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Session Plan. Chapter Twelve: REITs as investment alternative QQD of REITs REIT Valuation Techniques The Send-Off. Origins of REITs. Massachusetts Trust (19 th Century until 1935) Filled void for corporations owning RE No federal tax, & no distributions tax for shareholders!!

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session plan
Session Plan
  • Chapter Twelve:
    • REITs as investment alternative
    • QQD of REITs
    • REIT Valuation Techniques
    • The Send-Off
origins of reits
Origins of REITs
  • Massachusetts Trust (19th Century until 1935)
    • Filled void for corporations owning RE
    • No federal tax, & no distributions tax for shareholders!!
  • Investment Company Act of 1940
    • 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
Real Estate Investment Trusts (REITs)
  • First established in US in 1960
    • 1971 Australia, 1985 Turkey, Canada 1993, Singapore 1999, Japan 2000, Hong Kong & France 2003, Germany in 2007
  • US Minimum Requirements
    • 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
    • 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
REIT Organizational Structures
  • UPREIT: Umbrella Partnership REIT
    • 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 structures1
REIT Organizational Structures
  • Down REIT:
    • 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
REIT Incentive Issues
    • Management could be reluctant to sell if they own operating units rather than REIT shares
      • Subject to tax when sold
  • Down REIT:
    • If management does not own operating units, could become “trigger happy” with sales given the lack of tax consequences from sale
reit taxation
REIT Taxation
  • Shareholders pay taxes on dividends received via form 1099
  • 721 Exchange: Like Kind Exchange for REITs
    • Limited Partners of Up and Down REITs can exchange partnership units for interests in other RE via like kind exchange
      • 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
Types of REITS
  • Mortgage REITs
    • Heyday in 1970s
  • Equity REITs
    • Most common form today
  • Hybrid REITs
    • Invest in both mortgages and equity
  • Mutual Fund REITs
    • Common for personal investors
mutual fund reits
Mutual Fund REITs
  • First mutual fund in Netherlands in 1774
  • Modern mutual funds began in US in 1924
    • 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
      • Mgmt company shareholder interests are introduced
      • Higher costs typically given competing goals of shareholder wealth creation & profit for external mgmt company
reit historical performance
REIT Historical Performance

As you can see, mortgage REITs are historically more volatile than equity REITs

portfolio mix strategy
“Portfolio Mix” Strategy
  • Investors can review annual reports of REIT mutual funds to obtain information for how they allocate their investment dollars.

It looks like REIT 1 has more confidence in the office market but much less in retail than does REIT 2

quantity strategy
“Quantity” Strategy
  • This strategy involves maximizing the gross potential income by keeping overall portfolio vacancy rates as low as possible.
quality strategy
“Quality” Strategy
  • Another portfolio diversification strategy is to concentrate on properties that have high quality, nationally known companies as tenants.

See any problem companies here?

durability strategy
“Durability” Strategy
  • Let’s see how REIT 1 looks in terms of the durability of the lease income.

For Retail: low percentage of portfolio but long leases.

geographic dispersion strategy
“Geographic Dispersion” Strategy
  • REITs (or wealthy investors) have the ability to reduce local market risk via diversification.
  • Below is how REIT 1 is diversified in this way...
geographic dispersion strategy continued
“Geographic Dispersion” Strategy Continued
  • Another method of viewing this type of portfolio risk smoothing is by Metropolitan Statistical Area (MSA):
reit the qqd framework
REIT & The QQD Framework
  • Quantity Strategy
    • Strong dividends, maximize GPI, growth orientation purchased at discount
      • Focus strategy: less diversified
      • Diversified: higher expenses
  • Quality Strategy
    • Nationally known tenants, NNN REITs, Blue Chip REITs
  • Durability Strategy
    • Tenant rollover risk, length of leases, geographic dispersion
reit the qqd framework1
REIT & The QQD Framework
  • Lease Rollover Risk
    • 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
    • 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
REIT Valuation Techniques
  • Gordon Dividend Growth Model
  • Funds from Operations (FFO) Multiple
  • Net Asset Value (NAV)
gordon dividend growth model
Gordon Dividend Growth Model
  • 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
    • Add in reversion to obtain PV of firm
    • Divide by # of outstanding shares to obtain D1

V = D1


$50.00 = $3.00


ffo multiple
FFO Multiple
  • 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
    • Value = FFO/share * FFO Multiple
  • Multiple: Historical multiple for REIT or peer group
    • Only as good as the comparables!!
net asset value nav
Net Asset Value (NAV)
  • Value = Aggregate Stabilized NOI

Blended Cap Rate

    • 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)
    • Holding Period Return= NAVnow –NAVprior + Divholding period


reit valuation issues
REIT Valuation Issues
  • Different classifications of recurring expenses for FFO
    • Tenant Improvements, Leasing Commissions
    • If categorize as expense, subtract from FFO
    • If categorize as capital improvement, amortized on balance sheet
  • Adjusted FFO (AFFO)
    • Adjusts FFO for expenses, while capitalized, which do not enhance property value
    • Eliminates straight lining of rents
      • FASB 13: Free rent or increases must be equalized (straight-lined) over term of lease
reit internationalization
REIT Internationalization
  • 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…
the end
The End?
  • “One repays a teacher badly if one always remains a pupil…”
    • Thus Spoke Zarathustra, On the Gift Giving Virtue, pg. 78
  • Go forth and invest in Real Estate!!

Friedrich Nietzsche