Pfi

[JeffW]

cancel that - I've re-read!

[Snoopy]

Now that I know more about how the PIE income distribution system works, it is time to revisit this topic

Building Depreciation Allowed FY2020,FY2021, FY2022	FY2018	FY2019	FY2020	FY2021	FY2022	5 year Total
Dividends Paid during Financial Year (1)	$37.902m	$37.654m	$37.961m	$38.723m	$39.886m	$192.126m
less Dividends reinvested during year (2)	$0.0m	$0.0m	$6.585m	$11.649m	$0.0m	$18.234m
equals Net dividends paid during year	$37.902m	$37.654m	$31.376m	$27.074m	$39.886m	$173.892m
IRD Operational Net Profit After Tax (2)	$32.045m	$34.488m	$29.660m	$33.674m	$28.326m	$158.193m
'Cash Earnings' available for distribution (3)	$32.045m	$34.488m	$36.514m	$41.935m	$39.962m	$184.944m

Notes

1/ Dividends paid and dividends reinvested over the financial year are taken from each respective 'Consolidated Statement of Changes in Equity' in the Annual Reports.
2/ Refer post 14.
3/ Refer post 13.


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Earnings will naturally vary from year to year. Companies set up as 'income generating vehicles', a category into which 'Property Owning PIEs' -like Property for Industry- fall, will often look across annual income perturbations, to distribute to their unit holders a predictable income stream. This means that rather than taking an 'annual view', comparing how income relates to dividends over a five year period seems more appropriate. For the five years in the above table, declared dividends have exceeded operational earnings by: 192.126/158.193= 21%, or $33.933m. However, a significant portion of these dividends have been clawed back via the dividend reinvestment scheme.

Further to this, the 'cash earnings' of PFI (which is not a term I like because some of these 'earnings' are not earnings but rather 'behave as such' by the way certain cash flows are treated under the PIE regime) have substantially exceeded the IRD recognised net profit after tax over the five years. Thus, in reality, these 'cash earnings' more than cover the net 'cash paid out in dividends'. The cashflow picture is looking a lot more stable than I had first imagined!

Nevertheless, the removal of the ability to offset 'structural building depreciation' will have a negative effect on cash flows, and hence potentially dividends going forwards. Given it is only the ability to offset 'structural building depreciation' that is being mooted as being disallowed, that effect may not be as great as some think in the overall picture. Increased profits from this change in policy should partially offset the former 'structural building depreciation' accounting entry that used to flow straight through to the dividend. The effective cash lost to unit holders in this policy change will be the increased government tax take on the increased profits. That's how I now see things anyway.

SNOOPY

[FTG]

Nevertheless, the removal of the ability to offset 'structural building depreciation' will have a negative effect on cash flows, and hence potentially dividends going forwards. Given it is only the ability to offset 'structural building depreciation' that is being mooted as being disallowed, that effect may not be as great as some think in the overall picture. Increased profits from this change in policy should partially offset the former 'structural building depreciation' accounting entry that used to flow straight through to the dividend. The effective cash lost to unit holders in this policy change will be the increased government tax take on the increased profits. That's how I now see things anyway.

SNOOPY

Lest not forget that the ability to claim structural building depreciation was actually removed over 10 years ago now (2010)!
Yes, it was reintroduced in 2020 (as part of the Govt Covid Stimulus Package), but at lower rates than previously applied; pre2010.

Therefore, the commercial property market business model (including, for example, valuation methodology & lease negotiating/structuring ) has evolved & adapted - at least for the bigger & smarter operators. Whilst some property owners may have had a faint hope that a change of Govt would make the 2020 introduced regime permanent, the seasoned operators have kept the bigger & more long term picture firmly in the viewfinder. I would suggest that with the depreciation related tax regime basically reverting back to pre2020 settings, there should be no negative effects on PFI's dividends.

Continued financing cost increases - now that could be a different story.

[Snoopy]

The aim of PFI is to provide reliable and steadily increasing dividend returns based on the concept of 'AFFO', which stands for Adjusted Funds From Operations. There is no internationally recognised standard outlining exactly how to calculate AFFO. But the general technique is to start from the property owning company's 'funds from operations' (FFO), and make adjustments consistent with retaining the quality of a company's underlying assets over time from that base.

FFO = net income + amortization + depreciation - capital gains from property sales

Adjustment's to FFO in order to calculate AFFO could typically be:

AFFO = FFO + rent increases - capital expenditures - routine maintenance amounts

Note the capital expenditure referred to is to maintain the quality of the company's existing properties, rather than being comprehensive budgets for new projects. PFI are not clear on exactly what method they use to calculate AFFO, although they do give us 'the numbers' (8.83cps over FY2022).

I am on record as saying I don't like AFFO as a measure. However, even though I don't like it, PFI seem determined to use it. So it then becomes imperative that I put some effort into understanding AFFO, from a PFI perspective.

AR2022 p89 tells us that:
a/ AFFO for FY2022 was $44.6m.
b/ The weighted average number of shares on issue over FY2022 was 504.719m

That means AFFO per share amounted to $44.6m/504.719m = 8.83cps over FY2022

I prefer to use the number of shares at the end of the year when looking at earnings per share figures. So from my perspective:
AFFO = $44.6m/502.050m = 8.88cps.

Compare this to my calculated 'earnings per share' for the year of 7.30c (my post 19).

What are the other changes, besides 'net profit' that might effect AFFO? I have identified 3 possibilities below:

i/ Structural building depreciation for the year I put at $11.536m (my post 13). This equates to $11.536m/502.050m = 2.40cps

ii/ From AR2022 p6
"Divestments saw four properties – 39 Edmundson Street in Napier, 330 Devon Street East and 20 Constance Street in New Plymouth, and 8A & B Canada Crescent in Christchurch –transacted at a combined gross sales price of $33.4 million. On average, these properties realised 8% above their most recent book value."
The gain in book value from these property sales amounts to 0.08x$33.4m= $2.672m or $2.672m/502.050m = 0.53cps
Note that gains in property sales are subtracted from AFFO.

iii/From AR2022 p49 (The cashflow statement) there was a: $23.766m - $19.157m = $4.609m reduction in the tax deductible expense of 'expenditure on investment properties', or 0.72$4.609m/502.05= 0.66cps

Put these three adjustments onto my earnings per share and I get: 7.30c+2.40c-0.53c+0.66c= 9.83cps. Given that this figure is significantly higher than the 8.88cps AFFO quoted, we might conclude that there are plenty of opportunities to increase 'cash earnings' above 'net profit'. An alternative conclusion might be that I have no idea what I am doing. But since PFI isn't exactly forward with how it achieves its own AFFO earnings figures, this is the best I can do today, given the information disclosed in the annual report.

SNOOPY

[Snoopy]

Lest not forget that the ability to claim structural building depreciation was actually removed over 10 years ago now (2010)!
Yes, it was reintroduced in 2020 (as part of the Govt Covid Stimulus Package), but at lower rates than previously applied; pre2010.

I was vaguely aware of structural building depreciation being allowed in the past, prior to it being reintroduced as a Covid stimulus package measure. I wasn't aware of deductions being allowed at a higher rate prior to 2010 though. I may be misunderstanding this. But I (simplistically?) thought that deductions of structural building depreciation as set during Covid would have been set at 100%. Yet you are saying that prior to 2010 the depreciation allowed was MORE than this? Can you expand please?

SNOOPY

[Snoopy]

The commercial property market business model (including, for example, valuation methodology & lease negotiating/structuring ) has evolved & adapted - at least for the bigger & smarter operators. Whilst some property owners may have had a faint hope that a change of Govt would make the 2020 introduced regime permanent, the seasoned operators have kept the bigger & more long term picture firmly in the viewfinder. I would suggest that with the depreciation related tax regime basically reverting back to pre2020 settings, there should be no negative effects on PFI's dividends.

I notice that in the FY2022 report on p6, written early in 2023 before election policies were announced:
"The projection for next year (FY2023) is a dividend of 8.10 to 8.30 cps, a further increase of up to 2.5%."

These guys at PFI aren't just 'possum in the headlights' slaves to government policy. They are working quietly and incrementally to improve the business all the time.

If I am right that it is only the 'tax take on the structural depreciation' from which unit holders will take a hit (because that is the only new money being taken out of the system), then we are looking at a hit on distributions, from an FY2022 perspective, amounting to something like 0.28x$11.538m = $3.231m. That equates to $3.231m/502.050m= 0.6cps going forwards. If PFI have been true to their forecasts, then 0.2cps the forecast 'new tax earnings dip' has already been made up over FY2023 in increased dividends.

Dividends paid so far relating to FY2023 include Q1 1.95c, Q2 1.95c and Q3 1.95cps. Those are above the respective quarterly payout figures of 1.80c, 1.80c and 1.85c for the previous year, the summed increase being 0.4cps for the year so far already. If PFI continue to be able to increase their underlying 'cash earnings' like that, then you may very well be right FTG. We get a flat year of dividend payouts for FY2024. Not the disastrous 'downsizing of payouts' that some were predicting.

SNOOPY

[Snoopy]

Continued financing cost increases - now that could be a different story.

Just taking a look at the 'composition of borrowings', as shown in Section 3 Funding in the annual report for FY2022, I total $403.705m out of the $603.705m total or 67% of borrowings to be at 'floating rates'. That is a lot. Moving onto the cashflow statement from the interim result for FY2023, interest payments rose from $10.566m to $13.904m, a rise of 31.6% for the half year period! But asset sales were up by a staggering $20.069m - $9.069m= $11.000m in the half year period too, so no worries. Plenty of assets there to sell so that PFI can keep paying those divvies!

Going back five years to FY2018 shows drawn bank facilities of $201.500m, to go alongside the PFI010 and PFI020 bonds with $100m of bond capital in each. Back then only 50.4% of borrowings were behest to the banks. So your hint is quite right. Maybe interest rate management skills need sharpening at PFI?

SNOOPY

[Snoopy]

The following table has been compiled under the assumption that 'structural depreciation for buildings' was not allowed. While this was the case in FY2018 and FY2019, I have had to make adjustments to the free cashflow of the company, and hence money available for dividends in FY2020, FY2021 and FY2022. Post 13 provides detail on what these assumptions are. Dividends are considered in the financial year they are paid.

Per Share Dividends	Div Q1	Div Q2	Div Q3	Div Q4	Depn. Tax Adjustment (1)	Annual Total
FY2018	2.15c	1.80c	1.80c	1.85c	N/A	7.6c
FY2019	2.10c	1.80c	1.80c	1.85c	N/A	7.55c
FY2020	2.15c	1.80c	1.80c	1.85c	(0.4c)	7.2c
FY2021	2.25c	1.80c	1.80c	1.85c	(0.5c)	7.2c
FY2022	2.45c	1.80c	1.80c	1.85c	(0.7c)	7.2c
Five Year Total						36.75c

Notes

1/ 'Depreciation Adjustment' adds the incremental taxation element of 'structural building depreciation'. This 'structural building depreciation' is extra money over and above earnings as measured by NPAT that would previously have been part of what is sometimes described as 'cash earnings'.

If structural building depreciation is no longer allowed, this increases profits and hence the tax take, in comparison with the real situation of tax deductability over FY2020, FY2021 and FY2022 being allowed over those years. The tax paid under each scenario (tax deductability 'allowed' or 'not allowed') may be found in post 13. And the incremental tax paid under the alternative 'no building structure depreciation allowed' scenario, may be calculated as follows.

FY2020: $13.370m - $11.535m = $1.835m. $1.835m/501.303m = 0.4cps
FY2021: $15.409m - $13.096m = $2.313m. $2.313m/505.494m = 0.5cps
FY2022: $14.426m - $11.015m = $3.411m. $3.411m/503.275m = 0.7cps

I am a newbie looking at these property PIEs. I think this is the right way to adjust the 'cash earnings' as they apply to dividends calculations, but I am prepared to be corrected. My Take: The 'helicopter view' of the cashflow, is that the only extra cash taken out of this money system by changing the depreciation rules goes to the government. So this means there is still some 'depreciation money' in the system that can be added to cashflow and be paid out in addition to net profit after tax earnings, even with the depreciation tax law changes. This means that dividends can still perpetually continue to be higher than NPAT. Just less so than before.

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Total modelled average net dividends over five years: 36.75c / 5 = 7.35c

As I write this the PFI010 and PFI020 bonds are trading around on the secondary market at the 6.5% level. For equity risk I require a gross level of return greater than that : 7.5%. This means my FY2022 capitalised valuation for PFI to get my required rate of return works out as:

(7.35c/0.72)/0.075 = $1.36

I could 'look through' current high interest rates, in anticipation of interest rates being a percentage lower in a year's time. That would change my capitalised valuation to:

(7.35c/0.72)/0.065 = $1.57

We can add a multiplicative PIE fudge factor' onto shareholder returns from the point of view of a marginal 33% income tax rate payer. This is: (1-0.28)/(1-0.33) = 1.075. This increases 'fair value; to $1.57 x 1.075 = $1.69

An alternative multiplicative PIE fudge factor' on shareholder returns from the point of view of a marginal 39% income tax rate payer can be calculated. This is: (1-0.28)/(1-0.39) = 1.18 This increases 'fair value' of PFI shares to $1.57 x 1.18 = $1.85

Even this is still well below current market prices of $2.24 though. My conclusion is that PFI as a head share on the market today, with soaring construction costs in brownfield development project risk, is looking too expensive. With interest rates as they are, and PFI in my judgement most unlikely to default on bond interest payments, it is looking to me like the PFI010 and PFI020 bonds might be a better investment bet than the shares on today's market.

SNOOPY

[FTG]

Snoopy, if you are wanting a blow by blow (timeline) account of NZ's tax policies relating to building depreciation, including applicable rates & methodology (SL, DV etc), then Dr Google should suffice. At least much better than I can articulate here with brevity.

Other than from the IRD itself, I'm sure you will find also various papers addressing your questions, published by the Big 4 etc.

[Snoopy]

Snoopy. Long term property investors would argue that the long run attractiveness of investing in property is that not only do you get the net rent but over time property values rise with inflation. Does your ROE calculations account for inflation increasing the value of the assets over time?

Pinching a good thought from kiwikeith on the IPL thread, because it is equally applicable here.

The direct answer to this question is that I remove any property value gains from the shareholder equity, before I look at the return on that shareholder equity. If I didn't do that, then any calculated return on equity would be penalised, because a property happened to have gone up in value. Clearly as property investors, we want our properties to go up in value. So to say your return on equity, i.e. rental yield, is going down simply because you have been very successful in selecting your property that has gone up in value, would be a nonsensical way to go about evaluating your property returns. The question becomes more nuanced when you ask how total returns are measured, in light of increasing asset values.

Prior to CY2021, we had the very favourable situation for property investors with steady rises in the value of rental contracts, coupled with a concomitant rise in the value of the underlying assets reflecting amongst other things, their ability to earn more rent. Then when interest rates rose suddenly, even as rents held steady, the value of investor's properties started to fall and in some instances fall significantly. In most instances though, this was due to a rise in capitalisation rates reducing the present value of future earnings. Far more worrying than that, would have been tenants going broke and leaving the landlord with empty buildings that were not easy to re-rent. Thankfully this hasn't happened with PFI. And with the supply of land in industrial Auckland being 'tight', I don't think it is likely to happen. Capitalisation rates tend to be cyclical. So over the longer term, you can argue that changes in investor property values do reflect its improved rentability, and are not a result of capitalisation rates 'blowing in the wind'. Furthermore although such revaluations are not an immediate cash benefit, to the property investor, such increased valuations can be 'borrowed against', - a process that allows cash to be raised. Furthermore if such revalued buildings are sold then cash is raised, albeit at the expense of the loss of the income stream in the future that gave rise to that 'cash revalued upward property' in the first place.

The point of my musings here, is to bring up the idea of 'double counting'. If we measure the same benefit twice, both as 'increased income', and as an increased value of the property itself, are we just 'kidding ourselves' into believing we are doing twice as well as we really are? My answer is 'yes' and 'no' depending on the specific situation.

A property is valued on its future earnings capacity. So if you have updated your property to improve its rent-ability, for example pulled down an old warehouse and built a new one with rent-able office space above it, then yes you have improved the rent-ability of that property. Another growth scenario might be that you do nothing to your property. But the city your warehouse serves grows around you. Thus your site becomes a more valuable prospect to a multitude of operators, which starts a bidding war to raise the rent of your tired old warehouse in the marketplace. I bring up this second example, to show that you don't have to spend money on a property for the increase in its value to be real. However in my third example, say you have a warehouse in a steady state town when interest rates fall, pushing the book value of your property up. I would argue that in this situation you have not made a capital gain. All that is happening is that a cyclical drop in interest rates is resulting in a temporary rise in value of your building. An interesting corollary of this thinking is to consider what might happen if interest rates drop to 'once in a generation' lows (as happened during Covid) and now start to rise again, depressing property valuations as a result.

Are those big falls in commercial property we have been seeing over the last year or two real? Using the previous paragraphs line of thinking, I would argue they are not real. But neither were the rises in property prices resulting from very low interest rates pushed through during Covid real either. My philosophy: In an environment where interest rates are swinging so violently, it is probably best to focus on the income generating ability of those property assets. This is where I have got to myself, valuing property today. If the income generation potential of a property does not marry up with its capital value on the balance sheet, then it is likely the capital value on the balance sheet that is wrong.

One advantage of PFI being around in its current form for 30 years this year is that these interest rate investment cycle variables that I have been talking about do tend to average out. And that means that the gains in net asset backing over the years at PFI, most likely are real. So that means we should take these gains into account when determining our investor returns at PFI. Post 20 in this thread puts those gains at: $314.916m + $607.285m = $922.201m to date.

Over 30 years, that works out at a 30 year annual compounding rate 'r' of:

($1,500.328m - $922.201m)(1+r)^30 = $1,500.338m
=> $578.127m (1+r)^30 = $1,500,338m
=> (1+r)^30 = 2.595
=> r=1.03, or 3% per annum.

What happens if we decide to add that into our valuation model?

SNOOPY