Why Allied Properties Real Estate Investment Trust’s (TSE:AP.UN) ROE Of 10.09% Does Not Tell The Whole Story

Allied Properties Real Estate Investment Trust (TSX:AP.UN) delivered an ROE of 10.09% over the past 12 months, which is relatively in-line with its industry average of 10.26% during the same period. But what is more interesting is whether AP.UN can sustain or improve on this level of return. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of AP.UN’s returns. View our latest analysis for Allied Properties Real Estate Investment Trust

What you must know about ROE

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 10.09% implies CA$0.1 returned on every CA$1 invested, so the higher the return, the better. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Office REITs sector by choosing the highest returning stock. However, this can be misleading as each firm has different costs of equity and debt levels i.e. the more debt Allied Properties Real Estate Investment Trust has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.

Return on Equity = Net Profit ÷ Shareholders Equity

ROE is measured against cost of equity in order to determine the efficiency of Allied Properties Real Estate Investment Trust’s equity capital deployed. Its cost of equity is 8.43%. Some of Allied Properties Real Estate Investment Trust’s peers may have a higher ROE but its cost of equity could exceed this return, leading to an unsustainable negative discrepancy i.e. the company spends more than it earns. This is not the case for Allied Properties Real Estate Investment Trust which is reassuring. ROE can be dissected into three distinct ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:

Dupont Formula

ROE = profit margin × asset turnover × financial leverage

ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)

ROE = annual net profit ÷ shareholders’ equity

TSX:AP.UN Last Perf Feb 23rd 18
TSX:AP.UN Last Perf Feb 23rd 18

The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Allied Properties Real Estate Investment Trust’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can determine if Allied Properties Real Estate Investment Trust’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at Allied Properties Real Estate Investment Trust’s debt-to-equity ratio. Currently the ratio stands at 59.70%, which is reasonable. This means Allied Properties Real Estate Investment Trust has not taken on too much leverage, and its current ROE is driven by its ability to grow its profit without a huge debt burden.

TSX:AP.UN Historical Debt Feb 23rd 18
TSX:AP.UN Historical Debt Feb 23rd 18

Next Steps:

While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Even though Allied Properties Real Estate Investment Trust returned below the industry average, its ROE comes in excess of its cost of equity. Its appropriate level of leverage means investors can be more confident in the sustainability of Allied Properties Real Estate Investment Trust’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.

For Allied Properties Real Estate Investment Trust, I’ve put together three essential factors you should further research: