A business plan that depends on leverage

Debt service

A dramatic impact on their FFO

In this post I propose to look at the impact of inflation and rising interest rates on residential REITs.

Real estate investment trusts (REITs) are thought to give investors the opportunity to invest in a portfolio of professionally managed income properties that historically offer stable returns and some chance for capital appreciation.

The most stable REIT

REITs very often focus on a particular type of income property, such as warehouses, shopping centers, office buildings or multiple residential buildings. We know that shopping centres have been negatively impacted by a move to online shopping and office buildings by work from home. One class of building is thought more stable than the rest. That is multiple occupancy residential buildings.

Rather than generalize, let’s look at one particular REIT. It is Morguard North American Residential Real Estate Investment Trust MRG.UN on the Toronto Stock Exchange. This is well managed REIT.

I used to own shares in Morguard Corporation (MRC) which not only owned a portfolio of income properties directly but also shares in REITs, including MRG, and also earned fees from portfolio management and real estate advisory services.

The sell side analyst’s report I have currently opines:  “We believe MRG offers income diversification and stability, with long-term growth potential by virtue of: 1) regional/economic diversification; 2) currency diversification; 3) properties of varied product types, price points, and tenant profiles in markets that are growing, i.e., primarily in the US Sun Belts and Greater Toronto Area; and 4) a track record of 93%– 98% occupancy over the past eight years.” The analyst’s target price is well above the current price.

What is not to like about this. Its current dividend yield is 4.4%.

The issue is a business plan that depends on leverage

There are a variety of types of companies in which the business plan revolves around leverage. Utilities are an example. They generate a steady stream of revenue from a broad base of customers. They typically have massive fixed assets such as power plants and distribution facilities with long lives. They also typically have very large long term debt. Managing that debt and particularly the cycle of maturities is critical.


Public real estate companies and REITS are in some ways a bit like utilities. They typically carry higher debt in the form of mortgages secured against individual income properties in their portfolio. During a period of gradually lowering long term interest rates these companies are consistently able to refinance their mortgages at lower and lower rates thus increasing their funds from operations (FFO), a key operating metric, without improving their operations. The key thing to understand is that typically each property in the portfolio has its own mortgage. The mortgage terms might be five years but each year there are maturities and the mortgages need to be refinanced. And that’s all good if rates are declining.

The reverse occurs in a period of increasing long term interest rates. The mortgages will be refinanced at higher interest rates and this can have a dramatic impact on their FFO. This is why these companies are so interest rate sensitive.

Let’s look at the financial highlights from the last annual report of MRG. There are only two lines you need to run your finger along. The first is the weighted average mortgage interest rate. You’ll see that it is steady at 3.5% and then dips to 3.3% in 2021. The second is funds from operations per unit – basic. It ranges from $1.15 to $1.23.

The simple question to ask is what happens to FFO if the weighted average mortgage rate goes to 5.5%?

MRG is simply a case in point

I would imagine that MRG is typical of REITs today. As I said above, it’s a well-managed company. But that won’t help it if mortgage interest rates permanently reset to normal levels. The ultra-low rates we have seen in the last twenty years have been an artificial creation of the Federal Reserve, the Bank of Canada and other central banks around the world. If the central bankers’ fondest wishes are realized the neutral rate of interest will settle well above where it has been the last decade and interest rates on mortgages on income properties will permanently reset to a higher level. This means that as every mortgage on a building comes due, it will be refinanced at a higher rate.


When we look at debt on company balance sheets we often think only about whether the company is in a strong financial condition and whether it can easily handle the debt. But, as we have seen, there are various companies whose business plan involves leverage. When rates are coming down this can provide a boost. When rates are going up, it can result is serious headwinds.


For a related post on how to think about corporate debt, check out Financial strength – the debt equity ratio has serious shortcomings


For readers wanting to dig deeper into the subject of how to identify and assess great companies, take a look at Part 6: The Hallmarks of Superb Businesses

In particular, see Chapter 35. Capital Structure, Strength and Economic Performance

This chapter contains the following sections:

35.01 Capital Structure

35.02 Debt

35.03 Book value of equity

35.04 Accounting treatment of intangibles

35.05 Accounting Goodwill and Economic Goodwill

35.06 The flip side

35.07 Understated tangible assets

35.08 Financial companies

35.09 General discussion of debt and debt equity ratios

35.10 Debt to equity ratio conclusion

35.11 Financial strength

35.12 Net long term debt to free cash flow

35.13 Cash flow fallacy

35.14 Net long term debt to NOPAT

35.15 Conclusion regarding coverage ratios

35.16 Measuring Economic Performance

35.17 Return on capital

35.18 Adjusted earnings

35.19 Reported earnings

35.20 Impact of expensing intangible investments

35.21 Capital

35.22 Potentially the bigger problem

35.23 True value of equity, ROC, ROIC and ROCE

35.24 Free cash flow yield

35.25 Coming up with free cash flow yield

35.26 ROC and a company’s cost of capital

35.27 Cost of capital

35.28 Some examples of weighted average cost of capital using CAPM

35.29 Does the use of CAPM make sense in calculation the cost of equity?

35.30 Can we replace CAPM in calculations of cost of equity capital?

35.31 Earnings yields and cost of capital

35.32 Banks and life insurance companies

35.33 Conclusions re ROC

35.34 Return on Equity

35.35 Other measures of company performance – Profit margins

35.36 Ratios used by management

35.37 Tying this together

35.38 Comparing with cost of capital

35.39 Conclusion


You can reach me by email at rodney@investingmotherlode.com

I’m also on Twitter @rodneylksmith


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