Real Estate Securities Lecture

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Real Estate Securities Lecture U of Iowa MBA Class: 

Real Estate Securities Lecture U of Iowa MBA Class Eric M. Lohmeier, CFA 21/10/03


PART I - Real Estate Securities Defined Generally recognized as a specific asset class (Stocks, Fixed Income, Commodities) Home Ownership represents largest %age of individual savings in the US Individual ownership also common in multi-family and free standing retail Forget everything you think you know about real estate from the above sources (for today’s lecture, anyway)


Institutional Real Estate – Ownership and Assets Corporations, Pensions and Insurers are a significant ‘direct owner’ of institutional real-estate Institutional direct ownership in the past primarily dependant upon size and the ability to achieve appropriate economies of scale Internally managed vs external advisor


Out of the Rubble, a Market is Born Real Estate laws written in the 70’s were finally institutionalized in the early 90’s to clean up an overbuilt and illiquid institutional real estate market from the 80’s (Think tech stocks in ’00) A liquid and deep institutional real estate market was created for the first time using Wall Street (vs Commercial Banks and Pensions) Pre-Modern REIT days, ‘Institutional’ real estate was exclusive OR disastrous (LP’s!)


REIT Structure REIT – Real Estate Investment Trusts: Company’s assets are held in the ‘trust’ and owned by the shareholders of the company Beauty of the structure is the income from the real estate portfolio passed through the corporation to the shareholders ‘tax-free’ in dividend income (90% RULE) Dividend Income taxed at an individual (entity) ordinary income rate vs Cap Gains


Why did this Structure click - Retail? Retail, Individuals could own this asset class efficiently for the first time Income, diversification and the liquidity (NYSE listed stocks) found a home Wall Street incentive (Capital Intensive + Sales Force + Real Estate characteristics = Fees, Fees, Fees)


Why did this Structure click - Institutional? Under a certain ‘size’ it was very difficult to invest in the asset class directly to take advantage of the correlation aspects of RE vs other asset classes Arguably at ‘any’ level real estate is less efficiently managed even with adequate $ through direct investment (I disagree) Wall Street incentive (Capital Intensive + Sales Force + Real Estate characteristics = Fees, Fees, Fees)


Market Depth Approximately a $200 billion equity market capitalization in REITs 50% + of this market held institutionally / 50% - held by individuals Of Institutional Ownership, approximately ½ held by mutual funds (a significant percentage are real estate dedicated funds) Pensions / Insurers participate in the other ½ to represent a portion of their real estate dedicated asset class investments (CALPERs)


PART II – Real Estate Securities Specifics and Valuation Institutional RE Asset Classes (Broad) Multi-Family / Apartments Retail (Malls, Strip Centers, Free Standing) Office (CBD, Suburban) Hotels MHC’s (Manufactured Home Community) Self Storage


Valuations and Risk In Real Estate, assets are bought and sold using Capitalization Rates (Inverse of a ‘multiple’) Cap Rates are applied to a RE asset’s Net Operating Income (NOI) ‘NOI’ is a proxy for a RE asset’s recurring cash flow Value = ‘NOI’ / Appropriate Cap Rate


Specifically… Property NOI = Revenues LESS (RE related expenses + Real Estate Taxes + Management Expense) For a COMPANY ‘Net Asset Value’ simply apply the same formula of the Property NOI – but use all recurring income (Other, etc) and count S, G & A as your Management Expense (in addition to any other mgmt expenses – STORY on external vs internal mgmt) Yes ‘Real Estate’ related taxes are an operating expense!


REIT Income Statement Jargon REITs use their own proxy for Real Estate Earnings (Non-GAAP – think pro-forma) FFO = Funds From Operations FFO = GAAP EPS plus (Real Estate related Depreciation / Amortization) less (Gains / (losses) on sale of Real Estate assets) Unfortunately, there isn’t a STANDARD definition of ‘FFO’ b/c it is non GAAP and company’s truly use (or abuse) this to their advantage! – (FFO is about as meaningful per company as CSCO’s ‘pro-forma’ earnings, for example)


Helpful Hints for Evaluating ‘FFO’ AFFO = Adjusted Funds From Operations AFFO = FFO less (Recurring capital expenditures) AFFO is a truer picture of a REITs recurring cash flows – cap ex discussion A back of the envelope method for estimating recurring cap ex is 50% of depreciation The BEST method for measuring recurring cap ex is industry sourced per square foot actual cap ex expense


Cap Rate Specifics… The market assigns cap rates to the various sectors of the real estate market based upon a variety of factors including: stability of asset class, lease terms, credit worthiness of tenants, fungibility, and barriers to new supply Remember: High cap rates = higher risks, lower value (inverse for low cap rates)


Average Asset Class Valuations per Specific Cap Rates 5% to 7%: Shopping Malls, MHC 7% to 9%: Class ‘A’ Office, Multi-family, Strip center retail, self-storage 9% +: Class ‘B’ (or -) Office, Hotels, Self-standing retail These are current market AVERAGE estimates – over time these have and will change again! (Discussion)


PART III – Random Miscellaneous The real estate security diversification argument holds significant water when measuring both public RE equities as well as private RE against large cap stock market and fixed income indexes HOWEVER – Public REITs have a high correlation with the Russell 2000 index! (VERY sensitive subject in ‘REIT’ world) FFO = ‘pro-forma’ earnings: Use either one at your own risk


Continued… If valuing real estate equities, INCORPORATE an ‘NAV’ value to your projections as opposed to ‘market multiple’ crap B/C of liquidity, cash inflows / outflows (generalist fund manager $) and other market structure issues, NAV’s of public real estate equities DO in fact de-couple from private Market Value! (’99/00 vs Today) – this market inefficiency means opportunity


Continued… Dividend Yields and long term volatilities are attractive in the public real estate markets, however: DO your NAV calculations AND AFFO dividend coverage ratios (Current Events example) Office and Multifamily current issues (negative dividend coverage!) Broad market interest – valuation disparity?


Continued… Sell-side research (my former profession) ‘mandatory’ that you maintain healthy skepticism! This research can be an excellent topographic map, but it is NOT an objective one In addition to location, location, location – pay attention to leverage, leverage, leverage! The market sometimes fails to (rarely discriminates per equity valuations) I think you should ;) CMBS, Agencies HUGE implications but save that one for another class, another day!


Conclusion / Q&A Please feel free to open this up and fire away. Over the last 7 years I have worked in equity research, investment banking and asset management. I would be happy to share any of these experiences (in addition to real estate related) with the class. I promised Dirk that I wouldn’t share Iowa City based MBA stories with the class, however - sorry about that, there are some pretty good ones.

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