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Can a simple scoresheet help you choose real estate stocks?

I previously described my systematic framework for choosing stocks in the financial sector, along with some additional analysis. The reason I looked into developing my strategy for selecting companies operating in financial industries, such as banking and insurance, is that I found that numerous quantitative or systematic studies and systems excluded those types of stocks. For instance, Joel Greenblatt’s “Magic Formula” is a well-publicized strategy that purposely excludes those firms. Alpha Architect’s quantitative value strategy is another systematic method that omits financials stocks. At face value, this is a logical idea. The financial statements of these types of firms are far different from any other sectors. This means that applying uniform criteria across a whole universe of stocks without accounting for these differences can be a serious mistake.

On the other hand, as I stated in my original article, I also believe that leaving out financial sector stocks altogether is not sensible. These companies can be profitable for their investors. Many firms operate in these sectors and they can be huge, making them very hard to avoid in any case. Instead, I believe that, in these cases, it is reasonable to implement a systematic method to choosing the most promising stocks in the financial sector, separately from other methods for choosing stocks in most other sectors. Therefore, I had devised my own framework for picking financial companies. My research, covering over almost 20 years of data, shows that it is possible to profitably and selectively invest in stocks in that sector by using quantitative analysis.

Another sector of the stock market that often gets passed over by quantitative investment research models is the category of real estate companies. Publicly traded real estate companies own and manage real estate property on behalf of their investors. Therefore, buying a real estate stock is essentially like indirectly getting access to the operations and profits of at least several buildings or locations. Some real estate stocks might specialize in specific types of property or location. For example, it probably won’t come as a surprise that Canadian Apartment Properties REIT (Symbol CAR.UN on the Toronto Stock Exchange) manages apartment buildings throughout Canada. These stocks also get excluded from the types of studies and systems mentioned previously because, just like financial sector stocks, they produce financial statements that look very different from other companies. It is worth noting that real estate stocks use to be considered part of the financial sector under the Global Industry Classification Standard (GICS), until they were separated into their own standalone sector starting in August 2016.

As with financial sector stocks, I believe that real estate stocks can be analyzed using systematic or quantitative methods. They have several advantages over buying real estate directly to get exposure to that portion of the economy. They can be bought and sold more easily, with much smaller investments. They are more diversified geographically and across different types, such as commercial, offices, and more. For example, in comparison, buying a home exposes you solely to the local residential market, which alone might not be enough investment diversification. At the same time, I believe it is important to try to analyze real estate stocks systematically, rather than haphazardly, to select stocks with better odds to increase in value.

In my previously cited research on investing in financial sector stocks, I chose to adapt the Piotroski F-Score, a simple but effective scoresheet for choosing stocks with better odds of going up in value, to the specifics of financial companies’ numbers. For financial companies, I got to a 6-point scoring system. For real estate stocks, I used this same scoresheet, with one important modification:

1) If Net income is positive, score 1, otherwise 0

2) If Return On Assets latest year is greater than ROA previous year, score 1, otherwise score 0

3) If Operating cash flow is greater than Net income, score 1, otherwise 0

4) If Ratio of long-term debt to total assets latest year is equal or less than Ratio of long-term debt to total assets previous year, score 1, otherwise 0

5) Financial leverage (total assets divided by total equity) latest year is equal or less than Financial leverage previous year, score 1, otherwise 0

6) If Shares outstanding latest year is equal or less than Shares outstanding previous year, score 1, otherwise 0

I deemed the last item, the count of shares, as being irrelevant for real estate stocks and the reason for that is the prevalence of Real Estate Investment Trusts (REITs). In Canada, at least 66% of the value of publicly-listed real estate stocks is in companies classified as REITs, based on MSCI’s index of investable Canadian real estate companies. Competitor FTSE’s index of Canadian real estate, which is used as benchmark for Vanguard’s FTSE Canadian Capped REIT Index Exchange-Traded Fund, has that proportion at almost 85%. In the United States, that proportion is 95%, going by MSCI’s US Real Estate index. These numbers are important because legislation stipulates that REITs in Canada must pay out at least 90% of their taxable income to their investors in the form of dividends. In the United States, REITs must also distribute at least 90% of their income to their shareholders. Other countries have similar laws for REITs. Consequently, since REITs are obligated to distribute almost all their income, they can’t accumulate and save to expand like other companies. Instead, apart from taking on more debt, they can only finance themselves by issuing new shares or units on an almost constant basis. REITs rarely, if ever, reduce the number of their shares. For instance, here is the share count for a few REIT companies over their last 5 fiscal years:

Source: Morningstar.com

Since REITs typically increase their number of shares or units, and REITs form the majority of real estate-sector stocks, using share count reduction as criteria for evaluating these companies seems irrelevant in my view.

Therefore, my checklist for investing in real estate consists of the 5 remaining criteria:

1) If Net income is positive, score 1, otherwise 0

2) If Return On Assets latest year is greater than ROA previous year, score 1, otherwise score 0

3) If Operating cash flow is greater than Net income, score 1, otherwise 0

4) If Ratio of long-term debt to total assets latest year is equal or less than Ratio of long-term debt to total assets previous year, score 1, otherwise 0

5) Financial leverage (total assets divided by total equity) latest year is equal or less than Financial leverage previous year, score 1, otherwise 0

So how did such a simple system perform in the past? Using Portfolio123.com, I researched real estate stocks in the United States and sorted them into 3 buckets based on their fundamental score with this checklist. For the period from April 30, 1999 to April 30, 2018, the group with the highest score generated an annualized return of 11.2%. The second highest scoring group produced returns of 9.1%. But the bottom third only returned 4.1%. Over the same period, the Vanguard Real Estate Index Fund (VGSIX) grew at a rate of 9.7% annually.

Source: Portfolio123.com

Source: Morningstar.com

Just as my previous research did for financial sector stocks, this study demonstrates that there can be value in using a systematic framework to invest in real estate sector stocks. If there are weaknesses to this analysis, it can be pointed out that a scoring system that consists of only 5 points may be oversimplifying. Also, this doesn’t use real estate-specific ratios and statistics such as Funds From Operations (FFO). I deliberately kept this scoring system to relatively common statistics that can be found in most stock-selecting tools. Nonetheless, I believe that this does demonstrate that it is possible, even preferable, to analyze real estate stocks in a quantifiable, systematic manner and I use this framework in my process for investing in these types of companies.

 

Ottawa, ON, Canada

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