Level II Alternatives item sets

Naomi Fischer is a portfolio manager at Ashby Wealth Partners, which manages investment portfolios for wealthy families. One of her clients, Robert Kane, has asked her to add real estate to his portfolio. Kane already owns two small office buildings directly and is unsure whether to buy a third building or to invest through listed real estate investment trusts. Fischer has identified Harbourline Logistics REIT, a listed owner of warehouses near major ports and motorway junctions, as a possible investment.

Fischer first estimates Harbourline Logistics REIT's net asset value per share. She bases the value of the properties on forecast cash net operating income for the next twelve months, which she estimates by applying a growth rate of 2.0% to the most recent twelve months of cash net operating income. She then capitalises the forecast at a market capitalisation rate of 6.0%, which she has taken from recent sales of similar warehouses. She adds the REIT's cash and other tangible assets at their book values and deducts its debt and other liabilities. Exhibit 1 shows the inputs. She excludes goodwill and deferred financing costs, which have no value in a liquidation of the assets.

Next, Fischer looks at the REIT's earnings. She explains to Kane that net income is not a good measure of a REIT's operating performance, because accounting depreciation on buildings usually exceeds the actual decline in their economic value, and because gains and losses on property sales are not part of recurring operations. Fischer prefers adjusted funds from operations for comparing REITs. Exhibit 2 gives the figures from the REIT's most recent annual report.

To compare Harbourline Logistics REIT with its peers, Fischer obtains the average price-to-AFFO multiple of listed logistics REITs, which is 15.0 times trailing AFFO. She believes the peers are similar in quality, leverage and growth prospects, so she is comfortable applying the peer multiple without adjustment. Harbourline Logistics REIT's shares currently trade at $20.00. Over the past year, the shares have ranged between $18.40 and $22.10, broadly in line with the listed logistics sector.

Kane makes three comments when Fischer presents her analysis. First, he says that the main attraction of the REIT is that he could sell the shares within a day if he needed the cash, whereas selling one of his buildings has taken him months in the past. Second, he says that REIT shares should be less volatile than his buildings, because the appraisals he receives on his buildings move only a few percent each year. Third, he says that owning REIT shares would give him more say over how the properties are managed than he has with his own buildings, because he would be one of many shareholders who can vote at the annual meeting.

Fischer tells Kane that she will respond to each comment in her written proposal. She also notes that the REIT's high dividend payout, which is required for it to keep its tax status, means it must rely on new equity and debt to fund growth, which can dilute existing shareholders when its shares trade below net asset value.

Fischer also checks the REIT's lease profile. Most of its warehouses are let to logistics and retail tenants on leases of five to ten years with fixed annual rent increases, which is why the REIT reports a straight-line rent adjustment. Occupancy has stayed above 95% for the past five years.

Kane asks Fischer to include in her proposal a comparison of the REIT's share price with her estimates of its value under each approach, so that he can see whether the shares look cheap or expensive before deciding how much to invest.