REITs – Real Estate Investment Trusts

1. REITs – Real Estate Investment Trusts Lecture Map • Definitions, characteristics, terms • Investment characteristics and performance

2. What is a REIT? • Owns, and in most cases operates, income-producing property (Equity REITs) • Office • Apartment • Retail (shopping centers) • Hotels • Warehouses (storage) • Some REITs also finance real estate (Mortgage REITs) • REIT shares trade on major exchanges • Provide a liquid alternative to real estate partnerships • Debt (bonds) are also publicly traded

3. Where did REITs come from? • Created in 1960 (act of Congress) as a way to make property investment available to individual investors • Offer expert management and familiar corporate governance structures (BOD) • REIT trivia – original REIT act was an amendment to an Act regarding excise taxes on cigars • REITs make equity interest in commercial property: • Divisible into shares that can be purchased by small investors • LIQUID – the shares trade on major exchanges, unlike private real estate partnerships, commingled funds

4. How Many REITs are there? • About 300, ≈ 2/3 of which are publicly traded • 149 on NYSE • 27 on American • 12 on NASDAQ • Total REIT assets ≈ $300 billion

5. Types of REITs • Equity REITs • Own and operate income-producing real estate • Perform leasing, development, and construction activities • 151 publicly traded equity REITs • Mortgage REITs • Hold mortgages on real property • Make mortgages (lend money), usually on existing property • Buy mortgages • 22 publicly traded mortgage REITs • Hybrid REITs • Both own properties and make loans

6. REIT Structures – UPREITs and Traditional REITs • UPREIT (Umbrella Partnership REIT) • First UPREIT was Taubman Realty IPO in 1992 • UPREIT structure created to shield owners contributing real estate assets to the REIT from capital gains taxes on contributed property • Transfer is then partnership shares for partnership shares, and this is not a taxable event for the owners • UPREIT owns a controlling interest in a limited partnership that owns the real estate • The Umbrella Partnership “shares” – known as operating partnership units, or OP units – are convertible into REIT shares and enjoy voting rights and dividends just like REIT shares • Convertibility allowed after one year, and triggers taxes

7. REITs and Taxes • REITs do not have to pay federal taxes at the corporate level if they follow certain rules • More specifically, REITs are allowed to deduct dividends paid to shareholders from taxable income, and thus have the ability to shield 100% of taxable income through distributions to shareholders • No other firm in the economy can deduct dividends • REIT shareholders still have to pay taxes on dividends and capital gains • Most states honor the REIT status and don’t require REITs to pay state taxes

8. Qualifying as a REIT – Asset Requirements • At least 75% of the value of a REIT’s assets must consist of real estate assets, cash, and government securities • Not more than 5% of assets can be securities of a single issuer • A REIT may not hold more than 10% of the outstanding voting securities of any one issuer

9. Qualifying as a REIT –Income Requirements • At least 75% of gross income must be derived from rents, interest on obligations secured by mortgages, gains from sale of assets, or income attributable to investments in other REITs • Not more than 30% of the entity’s gross income can be derived from sale or disposition of stock or securities held for less than six months or real property held for less than four years other than property involuntarily converted or foreclosed on

10. Qualifying as a REIT –Distribution Requirements • REITs must distribute at least 90% of taxable income to shareholders in the form of dividends • Note that taxable income is not cash flow (TI reflects depreciation), so they’re not completely broke • This distribution requirement affects growth strategies • Have to get additional funds for growth through capital markets, by selling more stock, or • Grow through acquisition or merger

11. Qualifying as a REIT –Stock and Ownership Requirements • Shares in a REIT 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 individuals during the last half of a taxable year

12. REIT Terms • FFO (Funds From Operations) – • The most commonly accepted and reported measure of a REIT’s operating performance • Equal to Net Income, excluding gains or losses from sales of property, and adding back real estate depreciation • FAD (Funds Available for Distribution) • Adjusts FFO for: • Accounting treatment of such items as • Straight line rents • Expensing vs. capitalizing capex items • Other non-recurring expenditures • Useful in evaluating safety of dividend payout • Dividend payout as a multiple of true cash flows • Possible to be paying out > 100% of FAD08. • Glimpse at future growth prospects

13. REIT Terms (cont.) • NAV (Net Asset Value) – • The net “market value” of the REIT’s assets, primarily the equity portion of the property (and buildings) owned by the REIT • Effectively the private market value of the assets

14. Calculating FFO Property NOI less: Corporate Overhead EBITDA Less: Interest Expense Less: D&A Less: Taxes Net Income (GAAP) Plus: Real Estate Related Depreciation Less: Non-recurring expenses/gains FFO (Funds from Operations)

15. Calculating FAD FFO Less adjustments (if any) AFFO Plus: Other D&A Other non-cash expenses Less: Debt Repayment FAD

16. Calculating NAV • NOI ÷ capitalization rate • Value real estate as the PV of cash flows • Balance sheet adjustments • deduct property and entity level debt, preferred stock, payables • Add cash, receivables, land value, interest in JV’s and market securities, etc. • Add value of 3rd party management fees

17. Calculating NAV (cont.) NOI (from portfolio) ÷ cap rate Real Estate Value Plus: Land Development (if any) at cost Cash, other net assets Less: Debt, net Other liabilities Existing Net Asset Value ÷ fully diluted shares outstanding NAV/share

18. REITs as an Investment • The pitch: • REITs provide opportunity for investment in commercial property with both liquidity and expert management • REITs provide high dividend yield • Often as high as 6-7% (vs. S&P 500 yield of 2-3%) • REITs are less volatile than other stocks, and thus provide a superior return-to-risk ratio • REITs have low correlation with the rest of the stock market, and thus offer real diversification benefits • REITs provide a hedge against inflation

19. REITs and the Efficient Frontier

20. REIT Dividend Yields

21. REITs and Alternative Investments(Returns over the last two years)

22. REITs and Alternative Investments(Returns over the last 13 years)

23. REITs and the Inflation Hedge story

24. REIT Valuation Drivers • Fundamental value of real estate • Quality of existing leases • Growth potential: of existing properties and acquisitions • Stability of cash flow and FFO • Expansion possibilities: development opportunities • Management Issues • Quality and governance • Financial structure • Do they have the financial capabilities to expand? • What does the balance sheet look like? Debt/equity ratio • Is this more important when REITs sell at a premium to NAV?

25. NAV vs. REIT Stock Price • Is NAV a good benchmark for REIT value? • Issues @ portfolio level • Property capitalization rates • Market vs. in-line rents • Value of non-income producing assets • Issues @entity level → “going concern” value • Value of management, “brand” entity

26. REIT Returns and Real Estate Returns • REIT prices move with real estate over the long run, but not short-term • What this means is that the discount and premium of REITs relative to their NAV varies over time. Perhaps, plus or minus 20% depending on how NAV is calculated. • Why do REIT prices deviate from NAV? • Partially due to measurement problems: appraisals are smoothed and may be based on the cash flows from current long-term leases. • Could also be due to managerial talent and corporate governance issues. • There are also supply and demand issues. • Do public investors want more exposure to real estate? • Are there credit constraints that make it difficult to raise debt capital to acquire real estate?

27. Why do REIT prices deviate from NAV? (cont) • Deviation from NAV = Deviation from Private Market Transaction Values • Benefits of public vs. private market execution: • Transparency • Diversification • Liquidity • Immediate current yield

28. Market Challenges for REITS Today • NAREIT index hit all time trading low at the peak in the NASDAQ index in 1999-2000 • Average trading discount 15-20% below NAV • REITs today trading at or above NAV • Reflects flight to “safety” of income producing assets across market sectors • Relative versus fundamental sector analysis • Driving capital flows

29. Funds Flows to REITs today • In addition to improved stock price performance, private market capital – debt and equity - is flowing to CREFs and REITS as well: • Private placements dwarf current public market access to equity • REITS are using cheap, available private JV funding to grow portfolios • Partial interest in properties • Third party management, transaction fees • As FFO grows from acquisitions, REITS will be able to raise cheaper equity via public market secondary issues later

30. Funds Flows to REITs today (cont.) • Should REITS be using cheap debt and equity capital to grow their portfolios today? • Weak market fundamentals could mean risky NOI streams from acquired properties • FFO, FAD weakness • Cap rate reversion possible • Damage to future NAV? • Refinancing risk as interest rates rise over time • FAD coverage • Debt/equity ratio maintenance