I am a student. What clues might be in an annual report if a REIT was paying its dividend by borrowing money? How do you think about capital structure in general? :) Thank you for the great article.
We appreciate your feedback and are glad you found it helpful.
As far as a litmus test warnings sign to see if the REIT isn’t covering its dividend you can look at the balance sheet over time. If debt is consistently increasing or the share count is rising rapidly you know something is up. The cash flow statement will pinpoint the problem and the key is to go further down the page than the operating cash flow line. A company may cover its dividend with its free cash flow (operating cash less capex), but in the case of IRM, there are significant recurring cash outflows in the financing section that must be considered. Operating cash flow itself may need adjustment for items such as stock compensation which are added back to net income to arrive at operating cash flow. Ironically, IRM’s traditional measure of free cash flow regularly doesn’t cover the dividend yet its AFFO covers it with room to spare. That’s a bad sign. Always remember that AFFO is the same to a REIT’s cash flow statement as non-GAAP earnings are to a traditional company’s income statement. It’s the number management wants you to use to evaluate performance and value their company. Never trust it and study each component and adjustment carefully and skeptically to determine if it accurately reflects the ongoing cash expenditures needed to support the company’s business model.
A REIT is supposed to be passive – that’s the rationale behind giving it the tax-free structure. It’s supposed to own and maintain property and collect rent and pass income back to retirees. So be skeptical of REITs that appear to have many other activities going on and report several other expenses and revenue sources that don’t relate to being a passive real estate owner. We would also say a REIT can acquire another REIT or build more real estate. But most years should be very vanilla – 4 out of 5 years they should have little problem showing that GAAP cash flow less some capital spending produces enough cash to service debt and dividends. Every year shouldn’t be an exception to the norm.
On legalese – figure out what 10% or 15% of pretax earnings is for most years. Then skim each legal issue to see if the potential loss/outcome exceeds that 10%-15% figure. Focus on those big ones that would exceed what is the potential characteristics (does it concern one product, does it concern one country, does it concern, does it concern a tort like asbestos or chemical leaks). More than likely the smaller cases will have some aspect of those same topics. However, it’s unlikely a company gets derailed over a small case. Worry if they can survive the big one.
Also, shareholder lawsuits frequently are paid out of insurance. The exceptions are the SEC is involved or they had to restate financials – those are important. The ones where they guided to $1.00 in EPS and came in at $0.95 because sales were light, they had a plant shut down – those tend to be very minor and unlikely to change the situation much.
I am a student. What clues might be in an annual report if a REIT was paying its dividend by borrowing money? How do you think about capital structure in general? :) Thank you for the great article.
Hi Smaug,
We appreciate your feedback and are glad you found it helpful.
As far as a litmus test warnings sign to see if the REIT isn’t covering its dividend you can look at the balance sheet over time. If debt is consistently increasing or the share count is rising rapidly you know something is up. The cash flow statement will pinpoint the problem and the key is to go further down the page than the operating cash flow line. A company may cover its dividend with its free cash flow (operating cash less capex), but in the case of IRM, there are significant recurring cash outflows in the financing section that must be considered. Operating cash flow itself may need adjustment for items such as stock compensation which are added back to net income to arrive at operating cash flow. Ironically, IRM’s traditional measure of free cash flow regularly doesn’t cover the dividend yet its AFFO covers it with room to spare. That’s a bad sign. Always remember that AFFO is the same to a REIT’s cash flow statement as non-GAAP earnings are to a traditional company’s income statement. It’s the number management wants you to use to evaluate performance and value their company. Never trust it and study each component and adjustment carefully and skeptically to determine if it accurately reflects the ongoing cash expenditures needed to support the company’s business model.
A REIT is supposed to be passive – that’s the rationale behind giving it the tax-free structure. It’s supposed to own and maintain property and collect rent and pass income back to retirees. So be skeptical of REITs that appear to have many other activities going on and report several other expenses and revenue sources that don’t relate to being a passive real estate owner. We would also say a REIT can acquire another REIT or build more real estate. But most years should be very vanilla – 4 out of 5 years they should have little problem showing that GAAP cash flow less some capital spending produces enough cash to service debt and dividends. Every year shouldn’t be an exception to the norm.
On legalese – figure out what 10% or 15% of pretax earnings is for most years. Then skim each legal issue to see if the potential loss/outcome exceeds that 10%-15% figure. Focus on those big ones that would exceed what is the potential characteristics (does it concern one product, does it concern one country, does it concern, does it concern a tort like asbestos or chemical leaks). More than likely the smaller cases will have some aspect of those same topics. However, it’s unlikely a company gets derailed over a small case. Worry if they can survive the big one.
Also, shareholder lawsuits frequently are paid out of insurance. The exceptions are the SEC is involved or they had to restate financials – those are important. The ones where they guided to $1.00 in EPS and came in at $0.95 because sales were light, they had a plant shut down – those tend to be very minor and unlikely to change the situation much.
Best of luck with your education!
Also, any tips on making reading legalese less boring sometimes? I eat ice cream after I finish a couple of pages, then start again. Thanks again. :)