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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