Copyright © 2008 by the McGraw-Hill Companies, Inc. All ...

Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Chapter 18:Chapter 18:

Sources of Commercial Debt

and Equity Capital

Sources of Commercial Debt

and Equity Capital

18-2

How Large is U.S. Commercial Real Estate Market?

Exhibit 18-1: Relative Size of Select Asset Categories

19.8

18.2

8.0

5.3

4.7

2.2

0 5 10 15 20 25

$ Trillions

Owner-Occupied Housing

Corporate Equites

Corporate & Foreign Bonds

Core Commercial Real Estate

Municipal Securities

US Treasury Securities

Core commercial real estate includes properties suitable for institutional ownership, excluding owner-occupied building and smaller properties

18-3

Value of U.S. Commercial RE?

--Direct vs. securitized investments?

--How leveraged is commercial real estate?

--RE owned by non-RE corporations?

$ Value(in $Billions)

Public Com. RE Equity 331Private Com. RE Equity 1,931Total Commercial Equity 2,262

Public Com. Debt (CMBSs) 835Private Com. Debt 2,204Total Commercial Debt 3,038

Total Value of Com. RE 5,300

Exhibit 18-2Value of Core U.S. Commercial Real Estate

Sector Values as % of Total US Commercial Real Estate Stock

6%

36%

16%

42%

Public Equity

Private Equity

Public Debt

Private Debt

18-4

Privately Owned Commercial RE

--88% ($1,700/$1,931) of private equity is owned by “non-institutional” investors

--Who are these guys??!!!

$ Value $ Value(in $Billions) Private Commercial RE Equity (in $Billions)

Public Com. RE Equity (REITs) 331 Pension Funds 146Private Com. RE Equity 1,931 Foreign Investors 53Total Commercial Equity 2,262 Life Insurance Companies 28

Private Financial Institutions 4Public Com. Debt (CMBSs) 835 Noninstitutional Core Investors 1,700Private Com. Debt 2,204 Total Privately Held Equity 1,931Total Commercial Debt 3,038

Total Value of Com. RE 5,300

Value of Core U.S. Commercial Real Estate EquityExhibit 18-3

18-5

Institutional Investors?

Public equity markets? • Real Estate Investment Trusts (REITs)

• Can be described as mutual funds for investing in real estate

• Diversification benefits

• Liquidity

• Types of REITs?• Equity REITs

• Mortgage REITs

• Hybrid REITs

18-6

More on REITs

REITs are not taxed at the corporate level if they satisfy a set of restrictive conditions on an ongoing basis:• At least 100 shareholders

• 75% of assets must be real estate, cash, or government securities

• At least 75% of gross income must come from real estate assets

• 90% of REIT taxable income must be paid out in dividends each year

18-7

Institutional Investors in Core Private Equity Markets?

Pension funds• Important participant in commercial real

estate equity markets

• Commingled real estate funds

Life insurance companies• Long-term liabilities a good match for long-

term, illiquid, real estate investments

• More active as lenders than as investors

18-8

Institutional Investors in Core Private Equity Markets?

Others:• Foreign investors

• Banks

• Savings associations

18-9

Non-Institutional Core Investors in Private Equity Markets?

Individuals and families RE syndications that form:

• Limited partnerships (LPs)

• Limited liability companies (LLCs)

• S corporations

Syndication is a pooling of private equity capital

18-10

Advantages of Pooled Ownership Structures?

Allows investors to purchase an interest in larger properties

Diversification of portfolio Economies of scale in acquisitions,

management and disposition Access to cheaper debt capital Expertise of management team hired by

organizer

18-11

Disadvantages of Pooled Ownership Structures?

Often must relinquish management control to active manager

Must compensate syndicator/manager with fees, salary and/or a disproportionate share of equity ownership

➨ lower returns on equity, all else equal

18-12

Forms of Ownership for Pooled Equity Investments in Real Estate

C corporation S corporation General partnership Limited partnership Limited liability company Tenancy-in-common

18-13

What Drives Choice of Ownership Form?

Federal income tax rules Desire of investors for limited liability Management control issues Ability to access debt and additional

equity capital Ability of investors to dispose of their

interests

18-14

Choosing Optimal Form of Ownership

18-15

Notes to Table

1 Investors cannot utilize losses that are in excess of their individual tax basis in the entity. S corporation shareholders cannot include their share of any corporation mtg. debt in the calculation of their tax basis.

2 The general partner(s) is subject to unlimited liability.

3 The general partner manages the operations of a limited partnership.

4 Corporate structures and LLCs allow ownership interests to be freely transferred; however, the actual liquidity of corporate or LLC investments depends on the size of the entity and, in the case of corporate shares, whether the shares are traded on a major exchange.

5 Co-tenants are jointly and severaly liable for all debts of the TIC. This potential liability may be avoided if investors use bankruptcy remote, special purpose entities to invest in the TIC.

18-16

What Ownership Structure is Typically Chosen by Noninstitutional Investors?

C-corporation and GP structures are seldom chosen

S-corporations are popular with some sole proprietors

However, LLCs and LPs are the two dominant ownership structures

Recent emergence of TIC structures, designed primarily to help investors avoid capital gain taxes, is an important trend

18-17

More on Limited Liability Companies

IRS gave partnership tax status in 1998, then all 50 states had to enact LLC laws

NOT a corporation, partnership, or sole proprietorship

IS a blend of some of best characteristics of corporations, partnerships, and sole proprietorship.

➨ a “super pass through entity” IS a separate legal entity (like a corporation), but

is treated as a partnership for tax purposes

18-18

More Limited Liability Companies

To create, “members” file articles of organization with state

Members should have an “operating agreement” that explains operation and management of business

Combines corporate characteristics of limited liability with flow-through tax characteristics of a partnership.

18-19

More Limited Liability Companies

Relative to LPs…• LLCs permit all owners to participate in

management & • have limited liability.

18-20

New to the Scene: Tenancy-in-Common (TIC) Investments

Co-ownership by two or more investors Investors possess undivided interests in

property Investors receive separate deed…considered

direct owners Investors share “pro rata” in CF, tax

consequences, and appreciation ≤ 35 investors

18-21

New to the Scene: Tenancy-in-Common (TIC) Investments

Co-owners must unanimously approve: • hiring of manager• sale of property• all leases• all mortgage liens

(voting implies a partnership)

For all other actions, co-owners may agree to be bound by a vote of more than 50% of co-owners

18-22

New to the Scene: Tenancy-in-Common (TIC) Investments

Approval requirements can be finessed (sort of) with a well-written TIC agreement• Allow other owners to buy out “problem” owners• Implied consent provision....if owners do not

object to a suggested management “action” of which they are informed, the action is automatically approved

• Master lease

18-23

Tenants in Common (TIC) Investments:So What’s all the Buzz?

In a tax-deferred exchange, real property can’t be exchanged for a partnership interest!

Also, in delayed exchange, seller must (1) identify replacement property within 45 days and (2) take title to replacement property within 180 days

However, under a revenue procedure released in March of 2002 by the IRS, taxpayers can exchange an interest in real property for a TIC investment

18-24

Tenants in Common (TIC) Investments:So What’s all the Buzz?

So……TIC properties:• Allow investor to complete a 1031 exchange• Often available as “turnkey” prepackaged

investments with mgmt and financing in place

• Allow investor to purchase any amount above a required minimum

→ thus allowing her to dollar match equity

received from relinquished property

Web Tip

A tenant-in-common trade

association

www.ticassoc.org

18-25

Other Advantages: Tenant in Common (TIC) Investments

Provide many of the benefits associated with other forms of co-ownership:• Access to more expensive properties• Portfolio diversification• Benefit from services of professionals in

acquisitions, mgmt, and dispositions • Access to cheaper debt capital

18-26

Disadvantage: Tenant in Common (TIC) Investments

Depending on structure, might be deemed a “security”• However, usually are Regulation D Private

Placement Offerings; thus exempt from public registration if sold only to “accredited” investors

• Sold only by licensed securities broker

Sponsor fees and expenses may consume up to 25% of equity

Illiquidity Joint and several liability

18-27

Choosing an Optimal Form of Ownership

In practice, choice is usually one of the following four

18-28

The Perspective in This Class?

Single property investment and decision making

Property level valuation…..not investor level valuation

…….although we will spend quite a bit of time with investor level taxation!!

18-29

Sources of Commercial Real Estate Debt  

$ ValuePublic Commercial RE Debt (in $Billions)

$ Value Agency & GSE-Backed CMBSs 130(in $Billions) Non-Government Backed CMBSs 553

Public Com. RE Equity 331 REIT Unsecured Debt 152Private Com. RE Equity 1,931 Total Publicly Traded Debt 835Total Commercial Equity 2,262

Private Commercial RE DebtPublic Com. Debt (CMBSs) 835 Commercial Banks 1,134Private Com. Debt 2,204 Savings Institutions 197Total Commercial Debt 3,038 Life Insurance Companies 263

Foreign Investors 215Total Value of Com. RE 5,300 Govern. Sponsored Enterprises 65

Pension Funds 21Other 309Total Privately Held Debt 2,204

Value of U.S. Commercial Real Estate DebtExhibit 18-5

18-30

Sources of Commercial Real Estate Debt

73% of outstanding commercial debt ($2.2 trillion) is privately held by individual and institutional investors such as:• Commercial banks

• Life insurance companies

• Foreign investors

• Savings associations

18-31

Sources of Commercial Real Estate Debt

27% of outstanding commercial debt ($835 billion) is publicly traded• GSE backed commercial mortgage-backed

securities (CMBSs)

• Non-government backed CMBS

• Investment grade unsecured debt of large REITs

18-32

Mortgage Originators vs. Long-Term Holders

Many long-term holders purchase mortgages in the secondary mortgage market

Who originates the mortgages purchased by life insurers, foreign investors, pension funds, and CMBS issuers?• Other long-term holders—primarily banks

• Mortgage banking companies

18-33

A Closer Look at Syndications A syndication is a group of people who

pool funds to invest in real estate. Not a separate form of ownership. RE syndicates are usually organized as

limited partnerships or limited liability companies• Syndicator is general partner (GP) in LP or

managing member in LLC• How are LPs and LLCs taxed?• Why are LPs and LLCs the dominate form of

ownership?

18-34

Advantages of Syndication(either through a LP or LLC)

Provides passive investors with benefits of real estate ownership

Professional management of properties Freedom from personal liability

18-35

Roles of the Syndicator/Organizer

Organization Phase• Develop concept

• Organize the legal entity

• Draft offering memorandum

• Market the ownership interests

• Acquire the real estate (or purchase option)

18-36

Roles of the Syndicator/Organizer

Operation Phase• Manage the syndication

• Send out tax information

• Manage the property?

18-37

Roles of the Syndicator/Organizer

Disposition Phase• Prepare the property for sale

• Market the property

• Send out final tax information

• Dissolve the syndication

18-38

Basics of Syndication Regulation

Under Federal Securities Acts of 1933 and 1934, all RE syndications are “securities”

All securities are subject to federal AND state securities laws

SEC has responsibility for administering federal securities laws• All offerings are registered with SEC

• All offerings provide adequate disclosure

Every state also has securities laws

18-39

A Closer Look at REITs

18-40

Security Offerings by REITs

0

5

10

15

20

25

30

35

40

45

50

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

$ in

Bil

lions

.

Debt Equity

Large surge in capital raising in 97-98 and 04-05; capital raised by REITs is primarily used to acquire properties

Exhibit 18-8

18-41

In What Do REITs Invest?

18-42

Measuring REIT Income: Funds From Operations (FFO)

Cash flow, expressed as “Funds from Operations” (FFO), is often used instead of accounting net income to measure current performance

FFO is a supplemental measure of a REIT's operating performance.

18-43

Funds From Operations (FFO)

FFO =

Net (accounting) income (excluding gains/losses from sales of property)

+ Depreciation (real property)

+ Amortization of leasing expenses

+ Amortization of tenant improvements

- Gaines/losses from infrequent and unusual events

18-44

Funds From Operations (FFO) FFO is different from GAAP net income

because commercial RE maintains value to a much greater extent than may other assets• Thus, economic depreciation < tax depreciation

Securities analysts judge REIT performance according to FFO growth

Price / FFO multiples reflect underlying RE value, management quality, and growth potential

18-45

How Are REIT Stocks Valued?

To determine share values, typical analyses involves one or more of the following criteria: • Management quality;

• Current prevailing dividend yield

• Anticipated total return from the stock

• Capital Sources• Because REITs are obligated to distribute 90% of

taxable income, they may require some external funding sources.

18-46

How Are Total Returns Estimated?

Investors attempt to forecast dividends REIT will pay out over time.

This projected dividend stream is converted into a present value

In practice, however, long-term dividend projections are difficult to develop

18-47

Net Asset Value

A commonly used valuation approach centers around concept of net asset value (NAV).

NAV is equal to estimated total market value of a REIT’s underlying assets, less all liabilities including mortgages.

18-48

How is NAV Used to Make Decisions?

If total stock market capitalization is greater than its NAV, REIT is said to be selling for a “premium” to NAV

A stock price in excess of per-share NAV may indicate a REIT is overpriced relative to value of assets currently in the portfolio

Conversely, REITs selling at “discounts” to NAV may signal buying opportunities for investors

18-49

REIT Investment Performance

Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

End of Chapter 18

End of Chapter 18