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Real Estate Investment Trusts
REITs

By: Jerome M
...
Underlying physical assets produce cash flows through products and sale of goods and commodities
2
...
The investment system matches heterogeneous investors (sources of capital) with heterogeneous
productive assets (physical assets and receivables)

4

Exhibit 2: Financial Markets with Asset Securitization
(2)

Firms
operations
(a bundle
of real
assets)

Securitized
Assets

Proceeds used to buy
assets for operation

2
...


Financial
manager

Firms sells securities
To raise capital

Financial
Markets
(investors
holding
Financial
Claims)

(4a)
Real assets generate
positive cash flow

(3)

Cash either reinvested
or returned to investors

(5)

(4b)

For securitized assets specific cash flow goes directly to investors
...


(1)

Investors
in securitized
Assets

---- Limited Managerial Discretion

Traditionally, investors in industrial firms “indirectly” own the underlying assets through ownership
of financial claims, they do not own the underlying real assets directly; securitization has made it
possible for investors to own directly the cash flows of specific assets or receivables of industrial and
financial firms
Real estate investors traditionally own “directly” the real assets ; asset securitization has made it
possible for these investors to indirectly own real estate related assets

In short asset securitization has changed the investments decision making

5

Asset Securitization has Changed
the Investment and Financing
Decisions
 Asset securitization has made it possible for investors



in real estate entities to own financial claims, (REIT,
MBS, CMBS), on the real estate (indirect ownership)
as well as own the real estate (direct ownership)
Asset securitization has also made it possible for
investors in industrial firms to own specific pieces of
the firm’s cash flows or receivables through ABS
(“direct ownership”), as well as hold financial claims on
the underlying productive real assets of the firm
(indirect ownership through shares and bonds)
6

What is Asset Securitization?


Generally speaking, this is the trend towards real assets,
commodities, products, or receivables , etc, being
transformed into liquid securities tradable in financial
markets
 real estate investment trusts (REITs) vs
...

commercial mortgages
 residential mortgage backed securities (RMBS) vs
...
receivables (credit
cards, auto loans, trade receivables, leases, royalties,
telephones receivables, future flows, infrastructure
projects, etc)

What is a REOC?
A company that derives its income from
real estate investment
...



8

U
...
S
...
S REITs are prohibited from certain lines of
business, e
...
hotel operations, parking
operations, REOCs are not
(2) REITs operating loss (OL) can be carried
forward for 15 years not back, REOCs can carry
loss back
(3) REOCs may decide to retain all of its earnings
to fund growth opportunities, REITs must pay 90%
of their earnings to shareholders to avoid double
taxation
9

What is a REIT?
Securitized real estate investment
 Ownership form created by tax code
 Basic requirements:


 Be

Real Estate
 Pass-through income to shareholders


High dividends / low retained earnings

 Avoid

corporate tax
10

General Structure of
Real Estate Investment Trusts (REITs)
Primary( Direct) Real Estate Capital Market

Secondary (Indirect) Real Estate Capital Market

Capital Market Investors
Subscribed in IPO allowing
REIT to raise capital

Sale Proceeds from
IPO subscription used
to purchase property

Property Owner/Seller
Income Producing
Real Estate

REIT
(Trust)
Rental Cash Flow

Investors
(Purchase Shares)
Dividend income/
Capital gains

Owner/Seller of Property
Sponsors REIT

11

Key Requirements of US REITs


Asset Test:






Income Test:





At least 95% of gross income must come from dividends, interests, rents, or gains
from sale of certain assets
No more than 30% of REITs gross income can be derived from sale of real estate
held for less than four years or securities held for less than six months

Distribution Test:




At least 75% of a REIT’s asset value must come from real estate, cash, and
government securities at the close of each quarter of taxable year
No more than 5% of the value of the assets may consist of the securities of one
issuer, and REIT may not own more than 10% of the outstanding shares of one
issuer, if those securities are not includable in the 75% test

At least 90% of the REIT taxable income must be distributed to shareholders

Stock and Ownership Test:




REIT shares must be transferable and must be held by a minimum of 100 persons
No more than 50% of REIT shares may be held by five or fewer persons

Other Typical Attributes of REITs







REITs can be structured either as a corporation
(US) or a unit trust (Australia)
REITs can either be directly managed internally
(US) or externally managed through a third party
asset management company (Asian Countries)
A REIT typically does not make a market – i
...

investors cannot require the REIT to redeem their
shares (they are closed-end funds)
Listed REITs are typically set up to operate
indefinitely, although they can be structured with
finite life
...




Specified Trusts
 purchase

a specific property (Rockerfeller Center
Properties)



Mixed Trusts
 invests

in both blank check and specific properties

15

Mortgage REITs


Invests in mortgages
 earn

the spread between costs of funds and
mortgage loan rates

16

U
...
REIT Property Sector and Subsector


Industrial/Office (9% / 21%)






Retail (25%)








Shopping Centers
Regional Malls
Free Standing

Residential (19%)





Office
Industrial
Mixed

Apartments
Manufactured Homes

Diversified (8%)
Others (18%)





Lodging/Resorts
Self Storage
Health Care**
Mortgages



Home Finance
Commercial Financing
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REIT Benefits


Invest in a diversified RE portfolio managed by
professionals
 Regular



Higher liquidity
 REIT




income and relatively high dividend yield

shares traded on stock exchanges

Access to broad capital markets
Corporate governance mechanisms

18

REIT Disadvantages


possible conflicts of interests between
sponsor and REIT shareholders

19

Innovation in U
...
REITs




Pre 1986 REITs – passive management
 Directors, trustees or employees of REITs were not
allowed to actively manage REIT properties
 Independent contractors performed these functions
 REIT owns underlying physical assets directly
Post 1986 REITs --- Modern REITs (active management)
 1986 Tax Reform Act relaxed management restrictions
 Allowed REITs to provide normal maintenance and
other services for tenants
 Created vertically-integrated operating companies
fundamentally different from passive REITs of pre-1986
20

Major ’90s Innovation: UPREIT
REIT formed by consolidating limitedpartnerships
 partnerships allocated REIT shares based
on appraised value of partnership property


21

Umbrella Partnership REITs or
UPREITs







REIT does not directly own the underlying properties
Rather the REIT and other real estate owners own units
(operating partnership units or OP units) in a partnership
The REIT and in real estate owners have contributed ort
sold properties to the partnership
OP units are convertible into shares of REIT, offering voting
rights and dividends
This complicated arrangement allowed property owners
(developers) to “sell” their properties to the REIT without
triggering taxable event

22

Umbrella REIT FORMATION
REIT Shareholders

B has the option to
convert OP units to
shares of REIT

B

REIT

A

A’s OP units are sold to REIT
for cash or shares

Umbrella Partnership Managed by A (formed by REIT)
General Manager of Operating Partnership is REIT

Property 1

Property 2

Property 3

Property 4
23

Taubman UPREIT
GM Pension Trust
Convertible debt

Taubman
75% ownership

Affiliates
25% ownership

Taubman Realty Group (TRG)
Partnership –
owns 19 shopping malls

24

The Innovation in UPREITs


The UPREIT is a form of financial engineering or
structured financing








The structure is a tax-deferred mechanism through which real
estate developers and other owners transferred properties in the
form of a tax-exchange
Since the transaction did not trigger a taxable event the REIT is
able to acquire properties at better earning multiples
Conceivably this resulted in shareholder wealth maximization
The development of UPREITs resulted in massive growth in REIT
equity market capitalization in 1990s
These modern REITs feature active management so as to grow
cash flows and portfolio size

25

Another Innovation in U
...
REITs Structure:
Paired Share REITs


It allows the REIT to enter into prohibited business
and still avoid double taxation
 The

process starts with an REIT acquiring an REOC
engaged in active real estate business that the REIT
cannot enter (e
...
parking operations, hotels, and health
businesses)
 All properties acquired by the REIT are leased back to
the REOC
 REOC in turn pays most of its income to the REIT in the
form of rent
 REIT passes most of its income to shareholders and
avoids double taxation
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International REITs Trend






The growing demand for publicly traded real estate likely to be met by
growth of REITs
Two largest REIT markets in the world are in the United States and
Australia
United States market commenced in the early 1960s
...
This was after the property
markets in both countries crashed in the early 1990s – Exhibit 4
REIT markets also established in:
 Canada, UK, Italy, Belgium, France, Netherlands, Japan, New
Zealand, Malaysia, Korea, Singapore, Hong Kong, Taiwan, to name a
few
27

US and Australian REIT Markets
Exhibit 4: US and Australia saw explosive growth in the early 1990s
Size of markets

Australia

180
150
120
90
60
30
0

400
300

50

80

200

40

60

100
0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
M arket cap

No
...
of t rust s

Of f ice
21%

Of f ice
21%

Source: NAREIT, UBS
28

Global REIT Performance
Total Returns
 Dividend Yields
 Correlations


29

Source: FTSE EPRA/NAREIT Global Real Estate Index – Monthly Bulletin

30

Source: FTSE EPRA/NAREIT Global Real Estate Index – Monthly Bulletin

31

Source: FTSE EPRA/NAREIT Global Real Estate Index – Monthly Bulletin

32

Source: FTSE EPRA/NAREIT Global Real Estate Index – Monthly Bulletin

33

Source: FTSE EPRA/NAREIT Global Real Estate Index – Monthly Bulletin

34

Source: FTSE EPRA/NAREIT Global Real Estate Index – Monthly Bulletin

35

Source: FTSE EPRA/NAREIT Global Real Estate Index – Monthly Bulletin

36

36 Month EUR Correlations

Source: FTSE EPRA/NAREIT Global Real Estate Index – Monthly Bulletin

37

36 month local correlations

Source: FTSE EPRA/NAREIT Global Real Estate Index – Monthly Bulletin

38

Source: FTSE EPRA/NAREIT Global Real Estate Index – Monthly Bulletin
39

Source: FTSE EPRA/NAREIT Global Real Estate Index – Monthly Bulletin
40

Source: FTSE EPRA/NAREIT Global Real Estate Index – Monthly Bulletin
41

Historical US REIT Performance
Sept 2003 to Sept 2013
 Sept 2002 to Sept 2007
 Sept 2006 to Sept 2007


42

Source: www
...
com

43

REIT Market Capitalization
250

$700,000

$600,000

200
$500,000
150

Number

$400,000

REITs
$300,000

100

Capitalization

$200,000
50
$100,000

0

$0
1971

1975

1979

1983

1987

1991

1995

1999

2003

2007

2011

44



Why the big increase in REIT numbers
and capitalization during the 1990s?

45

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

46

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


47

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

48

Structural Changes


Debt Rollover Timing
 Industry

refinanced with 5-7 year miniperms
following bond market rally of 1986

49

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
50

Dual Models of REIT Value


We earlier noted the existence of two parallel real estate
asset markets





The public market (stock market) where REITs trade
The Private property market where the REITs’ underlying
physical assets trade

Three fundamental questions arise from this dual market
model that are of interest to real estate investors



(1) Which asset market to use for real estate investment decision?
(2) Is there a possibility for arbitrage by trading between the two
markets to make seemingly (or nearly) riskless profits?
 (3) Do the two markets value differently the same underlying
physical asset?


First, we focus on the third question dealing with
differential valuation between the two markets
51

The Dual Market Nature of Real Estate Creates “Windows of Opportunity”
Exhibit 16:
End of Year Public vs Private Asset Mkt Com m ercial R
...
Values:
(Indexes set to have Equal Avg Values 1974-98)
2
...
0
1
...
6
1
...
2
1
...
Private Market
Real Estate Valuation
Consider a 20-building portfolio with 2
...
8%)

$40
...
0
$34
...
1
12
...
4 million

$16
...
40
$13
...
04
5
...
56 psf

Public Company Valuation (PCV) -- an IPO
Total Portfolio
Stabilized NOI
$16
...
12
Subtotal
$16
...
7
Estimated Dividend Yield Range
7
...
00%
Implied PCV Range
$195
...
3
Average Public MV
$179
...
56 psf
$0
...
51
$5
...
12 psf
$65
...
78 psf

Private Market Valuation (PMV)
Total Portfolio
Stabilized NOI
Estimated cap rate range:
9
...
25%
Implied Private Market
portfolio valuation

Average PMV

$16
...
56/PSF

$168
...
8

$67
...
31

$157
...
80/PSF

Public Vs
...
5M
Average Private MV
$157
...
5M
6
...
78/PSF
$62
...
98/PSF
14
...
Private Valuation Differentials:
Some Possible Explanations


( 1) The Public market ascribes value to more than just the
underlying property assets





Other factors include company management and its ability to
identify and create investment opportunities through active
management of the real estate

(2) The public market valuation includes a premium for
share liquidity
(3) Are REITs closed-end mutual funds or operating
companies?


Closed-end mutual funds model suggest REIT shares will generally
trade at values below their NAVs -- closed-end mutual fund
discount
 The Operating Corporation model suggests that REITs shares will
generally trade at values above their NAVs – growth opportunities
...
FFO


earnings per share (EPS) is a fictional
accounting number
 REIT



must distribute at least 90% of EPS

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

59

Earnings Measure for Industrial Corporations


The official GAAP accounting-based Net Income for industrial firms is
calculated as follows:
Revenue
- Operating expenses
= Earnings before interest, taxes, and depreciation (EBITDA)
- Depreciation and amortization
= Earnings before interest and taxes (EBIT)
- Interest
= Earnings before taxes (EBT)
- Taxes
= Net Income

-

This Net Income is the official measure of earnings for the typical
industrial corporation used as input to calculate Earnings Per Share
(EPS)
60

Earnings Measures for REITs


REIT taxable earnings, the official GAAP EBT (or EBIT –
interest) is not well suited for determining REITs
earnings:


Depreciation expenses are a particularly large portion of REIT
expense
 Unlike industrial firms the depreciation of real property by REITs is
often not matched by actual loss of value of the property over time


As a result other measures are used to track the earnings
of REITs by security analysts, such as Funds From
Operation (FFO), Funds Available for Distribution (FAD)
and Free Cash Flow (FCF) to equity

61

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
...
Moreover, NAREIT believes that items
classified by GAAP as extraordinary or unusual are not
meant to either increase or decrease reported FFO
...
Occupied space

75

Impact on FFO


Depending upon management’s 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


76

FFO Example


Washington Real Estate Investment Trust
(WRIT)
 See

supplement

77

REIT Growth
REITs have limited ability to grow through
retained earnings (little free cash flow)
 Most expand through additional stock
offerings (follow-on offerings)


78

FFO Growth
FFO Growth = Internal Growth + External
Growth

79

FFO Growth
Internal Growth
 Rental

Increases
 % Rent, Rent Bumps, etc

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