Real Estate Investment Trusts
(REITs)
1
What is it?
• Securitized real estate investment
• Ownership form created by IRS code
20:2
Requirements
• Assets
– 75% of assets must be real estate, cash, and
govt. securities
• other REIT shares are considered real estate assets
– not more than 5% of assets can be from 1 issuer
if not covered under above test
– may not have more than 10% of voting
securities of 1 issuer if not covered under 1st
test
20:3
Requirements
• Income
– 95% of gross income must be from dividends,
interest, rents, or gains from sale of certain
assets (real estate, cash, or govt securities).
– 75% of gross income must be derived from
rents, interest on mortgages, gains from sale of
certain assets, or income from other REITs
20:4
Requirements
• Income
– No more than 30% of gross income can be
derived from
• sale or disposition of securities held less than 6
months
• sale or disposition of real estate held for less than 4
years, except those involving foreclosures.
• properties held for sale in the normal course of
business (anti-dealer provision)
20:5
Requirements
• REIT Modernization Act of 1999 (effective
2001)
– REITs allowed to own 100% of a Taxable REIT
Subsidiary (TRS). TRS can provide services to
REIT tenants and others (previously, this was
not allowed). Debt and rental payments from
TRS to REIT are limited to ensure that the TRS
actually pays income taxes.
20:6
Requirements
• Distribution
– must distribute 90% of all taxable income to
investors
• mandates fairly low retained earnings policy
• has important implications for firm size
20:7
Requirements
• Management
– REIT managers must be passive
• REIT trustees, directors or employees may not
actively engage in managing or operating REIT
properties (includes providing service and collecting
rents from tenants).
• Managers may set policy: rental terms, choose
tenants, sign leases, make decisions about
properties.
20:8
Requirements
• Anti-concentration rule
– 5 or fewer entities may not own 50% or more
of the outstanding shares
– Exceptions:
• ‘look-through’ provision for US pension funds
• UPREIT structure (umbrella partnership)
20:9
Tax Treatment
• Accelerated depreciation is allowed for
determining taxable income
• 40 year asset life required for calculating
income available for distribution to
investors
20:10
REIT Types
• Equity
• Mortgage
• Hybrid
20:11
Equity REITs
• Blank Check
– does not disclose investments to shareholders
prior to acquisition.
• Specified Trusts
– purchase a specific property (Rockerfeller
Center Properties)
• Mixed Trusts
– invests in both blank check and specific
properties
20:12
Equity REITs
• Leveraged v. Unleveraged
• Finite-life v. Nonfinite-life
– finite-life is self-liquidating
20:13
Equity REITs
• Closed-End v. Open-End
– closed-end protect shareholders from future
dilution
• Exchange Trusts
– tax-free exchange of property for shares in the
REIT
20:14
Equity REITs
• Developmental-Joint Venture
– funds construction costs
– lower cost of capital for developer
20:15
Mortgage REITs
• Invests in mortgages
– earn the spread between costs of funds and
mortgage loan rates
20:16
UPREIT
• REIT formed by consolidating limitedpartnerships
• partnerships allocated REIT shares based on
appraised value of partnership property
20:17
Taubman UPREIT
20:18
REIT Benefits
• invest in a diversified RE portfolio managed
by professionals
• higher liquidity
20:19
REIT Disadvantages
• possible conflicts of interests between
sponsor and REIT shareholders
20:20
REIT Market Capitalization
$160,000
$140,000
200
180
160
$120,000
140
$100,000
$80,000
$60,000
120
100
Market Cap
Equity REITs
80
60
$40,000
40
$20,000
0
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$0
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20:22
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
20:23
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
20:24
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
20:25
Structural Changes
• Debt Rollover Timing
– Industry refinanced with 5-7 year miniperms
following bond market rally of 1986
20:26
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
20:27
Size of Equity REIT Market
• In the third quarter of 1995, 119 firms
included in the Wilshire Real Estate
Securities Index
– $42 billion in equity market capitalization
– With roughly 40% average leverage level, the
value of real estate owned by equity REITs is
about $100 billion
• compares to the $120-$150 billion owned by taxexempt institutions acting as fiduciaries for
20:28
beneficiaries
REIT Liquidity
• Research finds that equity REITs have the
same liquidity as firms in other industries,
holding constant firm size and exchange
listing
– liquidity measured as the bid-ask spread
20:29
REIT Liquidity
• Bid-Ask does not decrease during down real
estate markets relative to that for all stocks
– very different from liquidity conditions in
private markets
– must remember that bid-ask is for a marginal
change in ownership, transactions in the private
market typically involve whole properties or
portfolios of properties (control issues arise)
20:30
REIT Growth
• REITs have limited ability to grow through
retained earnings (little free cash flow)
• Most expand through additional stock
offerings (follow-on offerings)
20:31
EPS v. FFO
• earnings per share (EPS) is a fictional
accounting number
– REIT must distribute at least 95% of EPS
• funds from operations (FFO) is REIT cash
flow (no depreciation)
20:32
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. Adjustments for these entities are
to be calculated to reflect FFO on the same basis.
Moreover, NAREIT believes that items classified by
GAAP as extraordinary or unusual are not meant to either
increase or decrease reported FFO.
20:33
How to Calculate FFO
Revenues minus:
–
–
–
–
Operating expenses
Depreciation & amortization
Interest expense
General & Administrative expense
= NET INCOME (GAAP)
20:34
Reported FFO?
Net Income minus:
– Profit from real estate sales
plus:
– Real Estate Depreciation
= FFO
20:35
Analyst FFO?
FFO minus:
–
–
–
–
Recurring capital expenditures
Amortization of tenant improvements
Amortization of leasing commissions
Adjustment for rent straight-lining
= Adjusted FFO (AFFO)
20:36
• Payout Ratio = Dividend / FFO
20:37
Key Parts of FFO
• Depreciation and Amortization
– Old definition allowed add-back of D&A for
non-real estate items
• allowed firms to increase FFO in prospectuses via
debt buydowns and deferred financing
20:39
Key Parts (Nonrecurring Items)
• Focus FFO as a measure of recurring
operations
– restrict ability to affect FFO due to special
events
20:41
Key Parts (Nonrecurring Items)
• Focus attention on recurring maintenance
and capital expenditures that are necessary
to maintain the relative economic position
of the property
– reflect true economic depreciation
– probably should be subtracted, not added back
to determine FFO
• issue of whether capital expenditure is revenueenhancing
20:42
Impact on FFO
• Tenant Improvements (TI)
– landlord allowance to cover costs of
reconfiguring space for tenant
– TI are capitalized and depreciated - cash flow
from TI not included in FFO
– Implication:
• Mgt can use TI’s to raise occupancy and rent
revenue
20:44
Impact on FFO
• Leasing Commissions
– usually paid in cash when lease is signed
– cost is capitalized over life of lease, may not
show up in FFO
– 2 issues:
• leasing costs are an operating cost
• commissions are occasionally paid over lease term
20:45
Impact on FFO
• Straight-line Rents (REITS with long term
leases)
– count average rental rates over lease life in FFO
• over states revenue in early years and under state in
later years
20:46
Impact on FFO
• Lease guarantees
– REIT sponsor guarantees income on currently
vacant space using master lease (WHY?)
• may be for limited period - short term solution to
long term problem
• should have recourse to sponsor
• sponsor may be charging the REIT guarantee fees
20:47
Impact on FFO
• 3rd Party Income
– income from managing other properties
– highly variable
• Leased space v. Occupied space
20:48
Impact on FFO
• Ground Leases
– encumber the land underneath buildings (long
term)
– REITs may own buildings subject to a ground
lease or REITs may own the ground lease
(spread investing)
20:49
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
20:50
REIT Debt Usage
• Modest leverage levels compared to those
taken on by private real estate firms in mid80s.
– However, 20%-50% leverage levels are not low
when compared to other capital intensive
industries such as auto, chemical, etc..
20:53
FFO Growth
FFO Growth = Internal Growth + External
Growth
20:54
FFO Growth
Internal Growth
–
–
–
–
–
Rental Increases
% Rent, Rent Bumps, etc.
Tenant Upgrades
Property Refurbishments
Sale & Reinvestment
20:55
FFO Growth
External Growth
– Acquisitions
• Accretive = yield on investment is below cost of
capital
– Example: REIT raise $100m from stock and bond at 10%
WACC -- acquire property with a 12% yield == 2%
increase in FFO
• Deccretive = yield is below WACC
– Development & Expansion
20:56
REIT Debt Usage
• Use of secured debt
– Mortgaging properties one-by-one has been the
standard
– New realization that levering up via slices of
secured debt may not leave enough flexibility
for firms to take advantage of targets of
opportunities
20:57
REIT Debt Usage
• Use of unsecured debt
– real estate firms rapidly moving in this
direction
– other corporate entities raise such debt against
aggregate firm cash flows, not specific assets
20:58
Minimum Efficient Firm Size
• Typical REIT IPO from 1993
– $100,000,000 firm with 50/50 debt-equity ratio,
yielding 8% on equity
– implies roughly $4,000,000 in income
– even with relatively low payout ratio of 75% of
earnings, can retain only $1,000,000
20:60
What will $1,000,000 buy?
– for apartment REIT, good-sized garden apt.
complex costs $20-$25 million, retaining the
added $1,000,000 adds little flexibility with
respect to acquiring properties for portfolio.
– from broad capital market perspective, this firm
probably should increase payout ratio (this is
what happened in reality)
• shareholders received high dividend yield, firm had
to repeatedly go to the capital markets to fund
acquisitions
20:61
Now consider $10 billion firm
• Some now exist:
– same 50/50 debt-equity ratio and 8% yield on
equity
– implied income of about $400,000,000
20:62
$10 billion REIT
– if firm chooses not to aggressively expense, it
will have a relatively high payout ratio
• if that ratio is 95%, implies the firm can retain
$20,000,000
• that’s a good-sized garden apt complex, 1/5th of a
large regional mall, or a couple of decent-sized
warehouses or industrial sites.
20:65
$10 billion REIT
– if firm chooses to aggressively expense items to
reduce accounting earnings and lower its
required payout under the REIT tax law, the
situation is markedly different
• assume its payout ratio falls to 75%:
– ratio implies retention of $100,000,000
– which will buy a portfolio of any property type except
regional malls and downtown office buildings
20:66
• If you can retain this amount, you do not
have to go to Wall Street to fund every
portfolio purchase
– increases flexibility so that you can quickly
take advantage of targets of opportunity and
avoid investment banker fees
20:67
– achieving such internal financing capabilities is
goal of many firms
• given REIT tax law, fairly large scale is required
• average firm size is too small at the moment
– suggests that consolidation in the public
markets will continue in the next few years
20:68
– how consolidation occurs still is unknown
• REIT management's have implemented various
types of anti-takeover provisions
– 5 or fewer rule itself provides a natural defense
mechanism
• lack of truly independent boards a problem
20:69
• mergers difficult because acquired firm inevitably
has to be willing to hold the paper of acquiring firms
– requires common vision to make it work in the absence of
aggressive board intervention
• most likely path is continued acquisition of private
portfolios by public firms
– still occurring at rapid pace
– more that 80 firms with $1 billion equity market caps
– 25 largest firms have mean equity market cap of about
$5.5 billion (7/14/98)
20:70
What could stop consolidation in
the public markets?
• Discovery of fundamental diseconomies of
scale
– if real estate is inherently small scale business
because of the need to master local market
details, then really large firms are not feasible
• they will have lower returns on average than local
firms
20:71
REIT Research
Q:
Are REITs real estate or stocks?
– important implications for portfolio diversification
– do REITs provide a real estate index
A: REIT returns lag real estate cap rates
REIT returns and unsecured real estate returns share a
common component that reflects real estate fundamentals
REIT returns are noisy.
20:72
REIT Research
• Corporate Finance Issues
– Dividend policy
– Capital structure
20:73
REIT Research
• Risk and diversification
– REIT returns highly correlated with stocks (corr = .65 .8)
– real estate returns have low correlation with stocks
(corr=.1 - .3)
– REIT betas < 1
• Real estate portfolio allocation
– optimal allocation 10% to 19% real estate
– historic real estate allocation = 3%-5% (pension funds)
20:74
REIT Research
• REITs and Inflation Hedging
– depend on the time period under study
• 1970s - REITs are negatively correlated with
inflation
• 1980s - REITs are positively correlated with
inflation
20:75