Session Plan Chapter Twelve: – REITs as investment alternative – QQD of REITs – REIT Valuation Techniques – The Send-Off
Dec 27, 2015
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
-50.00
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Year
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Total US NAREIT Index
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
Heritage Foundation Index of Economic Freedom 1995-2011
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ore Brazil
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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