Session Plan

Chapter Twelve:– REITs as investment alternative– QQD of REITs– REIT Valuation Techniques– The Send-Off

Origins of REITs

Massachusetts Trust (19th Century until 1935)– Filled void for corporations owning RE– No federal tax, & no distributions tax for shareholders!!

Investment Company Act of 1940– Closed end mutual funds lobbied for equal treatment

until tax law was amended in 1960– External management structure was required until

1986

Real Estate Investment Trusts (REITs)

First established in US in 1960– 1971 Australia, 1985 Turkey, Canada 1993, Singapore 1999,

Japan 2000, Hong Kong & France 2003, Germany in 2007 US Minimum Requirements

– 100 shareholders– 75% of value of REIT assets in RE, cash, or gov’t securities– 95% of gross income from dividends, interest, rents, or gains from

sale of REIT assets– Shareholder distributions at least 90% of REIT taxable income

annually Additional European Requirements

– Leverage is limited (50% in Germany, France, Spain; 20% for most Austrian REITs, a coverage ratio of 1.25x EBIT/Int in UK)

– Limits for size of any one property (15% in G-REIT, 40% in UK)– EU REIT Strategies: Core/nuclear (low risk), Core-Plus/Value

Added (medium risk) and Opportunity (high risk)

REIT Organizational Structures

UPREIT: Umbrella Partnership REIT– Established in 1992 to allow existing RE operating

companies to bring property already owned under umbrella of REIT w/o capital gains tax

– REIT owns controlling interest in limited partnership that owns the real estate

– Owners of limited partnership can convert operating units into REIT shares, vote, & receive dividends

REIT Organizational Structures

Down REIT: – Formed after REIT goes public– Can own numerous partnerships at the same time– Down REIT owns property directly in REIT, but

holds some properties in partnership with others– No tax liability until partnership units are

converted into stock or sold

REIT Incentive Issues

UPREIT: – Management could be reluctant to sell if they own

operating units rather than REIT shares Subject to tax when sold

Down REIT:– If management does not own operating units,

could become “trigger happy” with sales given the lack of tax consequences from sale

REIT Taxation

Shareholders pay taxes on dividends received via form 1099

721 Exchange: Like Kind Exchange for REITs– Limited Partners of Up and Down REITs can exchange

partnership units for interests in other RE via like kind exchange

Must be investment grade property Investors receive operating units rather than property Up and Down REITs have advantages for tax sensitive sellers

Types of REITS

Mortgage REITs– Heyday in 1970s

Equity REITs– Most common form today

Hybrid REITs– Invest in both mortgages and equity

Mutual Fund REITs– Common for personal investors

Mutual Fund REITs

First mutual fund in Netherlands in 1774 Modern mutual funds began in US in 1924

– Was truly “mutual” as it was organized, operated, & managed by its own trustees

– Alpha Fund: shareholders own funds which own management company

– Omega Fund: Mgmt company shareholders own mgmt company which controls mutual fund owned by mutual fund shareholders

Mgmt company shareholder interests are introduced Higher costs typically given competing goals of shareholder

wealth creation & profit for external mgmt company

REIT Historical Performance

As you can see, mortgage REITs are historically more volatile than equity REITs

FTSE NAREIT US RE Index 1972-2011

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Equity REIT (no Timber)

Mortgage REIT

“Portfolio Mix” Strategy

Investors can review annual reports of REIT mutual funds to obtain information for how they allocate their investment dollars.

It looks like REIT 1 has more confidence in the office market but much less in retail than does REIT 2

  REIT 1 REIT 2

Office 38% 17.5%

Industrial 26% 5.9%

Apartments 20% 15.3%

Retail 15% 24.8%

Other 1% 36.5%

“Quantity” Strategy

This strategy involves maximizing the gross potential income by keeping overall portfolio vacancy rates as low as possible.

  REIT 1 REIT 2

Office 92% 92%

Retail 86% 92%

Industrial 87% 95%

Apartments 96% 97%

Weighted Avg. 91% 93%

“Quality” Strategy

Another portfolio diversification strategy is to concentrate on properties that have high quality, nationally known companies as tenants. Top 5 Tenants by Square Footage for REIT 1

Industrial Office Retail

Wal-Mart BHP Petroleum Publix Supermarkets

GE Deloitte & Touche Dick’s Sporting Goods

Regal West Crowell & Moring Wal-Mart

Restoration Hardware Bank of NY Mellon Ross Dress for Less

Kuehne & Nagel Microsoft Belk

See any problem companies here?

“Durability” Strategy

Let’s see how REIT 1 looks in terms of the durability of the lease income.

For Retail: low percentage of portfolio but long leases.

Type 2011 2012 2013 2014 2015 2016 & Beyond

Office 10.2% 6.8% 8.2% 11.9% 10.2% 38.3%

Retail 9.8% 10.9% 10.2% 7.6% 8.5% 36.6%

Industrial 12.9% 10.4% 17.3% 6.8% 22.1% 22.8%

“Geographic Dispersion” Strategy

REITs (or wealthy investors) have the ability to reduce local market risk via diversification.

Below is how REIT 1 is diversified in this way...

  East West South Midwest Foreign

Office 24.5% 17.5% 10.4% 1.2% 2.7%

Apartment 2.6% 6.2% 5.4% 0.0% 0.0%

Industrial 1.3% 7.0% 4.1% 1.3% 0.0%

Retail 3.2% 0.9% 8.5% 0.3% 2.4%

Storage 0.2% 0.2% 0.1% 0.0% 0.0%

“Geographic Dispersion” Strategy Continued

Another method of viewing this type of portfolio risk smoothing is by Metropolitan Statistical Area (MSA):

  MSA % of Total

1 Washington-Arlington-Alexandria-DC-VA-MD-WV 10.6%

2 Boston-Quincy MA 5.5%

3 Los Angeles-Long Beach-Glendale CA 5.4%

4 San Francisco-San Mateo-Redwood City CA 5.0%

5 Houston-Bay Town-Sugar Land TX 4.8%

REIT & The QQD Framework

Quantity Strategy– Strong dividends, maximize GPI, growth orientation

purchased at discount Focus strategy: less diversified Diversified: higher expenses

Quality Strategy– Nationally known tenants, NNN REITs, Blue Chip REITs

Durability Strategy– Tenant rollover risk, length of leases, geographic dispersion

REIT & The QQD Framework

Lease Rollover Risk– Attempt to diversify via the duration of the income

stream on associated properties.– Also based on the lack of a high concentration on

any particular tenant for the total revenue

Business Risk– Attempt to diversify via the region or type of

property in an effort to reduce concentration on one area or property type

REIT Valuation Techniques

Gordon Dividend Growth Model Funds from Operations (FFO) Multiple Net Asset Value (NAV)

Gordon Dividend Growth Model

Utilizes future dividend per share expected next year to calculate stock price as the present value of expected future dividends

Constant dividend growth is assumed Begin with DCF based on projected revenue and

expenses to estimate FFO for an assumed holding period

– Add in reversion to obtain PV of firm– Divide by # of outstanding shares to obtain D1

V = D1

(k-g)$50.00 = $3.00 (0.10-0.04)

FFO Multiple

Similar to the Price to Earnings Ratio FFO: Net income (GAAP) excluding gains or

losses from sales of property or debt restructuring adding back RE depreciation– Value = FFO/share * FFO Multiple

Multiple: Historical multiple for REIT or peer group– Only as good as the comparables!!

Net Asset Value (NAV)

Value = Aggregate Stabilized NOI Blended Cap Rate

– Blended cap rate is difficult for diversified assets – Rather: Find value of specific properties and divide by

property specific cap rates to obtain value of portfolio– Once find value, subtract out debt to obtain NAV

Shares quoted in terms of Net Asset Value (NAV)– Holding Period Return= NAVnow –NAVprior + Divholding period

NAVprior

Net Asset Value (NAV)

NAV

Per ShareRevenue 35,000,000$ 12.73$ Op Ex 15,000,000$ 5.45$ NOI 20,000,000$ 7.27$ Cap Rate 9.50%Value 210,526,316 76.56$ Debt 75,000,000 27.27$ NAV 135,526,316 49.28$

# of Shares 2,750,000

REIT Valuation Issues

Different classifications of recurring expenses for FFO

– Tenant Improvements, Leasing Commissions– If categorize as expense, subtract from FFO– If categorize as capital improvement, amortized on balance

sheet Adjusted FFO (AFFO)

– Adjusts FFO for expenses, while capitalized, which do not enhance property value

– Eliminates straight lining of rents FASB 13: Free rent or increases must be equalized (straight-

lined) over term of lease

REIT Internationalization

International RE Investment is becoming more of an area of study Historically International RE Investment focused on Blue Chip properties

in well known cities RE Investment becoming more frequent in Emerging Markets RE Investment in Developing Countries typically centers around Tier I

cities REITs have been embraced by Islamic Finance given the verifiable

nature of the assets included in the investment pool

The initial requirement for external management still exists in many countries…

Internal External BothFrance Australia United StatesTurkey Japan Canada

Singapore NetherlandsHong Kong BelgiumMalaysia Germany

Emerging Market Property Rights

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The End?

“One repays a teacher badly if one always remains a pupil…”

– Thus Spoke Zarathustra, On the Gift Giving Virtue, pg. 78

Go forth and invest in Real Estate!!

Friedrich Nietzsche