Real Estate Investment Trusts REITs

1
Chapter 21

• Real Estate Investment Trusts (REITs)

2
Overview

• Introduction
• History
• Legal Requirements
• Types of REITs
• Investment Appeal
• REIT Valuation
• Important Accounting Issues
• REITs in a Portfolio
• Recent Trends
• Useful Resources

3
Introduction

• A Real Estate Investment Trust is a publicly held
  or privately owned company that invests in and
  manages a portfolio of commercial properties or
  mortgage loans.
• A REIT is created based on Internal Revenue Code
  (Sections 856-858) to become a pass-through
  entity that distributes significant portion of
  its earnings and capital gains to its
  shareholders.
• REITs do not pay corporate taxes as long as
  qualification standards are met, but distributed
  earnings and capital gains are taxed at the
  shareholder level.

4
History

• Early form of REITs date back to 1900s known as
  the Massachusetts Trust. The trust income is
  distributed to beneficiaries (mostly wealthy) and
  trust did not pay taxes
• In 1930s a Supreme Court decision that trusts
  were not exempt from taxation.
• In September 14, 1960, REITs are created when
  President Eisenhower signed into law the REIT
  Act.
• In 1961, REITs are formed as Bradley Real Estate
  Investors, Continental Mortgage Investors, First
  Mortgage Investors, First Union Real Estate,
  Pennsylvania REIT and Washington REIT.
• In June 14, 1965, Continental Mortgage Investors
  becomes the first REIT to be listed on the NYSE.
• The Economic Recovery Act of 1981 allowed short
  depreciation lives and ability pass-through
  losses to investors by partnerships REITs were
  not as popular.
• The period between 1981 and 1986 experienced the
  largest overbuilding in the history.

5
History Continued

• In 1986, President Reagan signs the Tax Reform
  Act that allows REITs to develop and manage their
  own properties rather than contracting out these
  services.
• In 1986, provisions of 1981 Act is eliminated
  leading to scarce capital. REITs suffer from
  general overbuilding and limited capital for real
  estate investments.
• In November 22, 1991, Kimco Realty Corporation
  concludes the first successful REIT IPO in many
  years. This marks the beginning of the modern
  REIT era.
• In December 12, 1991, New Plan becomes the first
  publicly traded REIT to achieve a 1 billion
  equity market capitalization.
• In December 20, 1992, Taubman Centers, Inc.
  concludes the first IPO of an UPREIT.
• In 1993, as part of the Omnibus Budget
  Reconciliation Act of 1993, President Clinton
  signs into law a change to the "Five or Fewer"
  rule that makes it easier for pension plans to
  invest in REITs.
• In 2001, SP decided to include Equity Office
  Properties in 500 Index.

6
Umbrella Partnership REIT (UPREIT)

• An UPREIT is a REIT that owns a controlling
  interest in a limited partnership that owns the
  real estate.
• It was first used in 1992 with the IPO of Taubman
  Centers, Inc.
• It allowed transfer of properties with little or
  no book values into a REIT form
• Owners did not recognize taxable capital gains
  since the exchange of one partnership interest
  for the other is not a taxable event.
• The units received can be converted into shares
  of the REIT.

7
Legal Requirements

• Asset Requirements
• At least 75 percent of the value of a REITs
  assets must consist of real estate assets, cash,
  and government securities
• Not more than 5 percent of the value of the
  assets may consist of the securities of any one
  issuer if the securities are not includable under
  the 75 percent test
• A REIT may not hold more than 10 percent of the
  outstanding voting securities of any one issuer
  if those securities are not includable under the
  75 percent test
• Not more than 20 percent of its assets can
  consist of stocks in taxable REIT subsidiaries
• Distribution Requirement
• Distributions to shareholders must equal or
  exceed the sum of 90 percent of REIT taxable
  income

8
Legal Requirements - Continued

• Income Requirements
• At least 95 percent of the entitys gross income
  must be derived from dividends, interest, rents,
  or gains from the sale of certain assets
• At least 75 percent of gross income must be
  derived from rents, interest obligations secured
  by mortgages, gains from the sale of certain
  assets, or income attributable to investments in
  other REITs
• Stock and Ownership Requirements
• Be taxable as a corporation
• Be managed by a board of directors or trustees
• Have shares that are fully transferable
• Shares in a REIT must be transferable and must be
  held by a minimum of 100 persons
• No more than 50 percent of REIT shares may be
  held by five or fewer individuals during the last
  half of a taxable year

9
Types of REITs

• REITs can be classified by their assets
• Equity REITs
• Industrial/Office
• Retail
• Residential
• Diversified
• Lodging/Resorts
• Health Care
• Self Storage
• Specialty Prisons, Theaters, Golf Courses,
  Timberland, Student Housing,
• Mortgage REITs
• Hybrid REITs

10
Types of REITs
Sources REIT classifications NAREIT at
http//www.nareit.com/library/performance/reitwatc
hquery.cfm and Market Values MSN.
11
Investment Appeal

• REITs are another form of securitized real estate
  investments that allow greater participation by
  public in real estate
• REITs provide investors opportunities to
• Invest in a portfolio of real estate under
  professional management
• Own highly liquid real estate assets

12
REIT Valuation Dividend Discount Model (DDM)

• Value per share should be the present value of
  expected dividends
• If dividends grow at a constant rate then the
  equation becomes
• DIV BTCF from current properties NOI Debt
  Service

13
REIT Valuation Dividend Discount Model (DDM)

• The g is very important. It reflects
• Long run growth in BTCF (same store growth)
• Long run ability of REIT management to generate
  growth opportunities (NPVgt0 projects)
• Discount rate is the cost of equity and can be
  estimated using

14
REIT Valuation Funds From Operations (FFO)

• Funds From Operations (FFO) is a measure of cash
  flow available to the REIT for distributions to
  shareholders
• FFO is similar to earnings per share (EPS),
  however, EPS is based on accounting income which
  is reduced by any depreciation and amortization
  which are non-cash deductions.
• FFO is calculated by adding back depreciation and
  amortization and other non-cash deductions to
  earnings.
• Dividends per share is what the REIT actual
  distributes to shareholders.

15
REIT Valuation Funds From Operations (FFO)

• National Association of Real Estate Investment
  Trusts (NAREIT) defines FFO as follows
• FUNDS FROM OPERATIONS means net income (computed
  in accordance with generally accepted accounting
  principles), excluding gains (or losses) from
  sales of property, plus depreciation and
  amortization, and after adjustments for
  unconsolidated partnerships and joint ventures.
  Adjustments for unconsolidated partnerships and
  joint ventures will be calculated to reflect
  funds from operations on the same basis.

Source http//www.nareit.com/policy/accounting/wh
itepaper.cfm
16
REIT Valuation Funds From Operations (FFO)
17
REIT Valuation Funds Available for Distribution
(FAD) or Adjusted FFO (AFFO)

• The following adjustments to FFO is made
• Deduct Capital Improvement Expenditures
• Deduct Amortization of Debt Principal
• Adjust for variations in rent.
• Reported rental income is based on straight-line
  rent collection over leases and their terms. Any
  adjustment would reflect actual rent collections.

18
REIT Net Asset Value (NAV)

• A REITs NAV is net value of equity investments
  in properties owned on a per share basis.
• This requires the estimation of private
  transaction value of properties owned by a REIT.
• The market price of a REIT should be close to its
  NAV.
• Analysts use different methods to estimate NAV
  leading to variation in estimates.
• Most common method of single property valuation
  is to capitalize NOI of a specific property.
• Most NAV computations ignore the managements
  ability to create or destroy value.

19
REIT Share Price Premiums toGreen Street NAV
EstimatesJanuary 1990 - November 2006
Sources http//www.greenstreetadvisors.com/about/
page/research_nav/
20
REIT Valuation Multiples
21
Net Asset Values and Future Returns

• William M. Gentry, W. M., C. M. Jones, and C. J.
  Mayer (2004) find large positive excess returns
  to a strategy of buying stocks that trade at a
  discount to NAV, and shorting stocks trading at a
  premium to NAV. Estimated alphas from this
  strategy are between 0.9 and 1.8 per month,
  with little risk.
• Source NBER, Working Paper 10850 available at
  http//www.nber.org/papers/w10850

22
Sample Graphs from the previous paper
Source NBER, Working Paper 10850 available at
http//www.nber.org/papers/w10850
23
Sample Graphs from the previous paper
Source NBER, Working Paper 10850 available at
http//www.nber.org/papers/w10850
24
Sample Graphs from the previous paper
Source NBER, Working Paper 10850 available at
http//www.nber.org/papers/w10850
25
Important Accounting Issues

• Tenant Improvements and Free Rent Effects on
  FFO
• Use of tenant improvements and free rent to
  improve occupancy (reduce vacancy)
• If they are large relative to others, it may be a
  sign of serious problems
• Tenant improvements are capitalized and then
  depreciated
• FFO is not affected by tenant improvements since
  FFO is earnings before depreciation. In fact
  occurring now and changes depreciation in the
  future
• FFO footnote of signed leases scheduled to
  commence refer to leases that are included in
  FFO, but have not yet provided actual cash
  receipts of lease payments

26
Important Accounting Issues Continued

• Leasing Commissions and Related Costs
• Commissions paid to brokers paid in cash and
  capitalized over the life of the lease
• They are included in depreciation and
  amortization expense
• Use of FFO overlooks deferred leasing costs
• Many REIT have in house services and pay their
  employees salaries and commissions. These
  payments are still capitalized

27
Important Accounting Issues Continued

• Use of Straight-Line Rents
• This becomes an important issue in cases where
  lease contracts have steps over a long period of
  time (not likely in residential REITs)
• If straight-line reporting is used then lease
  payment is averaged over the lease term and
  reported as if actually collected at that average
• In early years FFO is higher than actual and
  lower than actual in later years
• This is as mentioned before one of the primary
  reasons why analysts prefer Adjusted FFO
• Managers should provide more information to
  eliminate or reduce effects of straight-line rent
  on FFO

28
Important Accounting Issues Continued

• FFO and Income from Managing Other Properties
• REITs receive significant income from managing
  third party properties
• However, this type of income more volatile than
  core rent revenue
• The nature of management income should be
  examined in greater detail reliability,
  sustainability

29
Important Accounting Issues Continued

• Types of Mortgage Debt and Other Obligations
• Examination of REIT liabilities
• Existence of Ground Leases
• Ground leases (net leases) allow the tenant to
  build and operate a structure on land. The
  tenant pays rent to the owner and at the end of
  the lease term land owner owns residual rights to
  all improvements on the land when lease expires
• A REIT may own a building on a land with ground
  lease.
• If REIT can grow income from renting the
  building, but make fixed ground lease payments
• Risk is that REIT may have to give up the
  building if ground lease term expires without
  renewal
• Cash flows from a building subject to ground
  lease expiring soon should be discounted heavily
• A REIT may acquire a ground lease from an owner
  (REIT does not own the building and land reverts
  back to original owner)
• This type of investment is called spread
  investing
• REIT collects rent from building owner and pay
  fixed rent to land owner
• Ground leases are common among retail REITs

30
Important Accounting Issues Continued

• Lease Renewal Options and REIT Rent Growth
• Lease rollover schedules where long-term leases
  are common (regional malls, industrial
  properties, and offices) should be carefully
  reviewed
• More information provided by REIT greater the
  understanding of changes in business conditions
  of REITs
• Especially the rent changes around lease
  rollovers provide the most useful information

31
Important Accounting Issues Continued

• Occupancy Numbers Leased Space or Occupied Space
• Leased space may not generate revenue now
• The amount of leased space is often higher than
  occupied space
• REITs may have their preferred method of
  reporting one of these figures that make
  comparisons among REITs difficult

32
Important Accounting Issues Continued

• Additional Costs of Being a Public Company
• Costs related to directors fees, listing on
  stock exchanges, and filing of annual and
  quarterly statements
• Sarbanes-Oxley Act of 2002 significantly
  increased the cost of being a public company

33
Useful Resources

• SNL Financial See Industry Data and Estimate
  Comparison
• NAREIT
• 1031 Exchanges
• National Association of Homebuilders See
  Resources and Economic Housing Data"
• MIT Commercial Real Estate Data Laboratory
  Index return over a time period may be a useful. 
  Also see NCREIF link for cap rates
• NCREIF
• REIT Cafe