Red Flags in Conducting Due Diligence on Listed Real Estate Companies

When deciding to spend time researching a real estate company, it is useful to start with red flags.

I find that starting with related parties is often the most effective approach. Begin by examining the company’s early financial statements. In the initial listing periods, companies tend to be smaller, and individual transactions are more significant. These early financials often provide more detailed disclosures compared to later periods, where transactions may be considered non-material. Take notes on all related parties, and keep this list for future reference, as names tend to reappear in later periods. Additionally, searching online for lawsuits and news involving these early-day related parties can provide valuable context. For instance, one company I researched, provided a loan to its controlling shareholder to invest alongside the company in a certain asset. The loan accrued interest at a significantly low rate and remained on the books for years. This posed a risk to minority shareholders, as they effectively financed the controlling shareholder’s equity investment without real collateral. Despite assurances from investor relations that the loan would be repaid by year-end, it remains outstanding, with its value at one point exceeding the company's whole market cap. The company's shares fell by 85% since the IR call, highlighting the potential pitfalls of such transactions and providing insight into the character of executives who allow such practices. Another example of related-party red flags involves a company that acquired a majority stake in a low-leverage company, using the target's balance sheet to borrow additional funds. These funds were then diverted to the controlling shareholder via upstream loans and downstream asset sales. Questions to IR were brushed away, and shares dropped more than 40% since, while the relevant benchmark rose by 15%.

Next, examine the executive compensation section to understand how it is structured. Ensure that compensation is tied to the company's real value drivers rather than the share price, which can be manipulated through buybacks, or to accounting figures that can be manipulated by executives (e.g., NAV, non-cash items, etc). For example, one company that spent heavily on share buybacks had 40% of its executive compensation tied to stock price growth. While buy-backs are generally seen as positive, they should not be used to game the executive paycheck. There is no real value created by a buy-back.

Pull financial statements of related parties from the company register, where available. This can confirm how related parties describe transactions with the target company and reveal undisclosed beneficial owners, transaction details, or original property costs. In real estate transactions, assets are sometimes sold in share deals. Even if the land register is not public, ownership can be tracked via company registers if the holding company’s name is available. Analyzing these can reveal seller involvement in the acquiring entity or financing it with equity or debt. This might serve either to demonstrate to the market/valuator that the selling entity can sell assets at a certain price or to strip assets from the company at a low price. Some of these investments into the acquiring party by the researched company might pass as "Non-Material" and show up as an “Other Asset” with no disclosure, while a public register might provide information about the acquiring entity and its investors/financiers.

Create a spreadsheet detailing the acquisition and sale of specific assets to determine if the company has a history of profitable transaction cycles of buying and selling properties at a profit, or if it is like many REITs that buy income only to sell assets at a loss when leases end. Verify and compare actual results to the company and analysts' narrative. For example, a company might claim to sell a property above book value, but without knowing the historical cost, it’s hard to assess management's asset management skills.

Cash is king for yielding properties. To get a better understanding of a company's performance, it's useful to create an adjusted balance sheet and P&L, adjusting for valuation gains to determine the cash yield.  For example, one company I researched was touted by sell-side analysts as able to acquire low-yielding assets and rapidly transform them into high-yielding properties. However, due to the company's frequent acquisitions and booking of valuation gains, verifying this claim proved challenging. It was only by constructing a cash-based portfolio value and comparing it with the actual cash flow that the true situation became clear - the sell-side narrative was not supported by cash income.