Cash piles chasing the same opportunities
Some companies are still trying to buy or develop buildings and expand their portfolio in the conventional manner, while others have been looking to buy entire companies under a mergers and acquisitions strategy or alternatively have raised dividends to return cash to their investors. But buying a high-quality portfolio or top-rated individual properties with the aim of improving company profitability is by no means straightforward in the present market conditions. The competition to invest in real estate is fierce, with USD 294 billion held globally by private funds at the end of Q3 2018 waiting in the wings.
It is hard for companies to grow earnings by acquiring high-quality assets since the initial yields for these buildings are too low currently; many investors these days are looking for well-situated, high-quality properties which they believe offer secure income growth over the long term. Although secondary assets may be cheaper, this is often for good reason. Another factor is the cost of capital. For listed companies, this is often higher than for private buyers, which makes it difficult for them to compete.
In place: provisions for buy-backs
So what should real estate companies do in such circumstances? According to data provider SNL, publicly-held companies are currently sitting on USD 99 billion, with Hong Kong, US and Japanese companies holding the largest war chests. In an ideal world, management could try to do a number of things with their free cash flow. One option would be to buy back their own shares. SNL data shows that while 140 companies currently have a provision in place for buying back shares, 60 have yet to exercise the repurchase option.
Exhibit 1: Cash-rich: Free cash flow of real estate property companies (by country)
Source: S&P Global Market Intelligence, the FTSE EPRA Nareit Developed global index, data as at 31/10/2018.
Enthusiasm for buying stock has been mixed among both investors and public real estate companies. For companies, a buy-back can be seen as an earnings management tool. Companies have been criticised for repurchasing shares to boost their earnings per share and even masking financial issues by boosting share prices artificially rather than buying shares because they are cheap. There has also been scepticism about the ability of a company to correctly time an advantageous repurchase.
Buy-backs: putting cash to work
However, if a property company believes its shares trade at below their net asset value (NAV), repurchases can prove a profitable investment as the share price subsequently rises to its intrinsic value. In the previous column, we observed that listed real-estate companies across the world are trading at discounts to NAV and that, globally, the current average discount is 16%, which is attractive from an historical perspective (source: UBS, as at 29 October 2018).
A repurchase typically sends a strong signal to the market that management believes the equity of the company is undervalued. Financial research has shown that companies make poor use of retained earnings, so long-term total returns tend to be stronger when they put their cash to work. If shares are undervalued, the implied return on purchasing them is especially high, making buy-backs more attractive than other investment opportunities.
Indeed, investors will look at the companies that they own and which have excess capital and ask, “what will the managers do with my money?” Shareholders would expect a company to put their money to work by investing it in the best opportunities available. If there is no attractive building, portfolio or company to buy, shareholders could be forgiven for asking for a buy-back. After all, buying your own stock implies that a company is investing in the ideas, assets and, of course, management that matches the company’s investment strategy at an attractive price.
The buy-back as an act of faith
After the recent sell-off across global equity markets, real-estate companies could do worse than take advantage of lower stock prices to put money to work. Buy-backs are conventionally seen as earnings accretive and thus value-adding for shareholders. Clearly, they should only be pursued when management is confident the shares are undervalued.
If listed companies cannot find what they are looking for in their traditional markets, it could help them avoid overpaying for buildings or expanding into sectors and locations they know little about. What is more, the principle of buying your own stock is an act of faith in your own existing portfolio and the skill of your management team.