The real estate industry has experienced a shaky year and this is of course reflected in the stock market. The Tel Aviv Real Estate Index has plummeted in the past year, erasing all the significant increase it recorded during the Corona period. In recent weeks, the declines have been getting stronger.
The consensus in the capital market is that the real estate companies, whether yielding real estate or residential real estate are expected to be among the main victims of the increase in the Bank of Israel’s interest rate, which has increased in the Israeli economy from a rate of 0.1% to the current rate of 4.5%. The damage is significant – the discount rate of the real estate companies, the yield should economically increase when the interest rate rises (assuming the increase is expected to be constant, more detail below), thereby lowering the value of the assets – and the residential real estate companies are harmed by a possible decrease in housing prices, whether a real decrease or a nominal decrease at the same time as the increase in price Financing expenses and the decrease in demand due to the increase in mortgage repayments.
The declines in stocks are only part of the story. The bonds also fell when the yields in residential real estate rose almost overwhelmingly to a high single-digit and double-digit rate. that in the best case the interest expenses will rise dramatically, and in the worst case there will be great difficulty in raising at all, to the point of stopping fundraising through the capital market. Companies with double-digit yield bonds will have difficulty refinancing debts on the stock exchange.
The discussion about residential real estate companies is fascinating. But in this review, we will refer to the profitable real estate industry. The yielding real estate companies should be harmed as mentioned by an increase in the discount rate as a result of an increase in the interest rate. I will explain with an example. If I purchased a shopping center in Tel Aviv for NIS 100, and the center yields NIS 5 after its operating expenses, then I purchased with a discount-return rate of 5% ( 5 divided by 100 = 0.05 – 5%). If I was lucky and the shopping center yielded NIS 8, then the yield is 8%.
Let’s say I purchased the shopping center at a discount rate of 5%, while the interest rate in the economy was 0.1%, and the interest rates offered by the banks on long-term deposits were around 0.5% – so the purchase overall “makes sense”. But what happens if the interest rate in the economy rises to 4%, and suddenly I can get an annual interest rate of 5% per year? Suddenly the purchase makes less sense. So, yes, the advantage in the commercial center in Tel Aviv, whose value is expected to increase over time, And the rents are also supposed to rise in line with inflation, and still: the higher the bank interest rate, the less I prefer to purchase real estate assets, and if I buy, I will do so at lower prices.
But this is assuming and the interest rate is expected to remain high. If the interest rate is expected to decrease, and this is not something that is estimated to be permanent, then usually the effect will not be so acute on the real estate industry.
“What are all these English boxes?!” – and which section inFFO May mislead investors?
One of the most confusing things for beginning investors in the profitable real estate industry is the letters in English – FLO, NOI, LTV which make the companies’ financial statements scary. So we will list: WE This is net operating income. That is, income from rent, less direct expenses on rent. such as the costs of security, electricity, licensing and cleaning if they are imposed on the lessor. LTV This is a figure that is heard more in the debt market, but is also important for stock investors and is the liabilities divided by the assets. The higher this rate – the higher the company’s financial risk, because it means it has more debts in relation to assets.
the figure FFO constitutes a type of net profit, flows to the yielding real estate companies. It basically consists of the company’s net profit, neutralizing depreciation, asset valuations and deferred tax expenses. Because of the neutralization of upward or downward valuations, the profit does not include an increase in the value of the assets, which over a long period of time A rule of thumb. A multiplier FFO It is the multiplier that is referred to in the capital market as the most relevant because it actually represents the real estate company’s profit multiplier, with the adjustments required specifically for a real estate company.
but inFFO that the companies in Rish Gali present in reports, press releases and in almost every review you will see hides a “half trick”. The companies actually neutralize their linkage expenses on the debt, and do not include them inFFO.
That is, if a certain company has index-linked debt with an interest rate of, say, 3% (if it weren’t for the index-linking, the investors would have sought other “compensation” in the form of a higher interest rate) in the amount of one billion shekels, if the index rose 1%, then it should incur an expense of 10 million shekels, Because it will have to pay it to investors because of the increase in the index. But what – the companies neutralize it from the-FFOthey just don’t write in theFFO The “management approach” this expense. This creates a great difficulty in comparing companies.
For suppose there are two companies, completely identical; Company A took 100% of its debt linked to the index and therefore pays 2% on it, Company B took 100% of its debt not linked to the index and therefore pays 5% on it – it turns out that Company A, although in the end it is expected to pay like Company B, will record less than half of the expenses The financing of Company B, only because of the trick in calculating theFFO she does
So this trick is really problematic, but on the other hand it should be remembered that there are those who believe that there is logic in neutralizing the index-linking expenses. Because the logic says that just as the debt is attached to the index, so is the value of the property over time – and therefore it is offset. In any case, and whatever approach you choose, there is in the table the rubric of “FFO Coordinated” in which I included the indexation expenses.
Another thing that is important to remember, if we are dealing with yielding real estate is the section “Capital attributed to the owners of the company”, in our table we took this figure and not the equity. Why? This is due to an accounting method that says that if a company controls another company, sometimes it can be Even with a holding rate of less than 50% (let’s say if the other shareholders are too small to control the company), she records 100% of the subsidiary’s capital in the financial statement, even though she may only own 51%.
On the other hand, the capital section attributed to the owners of the company actually does not include the 49% that is not under its control and it is more correct to include it in the capital multiplier. In addition, almost every real estate company has “hold assets” on its balance sheet – some less and some more. Hold assets are assets whose value is on the balance sheet, and sometimes the company has also invested some capital in them – such as the expansion of a yielding asset, a yielding asset under construction, land or just rights Construction on a significant scale that increases the value of the assets, but they do not generate cash flow for the company. When investing in the company – you should also look at these assets, and try to give them the appropriate value, separately from theFFO (It should be noted that many times, as part of the accounting, companies “capitalize interest expenses” into these assets, and actually reduce the interest expenses recorded in the income statement).
What is expected to happen in the near future?
It is very possible that in the next quarter, or the one after that, as long as there are no unexpected changes for the better on the front of the interest rate – we will start to see that assets will be written down. What is clear is that in today’s interest rate environment it will be rare to see assets whose discount rate decreases, when the increases in value will mainly result from an increase inWE.
At the end of the day, the auditors of public companies act as a kind of one piece. Just as it is not possible for all the companies to appraise assets and lower the discount rates, and only one with a similar asset profile will not do so – the same goes for the other side, it will be rare to see appraisers who will go against the flow, except in extreme cases.
In any case – and after this theoretical break on the psychology of the appraisers, it is appropriate to check the covenants on the debt of the real estate companies in which they invest. That is, after what loss, and how much capital is written off, the debt holders have the right to bring the debt to immediate repayment and also pay attention to the repayment schedule “And to the assets in the hold”, on the balance sheet.
*Disclosure The writer does not own the shares mentioned in the article, but may own some of these shares in the future. The article does not contain any recommendation to act in securities.