ARA Analysis - Part II

Part II

Now that we have a basic understanding of ARA and before we dive into the details of ARA's various business segments, the questions we need to ask ourselves is - What are we buying? What are the risks that we underwrite when we buy ARA?

What are We Buying
Let's us attempt to answer the first question. The common-sense answer to that will be - we are buying a fund manager. However, that is only half the answer. What we are buying is a portfolio of [REITs and real estate funds]. If we look at how ARA makes money, this become obvious because ARA's cashflow ( perf fee as a % of net property income) is contingent on the REIT's cashflow.

But to say that we are buying a fund manager + a portfolio of [REITs and real estate funds] is only 75% right. To say that we are buying a portfolio of REITs is slightly misleading because a REIT mainly provides exposure to the rental streams of an asset . A buyer of a REIT does not directly or necessary suffer from a change in capital value of the asset. On the other hand, ARA gets exposure to both the rental stream (via its perf fee structure) and capital values (via its base fee structure - % of gross asset values)

Because of how ARA obtain it revenue streams - via a base fee that is a % of gross asset values and perf fee that is a % of rental stream (net property income) - we need to see through the REITs and real estate funds to see what these funds are holding. And if we do that, then we see that what we are really buying is a fund manger + a portfolio of real estate.

A fund manager + a portfolio of real estate will be true if ARA receives all its income by cash. But because of its arrangements with some of the REITs to receive payments in kind (REIT units), you end up buying a fund manager + a portfolio of real estate + a portfolio of REITs.

What are the Risk(s) Underwritten
Now that we understand what we are buying, we can much more easily comprehend the risks that we are getting exposure to. Consequently, we need to do some questioning as to whether the risk level is too high and whether we are willing to take on such risks.

Firstly, as a fund manager, a risk is ARA's ability to raise funds. This affect the ARA's profit as a huge proportion of their revenue is derived from a % base fee on the AUM being managed. It is generally easier to raise funds in a up-cycle in the real estate market. The ability to raise funds is also dependent on the demand for REITs (i.e. equity market risk) since a huge amount of funds under management are in REITs and one of ARA's core businesses is being a REIT manager. Lastly, the ability to raise fund is dependent on the funds that ARA has currently. Oftentimes, when raising funds, ARA will not be able to raise funds with mandates that are similar to what they have already, in fear of a conflict of interest. Hence, ARA faces a dilemma/constraint here.

Secondly, as a owner of a real estate portfolio, you face rental rate risk - a fall in rental income. In addition, you face capital value risk - a risk that capital values of the properties might fall. The latter is a more significant risk than the former because ARA derives more income from its base fees than performance fees for REITs. Going forward, as ARA's private funds exit, ARA's exposure to capital value risk will increase. This is because ARA shares in the returns of its private funds and the returns are dependent on capital values when the fund exit from its investments.

Also, as both a fund manager and an owner of a real estate portfolio, you want to grow your asset base. And ARA has every incentive to because they get fees whenever they acquire or divest assets for the REITs. So another risk is ARA's ability to acquire assets. This in turn brings into question ARA's ability to raise equity (i.e. equity market risk) and ability to raise debt to finance the acquistions.

Lastly, ARA faces equity market risks because some it may not necessarily receive its revenue in cash but in terms of units in the REITs. And under some circumstances, they may not be able to divest immediately nor are they able to sell all the units at the price which they got it for. This ties back to a former point on the demand for REITs and in turn the REIT's share price (i.e. equity market risk).

In concluson, the risks are

1) ability to raise funds - which in turn is partly related to the condition of the real estate market - link to pt 3

2) rental rate risk

3) capital value risk

4) ability to acquire assets

5) equity market risk/demand for REITs/ability to raise equity

6) ability to raise debt

Note that pt 2 is link to pt 3 as capital values are detemined partly by rental rate levels. However, they are not synonymous because capital values is a function of rental rates and cap rates. Think cap rates like the P/E ratio. The cap rate is partly determined by expectations of future rental levels and relative returns of other similar investments like bonds.

~To Be Continued~