is the historical capital expenditures for both Parkway and Highwoods as a percentage of
the enterprise value of each REIT. We see that the capital expenditures on Highwoods’ properties has
been quite consistent over the past 5 years with an average of 2.44% of EV. Parkway’s capex as a
percentage of EV is not as consistent but it was largely effected by the significant jump in EV associated
with Parkway’s acquisition spree between 2012 and 2014. In these years, CapEx did not represent the
full year CapEx for the properties Parkway owned at the end of the year as the properties were acquired
mid-year so they are not considered to be accurate estimates of the CapEx required for their buildings.
However in 2010 and 2011, Parkway’s CapEx as a percentage of its EV was 2.41% and 2.14% respectively
during a period in which they were not significantly acquiring properties which is in line with Highwood’s
average over the past 5 years of 2.44%. Therefore a reasonable estimate of the capital required for
Parkway’s buildings going forward can be made at 2.4% of EV.
2
Enterprise Value
Building Capital Expenditures
Year Parkway Highwoods Parkway % of EV Highwoods % of EV
2014
4,156
6,069
52.6
1.26%
163.8
2.70%
2013
4,114
6,224
35.4
0.86%
156.4
2.51%
2012
3,421
5,249
25.6
0.75%
115.4
2.20%
2011
1,951
4,566
41.8
2.14%
103.2
2.26%
2010
1,508
4,070
36.3
2.41%
102.7
2.52%
average
1.49%
2.44%
Acquisitions
Parkway has been on an acquisition spree over the past several years as shown in the table below. In
addition to these property purchases, they merged with Thomas Property Group on December 20, 2013
which was estimated to be valued at $1.2B. The acquisitions are listed below along with the purchase
price, stated cap rate, and the date of the announcement.
Building
One Buckhead Plaza
Corporate Center I,II,III
Courvoisier Centre
BofA Center
JTB Center
Total
Purchase Price
Stated Cap Rate
157,000,000
5.50%
475,000,000
5.85%
145,800,000
4.50%
52,500,000
6.30%
33,300,000
8.30%
863,600,000
Announcement Date
30-Oct-14
22-Sep-14
10-Apr-14
6-Jan-14
6-Jan-14
5.68%
From our prior discussion of the economics of REIT ownership, we know that the REIT will incur an SG&A
expense of approximately 75 bp of their EV. If each of these properties were valued by the market at
their acquisition price, then the REIT would incur a marginal 75 bp SG&A expense which would lower the
income return from 5.68% at the property level to 4.93% net of the SG&A expense.
Next we would make an estimate of the marginal capital required to sustain each of these buildings. We
have shown that historically 2.4% of a REITs’ EV is spent on capital to replace worn capital items at
properties. Again in this instance, if each of the properties acquired were valued by the market at their
acquisition price, then the REIT would incur a marginal capital cost of 2.4% of the acquired property. So
for properties acquired at a 5.68% cap rate, the REIT would need to put 2.4% of the value of the
property back into the property each year. If the property sells for the same price a year later but 2.4%
of the value of the building were spent in capital costs, the building would incur a 2.4% capital loss.
If we combine the SG&A costs with the capital costs, Parkway has acquired buildings that will create an
estimated 4.93% income return net of SG&A and an estimated 2.4% capital loss if there is no change in
NOI or cap rate movement or a total return of 2.53%. Both the SG&A cost and the capital costs are quite
consistent so the expected NOI growth must justify the acquisition. The estimated growth in NOI will
have a liner effect on capital returns as 1% annual growth in NOI will create a 1% annual growth in
capital returns.
3
NOI Growth
Parkway and many other REITs report operational metrics on a “same store” basis meaning they
presents the statistic for all of the properties they have owned for the past two years and show the
change in the metric. In projecting NOI growth in the future, it would be preferable to look at historical
NOI growth and use this historical data to project future NOI growth. Unfortunately Parkway has not
provided “same store” NOI growth consistently but it has provided “same store” rental growth. This
metric can be used as a proxy for historical NOI growth and projected into the future.
The chart shows the previous 9 years of “same store” revenue growth (the 2005 annual report did not
include this metric) for Parkway Properties with this metric is indexed to 10,000 in 2005. What the chart
shows is that the average revenue growth over the past 9 years for Parkway Properties has been 0.04%.
Parkway's "Same store" Revenue Growth
Year
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Geometric Mean
Revenue Growth
-1.80%
2.50%
2.60%
-0.80%
-2.80%
-5.40%
4.80%
-0.70%
2.40%
Indexed
10,000
9,820
10,066
10,327
10,245
9,958
9,420
9,872
9,803
10,038
0.04%
If we were to make a guess as to the historical NOI growth of Parkway’s properties, it would probably be
below the 0.04% revenue growth as property level expenses likely increased thereby reducing the net
income to the properties.
Parkway’s Cost of Debt
While it is not possible to directly observe the return threshold on assets Parkway needs to achieve, it is
possible to identify their cost of debt and determine what the NOI growth would need to be to achieve a
return on assets equal to their cost of debt. Shown below is an excerpt from Parkway’s 1Q15 10Q which
shows its weighted average cost of mortgage debt as 4.4%. So in order for Parkway to achieve its cost of
debt, the acquired properties must achieve an NOI growth of 4.4%-2.53% or approximately 1.9% which
is the difference between the cost of debt of 4.4% and the sum of the income return and estimated
capital return of 2.53%. Considering revenue growth has been virtually non-existent for the past 9 years
for Parkway Properties, a sustained 1.9% growth rate of NOI is considered extremely unlikely which
means that is also extremely unlikely that Parkway Properties will make even their cost of debt on their
properties let alone a premium.
4
Current Parkway Pricing
We can also look at how the market is currently pricing Parkway Properties and apply logic similar to
that applied to Parkway’s acquisitions. To do this, the implied cap rate of Parkway Properties needs to
be calculated. This metric looks through the balance sheet and sees what the market thinks the income
return generated by Parkway is valued at in terms of a cap rate. This income return is net of the SG&A
expense so one could add the estimated SG&A expense to this implied cap rate to get at what the
market thinks the properties are worth from a cap rate standpoint gross of the SG&A expense. Parkway
Properties’ stock closed at $17.94 per share on July 31, 2015 which translates into an implied cap rate of
6.25% which is net of Parkway’s SG&A expense. Gross of their SG&A expense, the cap rate on Parkway’s
properties would be 75 bp higher or 7.00%. This calculation is depicted below.
Interpretation of Current Parkway Pricing
If we take Parkway’s implied cap rate net of the SG&A expense of 6.25%, we can then apply an estimate
of the capital it will take to sustain this operating income of 2.4%. Without any NOI growth or movement
in the cap rate, this would yield a total return of 3.85%. We have shown that Parkway’s weighted
average mortgage cost is 4.4% so Parkway’s NOI growth would need to be 0.5% annually just to achieve
the cost of debt. To achieve even a modest return premium over Parkway’s cost of debt of 4%,
Parkway’s NOI growth would need to be 4.5% a year which is considered highly unlikely as the revenue
to Parkway’s properties on a “same store” basis have not been significantly different than 0% for the last
9 years.
5
Implication
The result of this analysis is dramatic as it implies that both the cap rate paid for office properties in the
markets in which Parkway owns properties and the implied capitalization rate for Parkway and similar
REITs similar should be much higher than they currently are. This is in order to account for the significant
capital required to maintain buildings and the negligible operating income growth achieved in these
markets. The chart below shows the performance of Parkway Properties’ stock compared to the
Vanguard all equity REIT Index ETF (ticker VNQ) since the advent of the ETF. What it shows is that
Parkway has been systemically overvalued owing to its stock’s consistent and significant market
underperformance. To price both Parkway Properties and properties located in its markets more
precisely, the cap rate on properties and similar REITs needs to dramatically increase. This is why the
REIT Emperor has no Clothes.
6
Calculation of Parkway's Implied Cap Rate
$
Equity
Common Stock
Share Price (COB 7/30/15)
Shares Outstanding
Market Capitalization
per share
17.94
111,538,000
2,000,991,720
Preferred Stock
Preferred stock coupon
Payout on preferred stock
-
Liabilities
Debt outstanding
Projected average cost of debt
Debt service
17.94
-
1,891,971,000
3.78%
71,441,301
16.96 1Q15 10Q
1Q15 10Q
0.64
3,892,962,720
66,675,000
3,826,287,720
34.90
0.60 1Q15 10Q
34.30
Total of equity and liabilities
Assets
Market implied total assets (market cap+debt+preferred)
Cash
Real Estate Assets (total assets - cash)
Off balance sheet debt
Pro-rata debt of unconsolidated JVs
Weighted cost of debt on unconsolidated JVs
Debt service for debt on unconsolidated JVs
21,961,651
2.45%
538,103
0.20 1Q15 10Q
1Q15 10Q
0.00
Real estate assets on balance sheet
Pro-rata share of unconsolidated JVs (real estate assets off
balance sheet)
3,826,287,720
34.30
21,961,651
0.20
Total
3,848,249,371
34.50
Sources of property level income
Projected FFO 2016
Debt service for balance sheet debt
Preferred stock dividend
Debt service for off balance sheet debt
1.51
0.64
0.00
0.00
Total
2.16
Implied Cap Rate
6.25%
7
NAREIT REITWatch
calculated above
calculated above
calculated above
Mr. Bollinger is the founder and CEO of Magnolia Realty Advisors. Prior to
founding Magnolia, he was an analyst at KBS Realty Advisors in Atlanta, GA
for 5 years where he worked on a 2 person asset management team
overseeing a $500M portfolio of commercial real estate. Prior to KBS, Mr.
Bollinger worked in the CMBS industry in New York City as a consultant for 3
years supporting clients such as Merrill Lynch and Bear Stearns. He earned
an MBA from Vanderbilt University and a BS in Industrial Engineering from
Virginia Tech.
Mr. Bollinger developed Magnolia’s strategy while working at KBS and
observing that the commercial real estate industry did a poor job at using
the data available to it to value both individual buildings and REITs. As such,
Mr. Bollinger developed a valuation methodology that incorporates all pertinent data into the valuation
process. Testing this valuation method showed that it would have provided significantly better valuation
estimates than the market did. This superior valuation method is the basis for Magnolia’s investment
strategy.
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