I was reading a tweet thread the other day regarding Artis REIT, and one of the replies was from a smart guy, who I know knows REITs well (he follows me after all!), questioning why Artis REIT’s FFO (funds from operations) was so different from its AFFO (adjusted funds from operations).
Hey Tyler, thanks for the article. Big fan of your work.
Quick question though. Noticed that FFO/AFFO calculations don't seem to take into account required principal repayments on mortgage debt. Am I wrong in this observation? Wondering how you think about these principal repayments, as they can be quite sizeable for REITs.
Thank you for the kind words Alex. Glad to have you as a reader.
You are correct. Principal repayments on debt are not an expense off FFO.
All the principal repayment does is turn cash into equity on a building or other asset. Same as your house. Your house is worth $500,000, your mortgage is $250,000 and your equity is $250,000. You make a payment and maybe your principal goes down $500 that month. Your house is worth $500,000 still, but while you may have $500 less cash in your pocket, your equity in the house is now $250,500. You aren't any worse off, you just traded one asset for another.
And if a REIT wants that principal repayment back, usually it is very simple. It refinances a different mortgage and borrows slightly more, turning building equity back into cash. Or it borrows on a corporates credit line or something, which keeps its debt metrics the exact same as before. 90% of the time that works fine.
The trouble lies when a REIT can't reborrow that principal repayment, or doing so will cost substantially more. That is the environment we are in now. Look at Slate Office, which is now against its 65% debt to asset covenant and has to have a special meeting to ask unitholders to remove that covenant so the REIT can borrow more money. Or look at any other REIT, most of which are refinancing debt at interest rates 3, 4, 5% higher. All this while building values are going down. This is the 10% of the time when principal repayments absolutely matter.
That said, I don't think of it as simple as "principal repayments should come off FFO". I don't even particularly think about principal repayments in the sense of what is required each month. I instead think of the maturities that a REIT has in the next year or two vs its current level of debt to assets. If a REIT with high debt (let's say over 50% for example) has 1/5th of its debt maturing over the next year or two, that is an issue worth diving deeper into. A REIT with debt at 35% with 1/10th of its debt maturing over the next year, that is already paying a pretty high rate - that one's not as likely to be an issue.
So I guess my short answer is, I don't particularly think about those principal repayments in and of themselves. I consider them a bit in relation to the overall debt situation, but for the most part, debt that matures in any given year is likely to greatly exceed scheduled principal repayments. And the scheduled principal repayments only really become an issue when looking at the other debt metrics, so that's where I look first.
Thanks for the explanation. As Samir Manji has noted in the last 3 conference call, the payout ratio is expected to be "lumpy" given multiple transactions & organic growth projects having come online, asset dispositions/public security trades, reduction in certain floating rate debts with asset sale proceeds, etc. It's important to follow the entire Artis story to have the full picture.
Thanks for that. I'm not particularly interested in the Artis story, nor do I want this post to come across as an indictment of Artis or anything. I think the AFFO payout ratio is high, not worrisomely so but still on the higher end, but between the things you mentioned, and the higher TI US office buildings, that AFFO payout ratio could come down considerably.
Hey Tyler, thanks for the article. Big fan of your work.
Quick question though. Noticed that FFO/AFFO calculations don't seem to take into account required principal repayments on mortgage debt. Am I wrong in this observation? Wondering how you think about these principal repayments, as they can be quite sizeable for REITs.
Thank you for the kind words Alex. Glad to have you as a reader.
You are correct. Principal repayments on debt are not an expense off FFO.
All the principal repayment does is turn cash into equity on a building or other asset. Same as your house. Your house is worth $500,000, your mortgage is $250,000 and your equity is $250,000. You make a payment and maybe your principal goes down $500 that month. Your house is worth $500,000 still, but while you may have $500 less cash in your pocket, your equity in the house is now $250,500. You aren't any worse off, you just traded one asset for another.
And if a REIT wants that principal repayment back, usually it is very simple. It refinances a different mortgage and borrows slightly more, turning building equity back into cash. Or it borrows on a corporates credit line or something, which keeps its debt metrics the exact same as before. 90% of the time that works fine.
The trouble lies when a REIT can't reborrow that principal repayment, or doing so will cost substantially more. That is the environment we are in now. Look at Slate Office, which is now against its 65% debt to asset covenant and has to have a special meeting to ask unitholders to remove that covenant so the REIT can borrow more money. Or look at any other REIT, most of which are refinancing debt at interest rates 3, 4, 5% higher. All this while building values are going down. This is the 10% of the time when principal repayments absolutely matter.
That said, I don't think of it as simple as "principal repayments should come off FFO". I don't even particularly think about principal repayments in the sense of what is required each month. I instead think of the maturities that a REIT has in the next year or two vs its current level of debt to assets. If a REIT with high debt (let's say over 50% for example) has 1/5th of its debt maturing over the next year or two, that is an issue worth diving deeper into. A REIT with debt at 35% with 1/10th of its debt maturing over the next year, that is already paying a pretty high rate - that one's not as likely to be an issue.
So I guess my short answer is, I don't particularly think about those principal repayments in and of themselves. I consider them a bit in relation to the overall debt situation, but for the most part, debt that matures in any given year is likely to greatly exceed scheduled principal repayments. And the scheduled principal repayments only really become an issue when looking at the other debt metrics, so that's where I look first.
Great article, I loved reading it and I learned a lot. thanks for sharing.
Thanks for the explanation. As Samir Manji has noted in the last 3 conference call, the payout ratio is expected to be "lumpy" given multiple transactions & organic growth projects having come online, asset dispositions/public security trades, reduction in certain floating rate debts with asset sale proceeds, etc. It's important to follow the entire Artis story to have the full picture.
Thanks for that. I'm not particularly interested in the Artis story, nor do I want this post to come across as an indictment of Artis or anything. I think the AFFO payout ratio is high, not worrisomely so but still on the higher end, but between the things you mentioned, and the higher TI US office buildings, that AFFO payout ratio could come down considerably.