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Real Estate Investment Trusts (REITs)

What is it?
Securitized real estate investment Ownership form created by IRS code

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Requirements
Assets
75% of assets must be real estate, cash, and govt. securities
other REIT shares are considered real estate assets

not more than 5% of assets can be from 1 issuer if not covered under above test may not have more than 10% of voting securities of 1 issuer if not covered under 1st test
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Requirements
Income
95% of gross income must be from dividends, interest, rents, or gains from sale of certain assets (real estate, cash, or govt securities). 75% of gross income must be derived from rents, interest on mortgages, gains from sale of certain assets, or income from other REITs

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Requirements
Income
No more than 30% of gross income can be derived from
sale or disposition of securities held less than 6 months sale or disposition of real estate held for less than 4 years, except those involving foreclosures. properties held for sale in the normal course of business (anti-dealer provision)
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Requirements
REIT Modernization Act of 1999 (effective 2001)
REITs allowed to own 100% of a Taxable REIT Subsidiary (TRS). TRS can provide services to REIT tenants and others (previously, this was not allowed). Debt and rental payments from TRS to REIT are limited to ensure that the TRS actually pays income taxes.
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Requirements
Distribution
must distribute 90% of all taxable income to investors
mandates fairly low retained earnings policy has important implications for firm size

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Requirements
Management
REIT managers must be passive
REIT trustees, directors or employees may not actively engage in managing or operating REIT properties (includes providing service and collecting rents from tenants). Managers may set policy: rental terms, choose tenants, sign leases, make decisions about properties.
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Requirements
Anti-concentration rule
5 or fewer entities may not own 50% or more of the outstanding shares Exceptions:
look-through provision for US pension funds UPREIT structure (umbrella partnership)

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Tax Treatment
Accelerated depreciation is allowed for determining taxable income 40 year asset life required for calculating income available for distribution to investors

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REIT Types
Equity Mortgage Hybrid

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Equity REITs
Blank Check
does not disclose investments to shareholders prior to acquisition.

Specified Trusts
purchase a specific property (Rockerfeller Center Properties)

Mixed Trusts
invests in both blank check and specific properties
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Equity REITs
Leveraged v. Unleveraged Finite-life v. Nonfinite-life
finite-life is self-liquidating

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Equity REITs
Closed-End v. Open-End
closed-end protect shareholders from future dilution

Exchange Trusts
tax-free exchange of property for shares in the REIT

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Equity REITs
Developmental-Joint Venture
funds construction costs lower cost of capital for developer

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Mortgage REITs
Invests in mortgages
earn the spread between costs of funds and mortgage loan rates

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UPREIT
REIT formed by consolidating limitedpartnerships partnerships allocated REIT shares based on appraised value of partnership property

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Taubman UPREIT

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REIT Benefits
invest in a diversified RE portfolio managed by professionals higher liquidity

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REIT Disadvantages
possible conflicts of interests between sponsor and REIT shareholders

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REIT Market Capitalization

$160,000

200 180 160

$140,000

$120,000 140 $100,000 120 100 80 60 $40,000 40 $20,000 20 0 Market Cap Equity REITs

$80,000

$60,000

$0
19 71 19 72 19 73 19 74 19 75 19 76 19 77 19 78 19 79 19 80 19 81 19 82 19 83 19 84 19 85 19 86 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00

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Structural Changes Influencing the REIT Market


1986 Tax Reform Act
Reduced incentives to hold real estate in private/partnership form (leveled playing field) Still, no move to public market financing until late 1992
TRA was necessary, but not sufficient condition for the rise of equity REITs

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Structural Changes
End of High LTV Nonrecourse Financing
By early 1990s, commercial banks and insurance companies had reduced exposure to real estate
Regulatory pressure on banks Regulatory pressure and changing business conditions on insurance companies

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Structural Changes
With high LTV nonrecourse loans, real estate owners had no need to raise equity
made them abnormal compared to other capital intensive businesses in the US

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Structural Changes
Debt Rollover Timing
Industry refinanced with 5-7 year miniperms following bond market rally of 1986

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Structural Changes
End of high LTV financing and debt rollovers created a capital squeeze in 1992 that forced many real estate owners to consider raising equity in the public markets for the first time UPREITs created
allowed original owners to maintain effective control of assets
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Size of Equity REIT Market


In the third quarter of 1995, 119 firms included in the Wilshire Real Estate Securities Index
$42 billion in equity market capitalization With roughly 40% average leverage level, the value of real estate owned by equity REITs is about $100 billion
compares to the $120-$150 billion owned by taxexempt institutions acting as fiduciaries for 20:28 beneficiaries

REIT Liquidity
Research finds that equity REITs have the same liquidity as firms in other industries, holding constant firm size and exchange listing
liquidity measured as the bid-ask spread

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REIT Liquidity
Bid-Ask does not decrease during down real estate markets relative to that for all stocks
very different from liquidity conditions in private markets must remember that bid-ask is for a marginal change in ownership, transactions in the private market typically involve whole properties or portfolios of properties (control issues arise)
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REIT Growth
REITs have limited ability to grow through retained earnings (little free cash flow) Most expand through additional stock offerings (follow-on offerings)

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EPS v. FFO
earnings per share (EPS) is a fictional accounting number
REIT must distribute at least 95% of EPS

funds from operations (FFO) is REIT cash flow (no depreciation)

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Funds From Operations (FFO)


FFO means net income (computed in accordance with GAAP), excluding gains (or losses) from debt restructuring and sales of property, plus depreciation and amortization of assets uniquely significant to the real estate industry, and after adjustments for unconsolidated entities in which the REIT holds an interest. Adjustments for these entities are to be calculated to reflect FFO on the same basis. Moreover, NAREIT believes that items classified by GAAP as extraordinary or unusual are not meant to either increase or decrease reported FFO.
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How to Calculate FFO


Revenues minus:
Operating expenses Depreciation & amortization Interest expense General & Administrative expense

= NET INCOME (GAAP)

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Reported FFO?
Net Income minus:
Profit from real estate sales

plus:
Real Estate Depreciation

= FFO

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Analyst FFO?
FFO minus:
Recurring capital expenditures Amortization of tenant improvements Amortization of leasing commissions Adjustment for rent straight-lining

= Adjusted FFO (AFFO)

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Payout Ratio = Dividend / FFO

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Key Parts of FFO


Depreciation and Amortization
Old definition allowed add-back of D&A for non-real estate items
allowed firms to increase FFO in prospectuses via debt buydowns and deferred financing

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Key Parts (Nonrecurring Items)


Focus FFO as a measure of recurring operations
restrict ability to affect FFO due to special events

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Key Parts (Nonrecurring Items)


Focus attention on recurring maintenance and capital expenditures that are necessary to maintain the relative economic position of the property
reflect true economic depreciation probably should be subtracted, not added back to determine FFO
issue of whether capital expenditure is revenueenhancing
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Impact on FFO
Tenant Improvements (TI)
landlord allowance to cover costs of reconfiguring space for tenant TI are capitalized and depreciated - cash flow from TI not included in FFO Implication:
Mgt can use TIs to raise occupancy and rent revenue
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Impact on FFO
Leasing Commissions
usually paid in cash when lease is signed cost is capitalized over life of lease, may not show up in FFO 2 issues:
leasing costs are an operating cost commissions are occasionally paid over lease term

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Impact on FFO
Straight-line Rents (REITS with long term leases)
count average rental rates over lease life in FFO
over states revenue in early years and under state in later years

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Impact on FFO
Lease guarantees
REIT sponsor guarantees income on currently vacant space using master lease (WHY?)
may be for limited period - short term solution to long term problem should have recourse to sponsor sponsor may be charging the REIT guarantee fees

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Impact on FFO
3rd Party Income
income from managing other properties highly variable

Leased space v. Occupied space

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Impact on FFO
Ground Leases
encumber the land underneath buildings (long term) REITs may own buildings subject to a ground lease or REITs may own the ground lease (spread investing)

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Impact on FFO
Depending upon managements strategy with respect to capitalizing or expensing items, calculated FFO and percentage of payout of net income can vary widely
Kimco Realty (KIM) expenses everything they can - reduces measured NOI -- increases amount they can retain (65% payout ratio - lowest in industry) Large group of about 10 has payout ratios over 95% -- capitalize aggressively -- raises FFO -- reduces what they can retain
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REIT Debt Usage


Modest leverage levels compared to those taken on by private real estate firms in mid80s.
However, 20%-50% leverage levels are not low when compared to other capital intensive industries such as auto, chemical, etc..

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FFO Growth
FFO Growth = Internal Growth + External Growth

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FFO Growth
Internal Growth
Rental Increases % Rent, Rent Bumps, etc. Tenant Upgrades Property Refurbishments Sale & Reinvestment

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FFO Growth
External Growth
Acquisitions
Accretive = yield on investment is below cost of capital
Example: REIT raise $100m from stock and bond at 10% WACC -- acquire property with a 12% yield == 2% increase in FFO

Deccretive = yield is below WACC

Development & Expansion


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REIT Debt Usage


Use of secured debt
Mortgaging properties one-by-one has been the standard New realization that levering up via slices of secured debt may not leave enough flexibility for firms to take advantage of targets of opportunities

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REIT Debt Usage


Use of unsecured debt
real estate firms rapidly moving in this direction other corporate entities raise such debt against aggregate firm cash flows, not specific assets

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Minimum Efficient Firm Size


Typical REIT IPO from 1993
$100,000,000 firm with 50/50 debt-equity ratio, yielding 8% on equity implies roughly $4,000,000 in income even with relatively low payout ratio of 75% of earnings, can retain only $1,000,000

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What will $1,000,000 buy?


for apartment REIT, good-sized garden apt. complex costs $20-$25 million, retaining the added $1,000,000 adds little flexibility with respect to acquiring properties for portfolio. from broad capital market perspective, this firm probably should increase payout ratio (this is what happened in reality)
shareholders received high dividend yield, firm had to repeatedly go to the capital markets to fund acquisitions
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Now consider $10 billion firm


Some now exist:
same 50/50 debt-equity ratio and 8% yield on equity implied income of about $400,000,000

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$10 billion REIT


if firm chooses not to aggressively expense, it will have a relatively high payout ratio
if that ratio is 95%, implies the firm can retain $20,000,000 thats a good-sized garden apt complex, 1/5th of a large regional mall, or a couple of decent-sized warehouses or industrial sites.

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$10 billion REIT


if firm chooses to aggressively expense items to reduce accounting earnings and lower its required payout under the REIT tax law, the situation is markedly different
assume its payout ratio falls to 75%:
ratio implies retention of $100,000,000 which will buy a portfolio of any property type except regional malls and downtown office buildings

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If you can retain this amount, you do not have to go to Wall Street to fund every portfolio purchase
increases flexibility so that you can quickly take advantage of targets of opportunity and avoid investment banker fees

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achieving such internal financing capabilities is goal of many firms


given REIT tax law, fairly large scale is required average firm size is too small at the moment

suggests that consolidation in the public markets will continue in the next few years

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how consolidation occurs still is unknown


REIT management's have implemented various types of anti-takeover provisions
5 or fewer rule itself provides a natural defense mechanism

lack of truly independent boards a problem

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mergers difficult because acquired firm inevitably has to be willing to hold the paper of acquiring firms
requires common vision to make it work in the absence of aggressive board intervention

most likely path is continued acquisition of private portfolios by public firms


still occurring at rapid pace more that 80 firms with $1 billion equity market caps 25 largest firms have mean equity market cap of about $5.5 billion (7/14/98)

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What could stop consolidation in the public markets?


Discovery of fundamental diseconomies of scale
if real estate is inherently small scale business because of the need to master local market details, then really large firms are not feasible
they will have lower returns on average than local firms

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REIT Research
Q:
Are REITs real estate or stocks?
important implications for portfolio diversification do REITs provide a real estate index A: REIT returns lag real estate cap rates REIT returns and unsecured real estate returns share a common component that reflects real estate fundamentals REIT returns are noisy.

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REIT Research
Corporate Finance Issues
Dividend policy Capital structure

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REIT Research
Risk and diversification REIT returns highly correlated with stocks (corr = .65 .8) real estate returns have low correlation with stocks (corr=.1 - .3) REIT betas < 1 Real estate portfolio allocation optimal allocation 10% to 19% real estate historic real estate allocation = 3%-5% (pension funds)
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REIT Research
REITs and Inflation Hedging
depend on the time period under study
1970s - REITs are negatively correlated with inflation 1980s - REITs are positively correlated with inflation

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