Session Plan

Chapter Twelve:
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REITs as investment alternative
QQD of REITs
REIT Valuation Techniques
The Send-Off
Origins of REITs

Massachusetts Trust (19th Century until 1935)
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
Filled void for corporations owning RE
No federal tax, & no distributions tax for shareholders!!
Investment Company Act of 1940
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Closed end mutual funds lobbied for equal treatment
until tax law was amended in 1960
External management structure was required until
1986
Real Estate Investment Trusts (REITs)

First established in US in 1960
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US Minimum Requirements
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
1971 Australia, 1985 Turkey, Canada 1993, Singapore 1999,
Japan 2000, Hong Kong & France 2003, Germany in 2007
100 shareholders
75% of value of REIT assets in RE, cash, or gov’t securities
95% of gross income from dividends, interest, rents, or gains from
sale of REIT assets
Shareholder distributions at least 90% of REIT taxable income
annually
Additional European Requirements
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Leverage is limited (50% in Germany, France, Spain; 20% for most
Austrian REITs, a coverage ratio of 1.25x EBIT/Int in UK)
Limits for size of any one property (15% in G-REIT, 40% in UK)
EU REIT Strategies: Core/nuclear (low risk), Core-Plus/Value
Added (medium risk) and Opportunity (high risk)
REIT Organizational Structures

UPREIT: Umbrella Partnership REIT
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Established in 1992 to allow existing RE
operating companies to bring property already
owned under umbrella of REIT w/o capital gains
tax
REIT owns controlling interest in limited
partnership that owns the real estate
Owners of limited partnership can convert
operating units into REIT shares, vote, & receive
dividends
REIT Organizational Structures

Down REIT:
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Formed after REIT goes public
Can own numerous partnerships at the same time
Down REIT owns property directly in REIT, but
holds some properties in partnership with others
No tax liability until partnership units are
converted into stock or sold
REIT Incentive Issues

UPREIT:
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Management could be reluctant to sell if they own
operating units rather than REIT shares
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
Subject to tax when sold
Down REIT:
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If management does not own operating units,
could become “trigger happy” with sales given the
lack of tax consequences from sale
REIT Taxation


Shareholders pay taxes on dividends received via
form 1099
721 Exchange: Like Kind Exchange for REITs
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Limited Partners of Up and Down REITs can exchange
partnership units for interests in other RE via like kind
exchange

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Must be investment grade property
Investors receive operating units rather than property
Up and Down REITs have advantages for tax sensitive sellers
Types of REITS
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Mortgage REITs
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Equity REITs
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Most common form today
Hybrid REITs
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Heyday in 1970s
Invest in both mortgages and equity
Mutual Fund REITs
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Common for personal investors
Mutual Fund REITs
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
First mutual fund in Netherlands in 1774
Modern mutual funds began in US in 1924
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Was truly “mutual” as it was organized, operated, &
managed by its own trustees
Alpha Fund: shareholders own funds which own
management company
Omega Fund: Mgmt company shareholders own mgmt
company which controls mutual fund owned by mutual fund
shareholders

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Mgmt company shareholder interests are introduced
Higher costs typically given competing goals of shareholder
wealth creation & profit for external mgmt company
REIT Historical Performance
FTSE NAREIT US RE Index 1972-2011
80.00
70.00
60.00
50.00
30.00
20.00
10.00
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
-10.00
1974
0.00
1972
Return (%)
40.00
-20.00
-30.00
-40.00
-50.00
Total US NAREIT Index
Year
Equity REIT (no Timber)
Mortgage REIT
As you can see, mortgage REITs are historically more volatile than equity REITs
“Portfolio Mix” Strategy

Investors can review annual reports of REIT mutual
funds to obtain information for how they allocate
their investment dollars.
REIT 1
REIT 2
Office
38%
17.5%
Industrial
26%
5.9%
Apartments
20%
15.3%
Retail
15%
24.8%
Other
1%
36.5%
It looks like REIT 1 has more confidence in the office
market but much less in retail than does REIT 2
“Quantity” Strategy

This strategy involves maximizing the gross
potential income by keeping overall portfolio
vacancy rates as low as possible.
REIT 1
REIT 2
Office
92%
92%
Retail
86%
92%
Industrial
87%
95%
Apartments
96%
97%
Weighted Avg.
91%
93%
“Quality” Strategy

Another portfolio diversification strategy is to
concentrate on properties that have high
quality, nationally known companies as tenants.
Top 5 Tenants by Square Footage for REIT 1
Industrial
Office
Retail
Wal-Mart
BHP Petroleum
Publix Supermarkets
GE
Deloitte & Touche
Dick’s Sporting Goods
Regal West
Crowell & Moring
Wal-Mart
Restoration Hardware
Bank of NY Mellon
Ross Dress for Less
Kuehne & Nagel
Microsoft
Belk
See any problem companies here?
“Durability” Strategy

Let’s see how REIT 1 looks in terms of the durability
of the lease income.
Type
2011
2012
2013
2014
2015
2016 & Beyond
Office
10.2%
6.8%
8.2%
11.9%
10.2%
38.3%
Retail
9.8%
10.9%
10.2%
7.6%
8.5%
36.6%
Industrial
12.9%
10.4%
17.3%
6.8%
22.1%
22.8%
For Retail: low percentage of portfolio but long leases.
“Geographic Dispersion” Strategy
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
REITs (or wealthy investors) have the ability to reduce
local market risk via diversification.
Below is how REIT 1 is diversified in this way...
East
West
South
Midwest
Foreign
Office
24.5%
17.5%
10.4%
1.2%
2.7%
Apartment
2.6%
6.2%
5.4%
0.0%
0.0%
Industrial
1.3%
7.0%
4.1%
1.3%
0.0%
Retail
3.2%
0.9%
8.5%
0.3%
2.4%
Storage
0.2%
0.2%
0.1%
0.0%
0.0%
“Geographic Dispersion” Strategy
Continued

Another method of viewing this type of portfolio
risk smoothing is by Metropolitan Statistical Area
(MSA):
MSA
% of Total
1 Washington-Arlington-Alexandria-DC-VA-MD-WV
10.6%
2 Boston-Quincy MA
5.5%
3 Los Angeles-Long Beach-Glendale CA
5.4%
4 San Francisco-San Mateo-Redwood City CA
5.0%
5 Houston-Bay Town-Sugar Land TX
4.8%
REIT & The QQD Framework
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Quantity Strategy
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Strong dividends, maximize GPI, growth orientation
purchased at discount
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Quality Strategy
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Focus strategy: less diversified
Diversified: higher expenses
Nationally known tenants, NNN REITs, Blue Chip REITs
Durability Strategy
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Tenant rollover risk, length of leases, geographic dispersion
REIT & The QQD Framework
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Lease Rollover Risk
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Attempt to diversify via the duration of the income
stream on associated properties.
Also based on the lack of a high concentration on
any particular tenant for the total revenue
Business Risk
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Attempt to diversify via the region or type of
property in an effort to reduce concentration on
one area or property type
REIT Valuation Techniques
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Gordon Dividend Growth Model
Funds from Operations (FFO) Multiple
Net Asset Value (NAV)
Gordon Dividend Growth Model
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Utilizes future dividend per share expected next year
to calculate stock price as the present value of
expected future dividends
Constant dividend growth is assumed
Begin with DCF based on projected revenue and
expenses to estimate FFO for an assumed holding
period
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Add in reversion to obtain PV of firm
Divide by # of outstanding shares to obtain D1
V = D1
(k-g)
$50.00 =
$3.00
(0.10-0.04)
FFO Multiple
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Similar to the Price to Earnings Ratio
FFO: Net income (GAAP) excluding gains or
losses from sales of property or debt
restructuring adding back RE depreciation
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Value = FFO/share * FFO Multiple
Multiple: Historical multiple for REIT or peer
group
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Only as good as the comparables!!
Net Asset Value (NAV)
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Value = Aggregate Stabilized NOI
Blended Cap Rate
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Blended cap rate is difficult for diversified assets
Rather: Find value of specific properties and divide by
property specific cap rates to obtain value of portfolio
Once find value, subtract out debt to obtain NAV
Shares quoted in terms of Net Asset Value (NAV)
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Holding Period Return= NAVnow –NAVprior + Divholding period
NAVprior
Net Asset Value (NAV)
NAV
Revenue
Op Ex
NOI
Cap Rate
Value
Debt
NAV
# of Shares
$
$
$
Per Share
35,000,000 $ 12.73
15,000,000 $ 5.45
20,000,000 $ 7.27
9.50%
210,526,316 $ 76.56
75,000,000 $ 27.27
135,526,316 $ 49.28
2,750,000
REIT Valuation Issues

Different classifications of recurring expenses for
FFO
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Tenant Improvements, Leasing Commissions
If categorize as expense, subtract from FFO
If categorize as capital improvement, amortized on balance
sheet
Adjusted FFO (AFFO)
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Adjusts FFO for expenses, while capitalized, which do not
enhance property value
Eliminates straight lining of rents
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FASB 13: Free rent or increases must be equalized (straightlined) over term of lease
REIT Internationalization
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International RE Investment is becoming more of an area of study
Historically International RE Investment focused on Blue Chip properties
in well known cities
RE Investment becoming more frequent in Emerging Markets
RE Investment in Developing Countries typically centers around Tier I
cities
REITs have been embraced by Islamic Finance given the verifiable nature
of the assets included in the investment pool
The initial requirement for external management still exists in many
countries…
Internal External
France Australia
Turkey
Japan
Singapore
Hong Kong
Malaysia
Both
United States
Canada
Netherlands
Belgium
Germany
Emerging Market Property Rights
Heritage Foundation Index of Economic Freedom 1995-2011
80
Brazil
60
China
40
India
Hong Kong
20
Year
11
20
10
20
09
20
08
20
07
20
06
20
05
20
04
20
03
20
02
20
01
20
00
20
99
19
98
19
97
19
96
19
95
0
19
Index Score
100
The End?

“One repays a
teacher badly if one
always remains a
pupil…”
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
Thus Spoke Zarathustra,
On the Gift Giving Virtue,
pg. 78
Go forth and invest
in Real Estate!!
Friedrich Nietzsche