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Chapter 21

Real Estate Investment Trusts (REITs)

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

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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.

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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.

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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, S&P decided to include Equity Office Properties in 500 Index.

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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.

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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

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Legal Requirements - Continued

Income Requirements: At least 95 percent of the entity’s 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

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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

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Types of REITsREIT Market Value Proportions by Type, 12/06/06

Residential16%

Mortgage5%

Lodging7%

Health Care5%

Diversified7%

Specialty4%

Storage5%

Retail24%

Industrial / Office25%

Hybrid2%

Industrial / Office

Retail

Residential

Mortgage

Lodging

Health Care

Diversified

Specialty

Storage

Hybrid

Sources: REIT classifications; NAREIT at http://www.nareit.com/library/performance/reitwatchquery.cfm and Market Values; MSN.

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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

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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

n

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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” (NPV>0 projects)

Discount rate is the cost of equity and can be estimated using: g

P

DIVrrrErr fMf

0

1or ][

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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.

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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/whitepaper.cfm

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REIT Valuation – Funds From Operations (FFO)

REIT Income Statement

REIT Cash Flow

Rent $100 $100

- Operating expenses 40 40

Net operating income 60 60

- Depreciation 40 -

Net income 20 -

Cash flow - 60

Number of shares 10 10

EPS $2 -

FFO per share - $6

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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.

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REIT Net Asset Value (NAV)

A REIT’s 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 management’s ability to create or destroy value.

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REIT Share Price Premiums toGreen Street NAV Estimates

January 1990 - November 2006

Sources: http://www.greenstreetadvisors.com/about/page/research_nav/

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REIT Valuation Multiples

P / FFO P / AFFO P / EPS P / NAV *Mean 15.78 19.69 71.04 -6.07Median 15.04 18.50 34.69 -7.07Min 8.95 10.32 4.06 -29.55Max 27.44 54.92 1,118.00 20.80Std 4.35 7.21 137.32 8.58Source: SNL Financial, 06/15/2007* (P / NAV) - 1 ] x 100( - ) Discount, ( + ) Premium

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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

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Sample Graphs from the previous paper

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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

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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

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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

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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

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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

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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

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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

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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

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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