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Edit Comment Close Premium member Presentation Transcript Real Estate Equity Securitization: Real Estate Equity Securitization Understanding Real Estate Investment Trust (REITs) Session SixThe Investment System and Capital Markets: The Investment System and Capital Markets The Investment System has Two Parts Underlying Real Assets: a collection of physical, human, and legal assets and relationships that produce cash flow through the production and sale of goods and services Financial Assets: these are not directly productive (as real assets), but are direct or indirect claims on the directly productive underlying real assets The investment system matches heterogeneous investors (sources of financial capital) with heterogeneous productive assets (physical capital) Slide3: Firms operations (a bundle of real assets and receivables Financial Markets (investors holding Indirect Financial Claims) Financial manager (1) (2) (3) (4b) (4a) Firms sells securities To raise capital Proceeds used to buy assets for operation Real assets generate positive cash flow Cash either reinvested or returned to investors Exhibit 1: Capital Markets without Asset Securitization Underlying physical assets produce cash flows through products and sale of goods and commodities Financial assets do not directly generate cash flow, but are indirect claims on the productive real assets 3. The investment system matches heterogeneous investors (sources of capital) with heterogeneous productive assets (physical assets and receivables) Managerial Discretion?Slide4: Firms operations (a bundle of real assets) Financial Markets (investors holding Financial Claims) Financial manager (1) (2) (3) (4b) (4a) Exhibit 2: Financial Markets with Asset Securitization Traditionally, investors in industrial firms “indirectly” own the underlying assets through ownership of financial claims, they do not own the underlying real assets directly; securitization has made it possible for investors to own directly the cash flows of specific assets or receivables of industrial and financial firms Real estate investors traditionally own “directly” the real assets ; asset securitization has made it possible for these investors to indirectly own real estate related assets In short asset securitization has changed the investments decision making Firms sells securities To raise capital Proceeds used to buy assets for operation Real assets generate positive cash flow Cash either reinvested or returned to investors Securitized Assets For securitized assets specific cash flow goes directly to investors. Securitized assets and their associated cash flows are in effect owned directly by investors ---- Limited Managerial Discretion (5) Investors in securitized AssetsAsset Securitization has Changed the Investment and Financing Decisions : Asset Securitization has Changed the Investment and Financing Decisions Asset securitization has made it possible for investors in real estate entities to own financial claims, (REIT, MBS, CMBS), on the real estate (indirect ownership) as well as own the real estate (direct ownership) Asset securitization has also made it possible for investors in industrial firms to own specific pieces of the firm’s cash flows or receivables through ABS (“direct ownership”), as well as hold financial claims on the underlying productive real assets of the firm (indirect ownership through shares and bonds) What is Asset Securitization?: What is Asset Securitization? Generally speaking, this is the trend towards real assets, commodities, products, or receivables , etc, being transformed into liquid securities tradable in financial markets real estate investment trusts (REITs) vs. real property commercial mortgage backed securities (CMBS) vs. commercial mortgages residential mortgage backed securities (RMBS) vs. residential mortgages asset backed securities (ABS) vs. receivables (credit cards, auto loans, trade receivables, leases, royalties, telephones receivables, future flows, infrastructure projects, etc) Real Estate Investment Trusts (REITs) –An Equity Securitization: Real Estate Investment Trusts (REITs) –An Equity Securitization What is Real Estate Investment Trust (REIT)? A REIT is a special investment vehicle that invests in income producing real property – office buildings, apartments, shopping malls, other retail, warehouses, whole mortgages, etc A key regulatory provision associated with all REITs is that it must distribute to share holders substantially all of its earnings (income plus capital gains) In the US a REIT also has elected under certain tax provisions for the investments to qualify for single taxation, either at the entity level or the investor level Real property owner (sponsor) works with an investment bank to form a REIT which is initially capitalized with the proceeds of initial public offering (IPO) and other debt financing Shares of REITs are typically publicly traded, although there private REITs Slide8: Exhibit 3: General Structure of Real Estate Investment Trusts (REITs) Capital Market Investors Subscribed in IPO allowing REIT to raise capital Sale Proceeds from IPO subscription used to purchase property Rental Cash Flow Dividend income/ Capital gains Primary( Direct) Real Estate Capital Market Secondary (Indirect) Real Estate Capital Market Owner/Seller of Property Sponsors REITOther Typical Attributes of REITs: Other Typical Attributes of REITs REITs can be structured either as a corporation (US) or a unit trust (Australia) REIT can either be directly managed internally (US) or externally managed through a third party asset management company (Asian Countries) A REIT typically does not make market – i.e. investors cannot require the REIT to redeem their shares (they are closed-end funds) Listed REITs are typically set up to operate indefinitely, although they can be structured with finite life Key Requirements of US REITs: Key Requirements of US REITs Asset Test: At least 75% of a REIT’s asset value must come from real estate, cash, and government securities at the close of each quarter of taxable year No more than 5% of the value of the assets may consist of the securities of one issuer, and REIT may not own more than 10% of the outstanding shares of one issuer, if those securities are not includable in the 75% test Income Test: At least 95% of gross income must come from dividends, interests, rents, or gains from sale of certain assets No more than 30% of REITs gross income can be derived from sale of real estate held for less than fours years or securities held for less than six months Distribution Test: At least 90% of the REIT taxable income must be distributed to shareholders Stock and Ownership Test: REIT shares must be transferable and must be held by a minimum of 100 persons No more than 50% of REIT shares may be held by five or fewer persons Types of Real Estate Investment Trust: Types of Real Estate Investment Trust Broadly speaking, there are three types of U.S. REITs: Equity REITs (EREITs) Invest primarily in equity property interests Mortgage REITs (MREITs) Hold predominantly mortgages Hybrid REITs Hold both property and mortgage interests U.S. REIT Property Sector and Sub-sector: U.S. REIT Property Sector and Sub-sector Industrial/Office (9%+21%) Office Industrial Mixed Retail (25%) Shopping Centers Regional Malls Free Standing Residential (19%) Apartments Manufactured Homes Diversified (8%) Others (18%) Lodging/Resorts Self Storage Health Care** Mortgages Home Finance Commercial Financing Investment Appeal of REITs (1): Investment Appeal of REITs (1) REITs offer individual investors fractional shares in investment grade and professionally managed income producing real estate investment – broaden investment choices Regular income stream and relatively high dividend yield The REIT vehicle creates liquidity because shares can be traded on organized exchanges, as opposed to direct ownership of the underlying property Liquidity in turn allows for easier entry and exit as market conditions dictate which reduces transactions costs Access to broad capital markets leads to market integration which can reduce cost of capitalInvestment Appeal of REITs (2): Investment Appeal of REITs (2) A REIT structure offers property owners a more efficient way of selling their properties to recoup capital investment REIT allows for orderly divestiture of real estate assets and redeploy capital on core business – corporate restructuring In many jurisdictions (US) REITs also offer tax advantages relative to other investment vehicles by removing double taxation ---???? REIT conduit also offers strong corporate governance mechanisms as well as separation of ownership and control Overall REITs tend to act as defensive stock or provide a hedge in bad times Innovation in U.S. REITs: Innovation in U.S. REITs Pre 1986 REITs – passive management Directors, trustees or employees of REITs were not allowed to actively manage REIT properties Independent contractors performed these functions REIT owns underlying physical assets directly Post 1986 REITs --- Modern REITs (active management) 1986 Tax Reform Act relaxed management restrictions Allowed REITs to provide normal maintenance and other services for tenants Created vertically-integrated operating companies fundamentally different from passive REITs of pre-1986Umbrella Partnership REITs or UPREITs: Umbrella Partnership REITs or UPREITs REIT does not directly own the underlying properties Rather the REIT and other real estate owners own units (operating partnership units or OP units) in a partnership The REIT and in real estate owners have contributed ort sold properties to the partnershipn OP units are convertible into shares of REIT, offering voting rights and dividends This complicated arrangement allowed property owners (developers) to “sell” their properties to the REIT without triggering taxable event Slide17: REIT Shareholders REIT A B Umbrella Partnership Managed by A (formed by REIT) General Manager of Operating Partnership is REIT Property 1 Property 2 Property 3 Property 4 A’s OP units are sold to REIT for cash or shares B has the option to convert OP units to shares of REIT Exhibit 4: Umbrella REIT FORMATIONThe Innovation in UPREITs: The Innovation in UPREITs The UPREIT is a form of financial engineering or structured financing The structure is a tax-deferred mechanism through which real estate developers and other owners transferred properties in the form of a tax-exchange Since the transaction did not trigger a taxable event the REIT is able to acquire properties at better earning multiples Conceivably this resulted in shareholder wealth maximization The development of UPREITs resulted in massive growth in REIT equity market capitalization in 1990s These modern REITs feature active management so as to grow cash flows and portfolio size U.S REITs versus U.S. REOC Structure: U.S REITs versus U.S. REOC Structure What is REOC? (1) U.S REITs are prohibited from certain lines of business, e.g. hotel operations, parking operations, REOCs are not (2) REITs operating loss (OL) can be carried forward for 15 years not back, REOCs can carry loss back (3) REOCs may decide to retain all of its earnings to fund growth opportunities, REITs must pay 90% of their earnings to shareholders to avoid double taxation Innovations in U.S. REITs Structure: Paired Share REITs: Innovations in U.S. REITs Structure: Paired Share REITs It allows the REIT to enter into prohibited business and still avoid double taxation The process starts with an REIT acquiring an REOC engaged in active real estate business that the REIT cannot enter (e.g. parking operations, hotels, and health businesses) All properties acquired by the REIT are leased back to the REOC REOC in turn pays most of its income to the REIT in the form of rent REIT passes most of its income to shareholders and avoids double taxation International REITs Trend: International REITs Trend The growing demand for publicly traded real estate likely to be met by growth of REITs Two largest REIT markets in the world are in the United States and Australia United States market commenced in the early 1960s. First Australian LPT IPO was in 1971 Both markets grew very rapidly in the 1990s. This was after the property markets in both countries crashed in the early 1990s – Exhibit 4 REIT markets also established in: Canada, UK, Italy, Belgium, France, Netherlands, Japan, New Zealand, Malaysia, Korea, Singapore, Hong Kong, Taiwan, to name a fewUS and Australian REIT Markets: US and Australian REIT Markets Exhibit 5: US and Australia saw explosive growth in the early 1990s Australia United States Source: NAREIT, UBS What REITs invest in Size of markets Australia United StatesExhibit 6: REIT Market Capitalizations: Exhibit 6: REIT Market Capitalizations Source: National Association of Real Estate Investment Trusts®, ASX, Bloomberg as of 31 March 2004 Institutional Ownership of U.S. REITs has Grown: Institutional Ownership of U.S. REITs has GrownInstitutional Ownership in All U.S. Stocks (Equities) : Institutional Ownership in All U.S. Stocks (Equities) Growing US REIT Market Capitalization: Now in Excess of US$260 billion: Growing US REIT Market Capitalization: Now in Excess of US$260 billionOver the past three and half decades U.S. REITs have grown more than four folds: Over the past three and half decades U.S. REITs have grown more than four foldsInstitutional Investment in U.S. REITs: Institutional Investment in U.S. REITsLong Term Performance of REIT vs. Other U.S. Benchmarks: Long Term Performance of REIT vs. Other U.S. BenchmarksGlobal Real Estate Performance: Global Real Estate Performance Source: National Association of Real Estate Investment Trusts®, as of June 2004 North America Europe Global Composite Asia Exhibit: 13Exhibit 15: US Office REITS Traded at significant Premium to NAV in late 1990s to 200os: Exhibit 15: US Office REITS Traded at significant Premium to NAV in late 1990s to 200osDual Models of REIT Value: Dual Models of REIT Value We earlier noted the existence of two parallel real estate asset markets The public market (stock market) where REITs trade The Private property market where the REITs’ underlying physical assets trade Three fundamental questions arise from this dual market model that are of interest to real estate investors (1) Which asset market to use for real estate investment decision? (2) Is there a possibility for arbitrage by trading between the two markets to make seemingly (or nearly) riskless profits? (3) Do the two markets value differently the same underlying physical asset? First, we focus on the third question dealing with differential valuation between the two markets Slide33: The Dual Market Nature of Real Estate Creates “Windows of Opportunity”Public versus. Private Market Real Estate Valuation: Public versus. Private Market Real Estate Valuation Consider a 20-building portfolio with 2.5 million rentable square feet Total Portfolio $/square foot Gross Rent $40.0 million $16.00 Less amortized concessions (15%) 6.0 2.40 Effective Rent $34.0 million $13.60 Less: Stabilized Vacancy (15%) 5.1 2.04 Less: Expenses (36.8%) 12.5 5.00 Net Operating Income (NOI) $16.4 million $6.56 psf Public Company Valuation (PCV) -- an IPO: Public Company Valuation (PCV) -- an IPO Total Portfolio $ per Square ft Stabilized NOI $16.4 M $6.56 psf Less Management expenses (75 bp) $1.2 $0.48 Subtotal $15.2 $6.08 Dividend Payout ratio 90% Dividend Cash Flow $13.7 $5.48 psf Estimated Dividend Yield Range 7.50% to 9.00% Implied PCV Range $182.7 M $73.08 psf $152.2 $60.88 Average Public MV $167.4 M $66.98 psfPrivate Market Valuation (PMV): Private Market Valuation (PMV) Total Portfolio $ per Square Stabilized NOI $16.4 M $6.56/PSF Estimated cap rate range: 9.75% to 11.25% Implied Private Market portfolio valuation $168.2 M $67.28/PSF $145.8 $58.31 Average PMV $157.0 M $62.80/PSF Public Vs. Private Market Valuation Differentials: Public Vs. Private Market Valuation Differentials Total Portfolio $ per Square ft Average Public MV $167.4M $66.96/PSF Average Private MV $157.0 $62.80 Absolute Difference: Public - Private $10.4M $4.16/PSF Percentage 6.21% 6.21% Public vs. Private Valuation Differentials: Some Possible Explanations: Public vs. Private Valuation Differentials: Some Possible Explanations ( 1) The Public market ascribes value to more than just the underlying property assets Other factors include company management and its ability to identify and create investment opportunities through active management of the real estate (2) The public market valuation includes a premium for share liquidity (3) Are REITs closed-end mutual funds or operating companies? Closed-end mutual funds model suggest REIT shares will generally trade at values below their NAVs -- closed-end mutual fund discount The Operating Corporation model suggests that REITs shares will generally trade at values above their NAVs – growth opportunities. Accounting and Financial Disclosure Issues associated with REITs: Accounting and Financial Disclosure Issues associated with REITs Like other economic units REITs have considerable latitude when accounting for their operations. Effects of tenant improvements and free rent on FFO: tenant improvements are depreciated over time so cost is currently incurred but recovered over time FFO will not reflect this cost compare cost per square foot for tenant improvement say three years before IPO an a year before IPO additional amount could represent attempt to boost occupancy rate to make IPO attractive to investors.Accounting and Financial Disclosure Issues: Accounting and Financial Disclosure Issues Capitalizing of leasing commissions these costs are included as depreciation or amortization thus FFO, a measure of REIT profitability, will not reflect these costs Uses of Straight-Line Rents: long term leases have stipulated increases (step-up leases) if revenue is based on “straight line” reported rent is averaged over life of lease reported FFO will therefore be higher than actual in earlier years and lower than actual in later yearsAccounting and Financial Disclosure Issues: Accounting and Financial Disclosure Issues Lease Guarantee: in some cases sponsor may guarantee the lease to prevent vacancy from occurring in what is known as master lease the sponsor takes the risk of leasing to other tenants helps the sponsor obtain credit for space providing no income Why should investors worry? guarantee might be for a short period guarantee may not have recourse they might be guarantee fees to be paid by the REITAccounting and Financial Disclosure Issues: Accounting and Financial Disclosure Issues FFO and income from managing other Properties: income from managing other properties not owned by REIT may increase FFO but the income may be more variable than income from underlying properties because of third party cancellation. thus many REIT security analysts assign a lower multiple to portion of FFO from management income. Types of mortgage debt and other Obligations: watch for participating mortgages they may improve earnings in early years by will affect future operating performance and depress earnings growthMore Financial Disclosure Issues: More Financial Disclosure Issues Existence of ground leases: what is a ground lease? fixed lease payment advantage disadvantage of giving up ownership how should you discount cash flow from buildings with approaching expiration date of ground lease? Lease Renewal Options: what are the terms, particularly the rent? “Leased space” versus “occupied space”: You do not have the permission to view this presentation. In order to view it, please contact the author of the presentation.
Session 6 Rinald Download Post to : URL : Related Presentations : Share Add to Flag Embed Email Send to Blogs and Networks Add to Channel Uploaded from authorPOINTLite Insert YouTube videos in PowerPont slides with aS Desktop Copy embed code: (To copy code, click on the text box) Embed: URL: Thumbnail: WordPress Embed Customize Embed The presentation is successfully added In Your Favorites. Views: 525 Category: Education License: All Rights Reserved Like it (1) Dislike it (0) Added: January 30, 2008 This Presentation is Public Favorites: 3 Presentation Description No description available. Comments Posting comment... By: rabi4250 (17 month(s) ago) please send it to me at rabindra.jha@isgn.com Saving..... Post Reply Close Saving..... Edit Comment Close By: caseynoel (19 month(s) ago) well done. please send me a copy at casey.noel@gmail.com. thanks Saving..... Post Reply Close Saving..... Edit Comment Close By: taufiq_786 (42 month(s) ago) nice presetation send me a copy at tofiq.golkhaw@iflexsolutions.com Saving..... Post Reply Close Saving..... Edit Comment Close Premium member Presentation Transcript Real Estate Equity Securitization: Real Estate Equity Securitization Understanding Real Estate Investment Trust (REITs) Session SixThe Investment System and Capital Markets: The Investment System and Capital Markets The Investment System has Two Parts Underlying Real Assets: a collection of physical, human, and legal assets and relationships that produce cash flow through the production and sale of goods and services Financial Assets: these are not directly productive (as real assets), but are direct or indirect claims on the directly productive underlying real assets The investment system matches heterogeneous investors (sources of financial capital) with heterogeneous productive assets (physical capital) Slide3: Firms operations (a bundle of real assets and receivables Financial Markets (investors holding Indirect Financial Claims) Financial manager (1) (2) (3) (4b) (4a) Firms sells securities To raise capital Proceeds used to buy assets for operation Real assets generate positive cash flow Cash either reinvested or returned to investors Exhibit 1: Capital Markets without Asset Securitization Underlying physical assets produce cash flows through products and sale of goods and commodities Financial assets do not directly generate cash flow, but are indirect claims on the productive real assets 3. The investment system matches heterogeneous investors (sources of capital) with heterogeneous productive assets (physical assets and receivables) Managerial Discretion?Slide4: Firms operations (a bundle of real assets) Financial Markets (investors holding Financial Claims) Financial manager (1) (2) (3) (4b) (4a) Exhibit 2: Financial Markets with Asset Securitization Traditionally, investors in industrial firms “indirectly” own the underlying assets through ownership of financial claims, they do not own the underlying real assets directly; securitization has made it possible for investors to own directly the cash flows of specific assets or receivables of industrial and financial firms Real estate investors traditionally own “directly” the real assets ; asset securitization has made it possible for these investors to indirectly own real estate related assets In short asset securitization has changed the investments decision making Firms sells securities To raise capital Proceeds used to buy assets for operation Real assets generate positive cash flow Cash either reinvested or returned to investors Securitized Assets For securitized assets specific cash flow goes directly to investors. Securitized assets and their associated cash flows are in effect owned directly by investors ---- Limited Managerial Discretion (5) Investors in securitized AssetsAsset Securitization has Changed the Investment and Financing Decisions : Asset Securitization has Changed the Investment and Financing Decisions Asset securitization has made it possible for investors in real estate entities to own financial claims, (REIT, MBS, CMBS), on the real estate (indirect ownership) as well as own the real estate (direct ownership) Asset securitization has also made it possible for investors in industrial firms to own specific pieces of the firm’s cash flows or receivables through ABS (“direct ownership”), as well as hold financial claims on the underlying productive real assets of the firm (indirect ownership through shares and bonds) What is Asset Securitization?: What is Asset Securitization? Generally speaking, this is the trend towards real assets, commodities, products, or receivables , etc, being transformed into liquid securities tradable in financial markets real estate investment trusts (REITs) vs. real property commercial mortgage backed securities (CMBS) vs. commercial mortgages residential mortgage backed securities (RMBS) vs. residential mortgages asset backed securities (ABS) vs. receivables (credit cards, auto loans, trade receivables, leases, royalties, telephones receivables, future flows, infrastructure projects, etc) Real Estate Investment Trusts (REITs) –An Equity Securitization: Real Estate Investment Trusts (REITs) –An Equity Securitization What is Real Estate Investment Trust (REIT)? A REIT is a special investment vehicle that invests in income producing real property – office buildings, apartments, shopping malls, other retail, warehouses, whole mortgages, etc A key regulatory provision associated with all REITs is that it must distribute to share holders substantially all of its earnings (income plus capital gains) In the US a REIT also has elected under certain tax provisions for the investments to qualify for single taxation, either at the entity level or the investor level Real property owner (sponsor) works with an investment bank to form a REIT which is initially capitalized with the proceeds of initial public offering (IPO) and other debt financing Shares of REITs are typically publicly traded, although there private REITs Slide8: Exhibit 3: General Structure of Real Estate Investment Trusts (REITs) Capital Market Investors Subscribed in IPO allowing REIT to raise capital Sale Proceeds from IPO subscription used to purchase property Rental Cash Flow Dividend income/ Capital gains Primary( Direct) Real Estate Capital Market Secondary (Indirect) Real Estate Capital Market Owner/Seller of Property Sponsors REITOther Typical Attributes of REITs: Other Typical Attributes of REITs REITs can be structured either as a corporation (US) or a unit trust (Australia) REIT can either be directly managed internally (US) or externally managed through a third party asset management company (Asian Countries) A REIT typically does not make market – i.e. investors cannot require the REIT to redeem their shares (they are closed-end funds) Listed REITs are typically set up to operate indefinitely, although they can be structured with finite life Key Requirements of US REITs: Key Requirements of US REITs Asset Test: At least 75% of a REIT’s asset value must come from real estate, cash, and government securities at the close of each quarter of taxable year No more than 5% of the value of the assets may consist of the securities of one issuer, and REIT may not own more than 10% of the outstanding shares of one issuer, if those securities are not includable in the 75% test Income Test: At least 95% of gross income must come from dividends, interests, rents, or gains from sale of certain assets No more than 30% of REITs gross income can be derived from sale of real estate held for less than fours years or securities held for less than six months Distribution Test: At least 90% of the REIT taxable income must be distributed to shareholders Stock and Ownership Test: REIT shares must be transferable and must be held by a minimum of 100 persons No more than 50% of REIT shares may be held by five or fewer persons Types of Real Estate Investment Trust: Types of Real Estate Investment Trust Broadly speaking, there are three types of U.S. REITs: Equity REITs (EREITs) Invest primarily in equity property interests Mortgage REITs (MREITs) Hold predominantly mortgages Hybrid REITs Hold both property and mortgage interests U.S. REIT Property Sector and Sub-sector: U.S. REIT Property Sector and Sub-sector Industrial/Office (9%+21%) Office Industrial Mixed Retail (25%) Shopping Centers Regional Malls Free Standing Residential (19%) Apartments Manufactured Homes Diversified (8%) Others (18%) Lodging/Resorts Self Storage Health Care** Mortgages Home Finance Commercial Financing Investment Appeal of REITs (1): Investment Appeal of REITs (1) REITs offer individual investors fractional shares in investment grade and professionally managed income producing real estate investment – broaden investment choices Regular income stream and relatively high dividend yield The REIT vehicle creates liquidity because shares can be traded on organized exchanges, as opposed to direct ownership of the underlying property Liquidity in turn allows for easier entry and exit as market conditions dictate which reduces transactions costs Access to broad capital markets leads to market integration which can reduce cost of capitalInvestment Appeal of REITs (2): Investment Appeal of REITs (2) A REIT structure offers property owners a more efficient way of selling their properties to recoup capital investment REIT allows for orderly divestiture of real estate assets and redeploy capital on core business – corporate restructuring In many jurisdictions (US) REITs also offer tax advantages relative to other investment vehicles by removing double taxation ---???? REIT conduit also offers strong corporate governance mechanisms as well as separation of ownership and control Overall REITs tend to act as defensive stock or provide a hedge in bad times Innovation in U.S. REITs: Innovation in U.S. REITs Pre 1986 REITs – passive management Directors, trustees or employees of REITs were not allowed to actively manage REIT properties Independent contractors performed these functions REIT owns underlying physical assets directly Post 1986 REITs --- Modern REITs (active management) 1986 Tax Reform Act relaxed management restrictions Allowed REITs to provide normal maintenance and other services for tenants Created vertically-integrated operating companies fundamentally different from passive REITs of pre-1986Umbrella Partnership REITs or UPREITs: Umbrella Partnership REITs or UPREITs REIT does not directly own the underlying properties Rather the REIT and other real estate owners own units (operating partnership units or OP units) in a partnership The REIT and in real estate owners have contributed ort sold properties to the partnershipn OP units are convertible into shares of REIT, offering voting rights and dividends This complicated arrangement allowed property owners (developers) to “sell” their properties to the REIT without triggering taxable event Slide17: REIT Shareholders REIT A B Umbrella Partnership Managed by A (formed by REIT) General Manager of Operating Partnership is REIT Property 1 Property 2 Property 3 Property 4 A’s OP units are sold to REIT for cash or shares B has the option to convert OP units to shares of REIT Exhibit 4: Umbrella REIT FORMATIONThe Innovation in UPREITs: The Innovation in UPREITs The UPREIT is a form of financial engineering or structured financing The structure is a tax-deferred mechanism through which real estate developers and other owners transferred properties in the form of a tax-exchange Since the transaction did not trigger a taxable event the REIT is able to acquire properties at better earning multiples Conceivably this resulted in shareholder wealth maximization The development of UPREITs resulted in massive growth in REIT equity market capitalization in 1990s These modern REITs feature active management so as to grow cash flows and portfolio size U.S REITs versus U.S. REOC Structure: U.S REITs versus U.S. REOC Structure What is REOC? (1) U.S REITs are prohibited from certain lines of business, e.g. hotel operations, parking operations, REOCs are not (2) REITs operating loss (OL) can be carried forward for 15 years not back, REOCs can carry loss back (3) REOCs may decide to retain all of its earnings to fund growth opportunities, REITs must pay 90% of their earnings to shareholders to avoid double taxation Innovations in U.S. REITs Structure: Paired Share REITs: Innovations in U.S. REITs Structure: Paired Share REITs It allows the REIT to enter into prohibited business and still avoid double taxation The process starts with an REIT acquiring an REOC engaged in active real estate business that the REIT cannot enter (e.g. parking operations, hotels, and health businesses) All properties acquired by the REIT are leased back to the REOC REOC in turn pays most of its income to the REIT in the form of rent REIT passes most of its income to shareholders and avoids double taxation International REITs Trend: International REITs Trend The growing demand for publicly traded real estate likely to be met by growth of REITs Two largest REIT markets in the world are in the United States and Australia United States market commenced in the early 1960s. First Australian LPT IPO was in 1971 Both markets grew very rapidly in the 1990s. This was after the property markets in both countries crashed in the early 1990s – Exhibit 4 REIT markets also established in: Canada, UK, Italy, Belgium, France, Netherlands, Japan, New Zealand, Malaysia, Korea, Singapore, Hong Kong, Taiwan, to name a fewUS and Australian REIT Markets: US and Australian REIT Markets Exhibit 5: US and Australia saw explosive growth in the early 1990s Australia United States Source: NAREIT, UBS What REITs invest in Size of markets Australia United StatesExhibit 6: REIT Market Capitalizations: Exhibit 6: REIT Market Capitalizations Source: National Association of Real Estate Investment Trusts®, ASX, Bloomberg as of 31 March 2004 Institutional Ownership of U.S. REITs has Grown: Institutional Ownership of U.S. REITs has GrownInstitutional Ownership in All U.S. Stocks (Equities) : Institutional Ownership in All U.S. Stocks (Equities) Growing US REIT Market Capitalization: Now in Excess of US$260 billion: Growing US REIT Market Capitalization: Now in Excess of US$260 billionOver the past three and half decades U.S. REITs have grown more than four folds: Over the past three and half decades U.S. REITs have grown more than four foldsInstitutional Investment in U.S. REITs: Institutional Investment in U.S. REITsLong Term Performance of REIT vs. Other U.S. Benchmarks: Long Term Performance of REIT vs. Other U.S. BenchmarksGlobal Real Estate Performance: Global Real Estate Performance Source: National Association of Real Estate Investment Trusts®, as of June 2004 North America Europe Global Composite Asia Exhibit: 13Exhibit 15: US Office REITS Traded at significant Premium to NAV in late 1990s to 200os: Exhibit 15: US Office REITS Traded at significant Premium to NAV in late 1990s to 200osDual Models of REIT Value: Dual Models of REIT Value We earlier noted the existence of two parallel real estate asset markets The public market (stock market) where REITs trade The Private property market where the REITs’ underlying physical assets trade Three fundamental questions arise from this dual market model that are of interest to real estate investors (1) Which asset market to use for real estate investment decision? (2) Is there a possibility for arbitrage by trading between the two markets to make seemingly (or nearly) riskless profits? (3) Do the two markets value differently the same underlying physical asset? First, we focus on the third question dealing with differential valuation between the two markets Slide33: The Dual Market Nature of Real Estate Creates “Windows of Opportunity”Public versus. Private Market Real Estate Valuation: Public versus. Private Market Real Estate Valuation Consider a 20-building portfolio with 2.5 million rentable square feet Total Portfolio $/square foot Gross Rent $40.0 million $16.00 Less amortized concessions (15%) 6.0 2.40 Effective Rent $34.0 million $13.60 Less: Stabilized Vacancy (15%) 5.1 2.04 Less: Expenses (36.8%) 12.5 5.00 Net Operating Income (NOI) $16.4 million $6.56 psf Public Company Valuation (PCV) -- an IPO: Public Company Valuation (PCV) -- an IPO Total Portfolio $ per Square ft Stabilized NOI $16.4 M $6.56 psf Less Management expenses (75 bp) $1.2 $0.48 Subtotal $15.2 $6.08 Dividend Payout ratio 90% Dividend Cash Flow $13.7 $5.48 psf Estimated Dividend Yield Range 7.50% to 9.00% Implied PCV Range $182.7 M $73.08 psf $152.2 $60.88 Average Public MV $167.4 M $66.98 psfPrivate Market Valuation (PMV): Private Market Valuation (PMV) Total Portfolio $ per Square Stabilized NOI $16.4 M $6.56/PSF Estimated cap rate range: 9.75% to 11.25% Implied Private Market portfolio valuation $168.2 M $67.28/PSF $145.8 $58.31 Average PMV $157.0 M $62.80/PSF Public Vs. Private Market Valuation Differentials: Public Vs. Private Market Valuation Differentials Total Portfolio $ per Square ft Average Public MV $167.4M $66.96/PSF Average Private MV $157.0 $62.80 Absolute Difference: Public - Private $10.4M $4.16/PSF Percentage 6.21% 6.21% Public vs. Private Valuation Differentials: Some Possible Explanations: Public vs. Private Valuation Differentials: Some Possible Explanations ( 1) The Public market ascribes value to more than just the underlying property assets Other factors include company management and its ability to identify and create investment opportunities through active management of the real estate (2) The public market valuation includes a premium for share liquidity (3) Are REITs closed-end mutual funds or operating companies? Closed-end mutual funds model suggest REIT shares will generally trade at values below their NAVs -- closed-end mutual fund discount The Operating Corporation model suggests that REITs shares will generally trade at values above their NAVs – growth opportunities. Accounting and Financial Disclosure Issues associated with REITs: Accounting and Financial Disclosure Issues associated with REITs Like other economic units REITs have considerable latitude when accounting for their operations. Effects of tenant improvements and free rent on FFO: tenant improvements are depreciated over time so cost is currently incurred but recovered over time FFO will not reflect this cost compare cost per square foot for tenant improvement say three years before IPO an a year before IPO additional amount could represent attempt to boost occupancy rate to make IPO attractive to investors.Accounting and Financial Disclosure Issues: Accounting and Financial Disclosure Issues Capitalizing of leasing commissions these costs are included as depreciation or amortization thus FFO, a measure of REIT profitability, will not reflect these costs Uses of Straight-Line Rents: long term leases have stipulated increases (step-up leases) if revenue is based on “straight line” reported rent is averaged over life of lease reported FFO will therefore be higher than actual in earlier years and lower than actual in later yearsAccounting and Financial Disclosure Issues: Accounting and Financial Disclosure Issues Lease Guarantee: in some cases sponsor may guarantee the lease to prevent vacancy from occurring in what is known as master lease the sponsor takes the risk of leasing to other tenants helps the sponsor obtain credit for space providing no income Why should investors worry? guarantee might be for a short period guarantee may not have recourse they might be guarantee fees to be paid by the REITAccounting and Financial Disclosure Issues: Accounting and Financial Disclosure Issues FFO and income from managing other Properties: income from managing other properties not owned by REIT may increase FFO but the income may be more variable than income from underlying properties because of third party cancellation. thus many REIT security analysts assign a lower multiple to portion of FFO from management income. Types of mortgage debt and other Obligations: watch for participating mortgages they may improve earnings in early years by will affect future operating performance and depress earnings growthMore Financial Disclosure Issues: More Financial Disclosure Issues Existence of ground leases: what is a ground lease? fixed lease payment advantage disadvantage of giving up ownership how should you discount cash flow from buildings with approaching expiration date of ground lease? Lease Renewal Options: what are the terms, particularly the rent? “Leased space” versus “occupied space”: