RFF Management Fee Analysis, page-24

Excellent discussion and analysis on this thread.

I believe RFF is a great stock, managed by great people. Short term volatility and market speculators aside, at 6% dividend yield, I am very bullish.

Having worked in the property industry, I would like to provide some thoughts on the issues raised in this thread and by B&B. Heavy reading and not advice but hopefully additive.

1. Management fees

Market practice in Australia (and in most jurisdictions globally) is for external management fees to be charged as a percentage of Gross Asset Value (GAV).
RFM’s management contract with RFF is to charge 1.05% of GAV. This is high but not outrageous, especially for a specialised asset class. (Specialists charge more than GPs)

While it may be interesting to benchmark fees to total income, in practice it isn’t that useful because income does not factor into the formula for calculating the management fee.

The reason that management fees have been growing as a percentage of income is because of the next point.

2. Value of property and cap rates

Property is primarily valued based on a capitalisation rate (cap rate).

Capitalisation rates are the ratio between income and gross asset value.

• For example, an asset generating $10 p.a. of income at a 10% cap rate would be valued at $100 ($10/10% = $100)
• The same asset generating $10 p.a. of income revalued at a 7.5% cap rate would be valued at $133 ($10/7.5% = $133)

Since IPO, RFF’s assets (together with almost all other real estate assets around the world) have experienced cap rate compression driven by falling interest rates.
This is part of the reason why RFF’s assets have gone up in value. (see chart below from JLL and Dexus on cap rate trends for office, retail and industrial property - https://www.reitasiapac.com/wp-content/uploads/2019/02/AREQR-Q1-2019.pdf)

As the example above illustrates, when cap rates compress, the asset value goes up.
If you follow the mathematics through, you will see that when cap rates compress, the percentage increase in asset value will already be greater than the percentage increase in the income.

For externally managed REITs like RFF, this results in GAV going up faster than income and thus management fees going up as a percentage of income. This has been normal for the entire real estate sector. One way to look at it is to focus on the 1.05% the manager is taking of this, but the investor is getting the 98.95%. Net-net, this is a good thing to the extent that it means the market is valuing RFF’s assets more highly than before.

Of course, in reality, property values change due to a combination of income growth and cap rate movements. For example 40% of RFF’s leases include fixed rental escalations of 2.5% p.a. meaning that each year, income from those leases will grow by 2.5% (see below from Pg14 of the FY19 results).

The final point to make here is that unlike many other countries (US for example), Australian accounting rules require A-REITs to maintain the book value of their investment properties to the market value.

This means that the balance sheet value of total assets is a fresh number. This is the reason why the ratio of income to assets has been falling - due to cap rate compression.
This is normal for almost all Australian REITs (and any other country where REITs mark the balance sheet value of investment properties to market value).

It also means that the statutory NPAT of A-REITs are not useful as it include the gains and losses from these revaluations.

This is why RFF point investors to AFFO measures - a far superior measure of income for a REIT. AFFO is a measure that has a standards framework set by the Property Council of Australia. (https://www.propertycouncil.com.au/Web/Advocacy/Capital_Markets/Web/Advocacy/SectorBasedAdvocacy/Capital_Markets.aspx)

3. Capitalisation of operating expenses - aka “rentalisation”

There has been discussion of RFF capitalising operating expenses as a way to inflate asset values and enabling RFM to charge higher management fees.

In reality, RFF’s leases are triple net leases, meaning that the tenant bears all the operating expenses and not RFF.

What RFF offers tenants is the option of paying for capital improvements in exchange for higher rents. The industry term is called rentalisation and is common place in specialised real estate - for example in the healthcare real estate sector (see below from Northwest disclosure on their Vital Healthcare REIT Pg39 - https://northwesthealthcareproperties.gcs-web.com/static-files/35f13030-4cf5-48e0-931e-197956bbefe2)

RFF discloses their pipeline of such capital expenditure (CAPEX) on page 26 of their FY19 presentation (see below).

To give you some insight into why this appealing to both landlord and tenant, imagine you are a tenant who signed a 15 year lease for a really old apartment.
You would like to do a major renovation but would need to use your savings and potentially borrow money to fund it.
In this case, the landlord comes to you with an offer to renovate for you, and in exchange, charge you more rent. If the landlord offers to “rentalise” the renovation costs at 10% p.a. (i.e. you pay 10% of the renovation costs each year).
- You do not have to spend your own capital to get a newly renovated apartment; and
- the landlord has managed to achieve a 10% p.a. return on the capital invested in your renovation.
For RFF, this is exactly what is happening but better - the “renovations” are investments in water, infrastructure, grafting, redevelopment, etc, and don’t depreciate like the renovation in this example would.

Yes, director's adding the cost of CAPEX attracts a higher GAV but only until the next revaluation when the valuer will apply a capitalisation rate to the higher income, adding to the value of the property.

4. JBS / J&F

People are questioning why RFF didn’t acquire J&F, which is instead owned by RFM. As I understand it, in economic terms, RFF gets all the financial benefit of owning J&F, while being able to maintain its REIT status (see the Explanatory Memorandum - https://ruralfunds.com.au/wp-content/uploads/sites/3/2018/07/20180712-RFF-EM-and-NOM.pdf). The REIT status, amounts other things, allows RFF to pass through its income without attracting corporate tax.

There are several tests to qualify as a REIT, but the most important one is that the majority of your revenue must be derived from passive sources. Trading of cattle is not passive but rent collecting and interest income is.

Per the EM, J&F’s role is to purchase cattle, fatten them up and sell them on. J&F make a regulated profit which it passes on to RFF.

Per the agreement, J&F must hold between 100,000 to 160,000 head of cattle at any time. The time horizon per animal is 100-140 days and the sale price is currently around $250 a head - a 3 year low.

Running a conservative estimate, if I take the mid-point of those ranges and at $250 a head, J&F would post revenue of c.$100m p.a. RFF posted revenue of $66m in FY19. If J&F were owned by RFF, trading revenue would comprise c.60% of RFF’s revenue in FY19. It would lose its REIT status as a matter of fact.

For completeness, $100m sounds like a lot but revenue is not profit. The agreement with JBS means J&F (RFM) pay for the cattle, the feed, mortality insurance and a management fee to JBS. Once those expenses are taken out, J&F’s profit is passed on to RFF in the form of a return on RFF’s $75 guarantee to J&F. This equates to between 9.4% - 11.2% p.a. interest depending on how much debt is in J&F. This is an excellent return given that the guarantee is secured against all the cattle as well as JBS.

More importantly, RFM does not obtain any economic benefit other then its management fee of 1.05% of the $75m that RFF has put in.

5. Audit fraud

Auditing is only as complex as the underlying business. RFF is a REIT. It collects rent and pays a dividend. Its bank balances and leases are not hard to audit. Investors have the added comfort that PwC gave FY19 sign-off with the added scrutiny of the Bonitas report having been already released and EY being asked explicitly to rebut Bonitas’ allegations. Overlaying the simplicity of a REIT audit, I cannot believe that two of the big four global audit firms who employ over 500,000 people world wide would be willing to stake their reputation if there was even a semblance of malpractice under these circumstances.