Chapter 24: The Role of Real Estate Investment Trusts REITs

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Chapter 24 The Role of Real Estate Investment
Trusts (REITs)

• Andrew Davidson
• Anthony B. Sanders
• Lan-Ling Wolff
• Anne Ching

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REITs

• Real estate investment trusts (or REITs) are
  essentially closed-end funds that hold real
  estate in their portfolios instead of stocks and
  bonds.
• As a consequence, they represent an alternative
  form of securitization.
• REITs can hold real property (e.g., shopping
  center, hotels and office buildings)
  shareholders in the REIT then share in the cash
  flows to the REIT as well as capital appreciation
  (upon sale of the asset).
• Hence, REITs represent one of the earliest
  example of securitizing real properties into
  securities.

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Real Estate Investment Trusts (REITs)

• Primary Advantages
• REITs are not subject to double taxation
• limited liability to shareholders
• REITs allow investors liquidity and
  diversification
• Primary Disadvantages
• income is portfolio income
• tax losses do not pass through to the
  shareholders
• REITs must meet substantial operating
  restrictions

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A Closer Look at Real Estate Investment Trusts
(REIT)

• A (REIT) is a corporate form of ownership engaged
  in real estate investment, but with no taxation
  at the corporate level.
• Basic operations
• REITs invest primarily in real property and
  mortgages.

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Qualifying as a REIT

• A REIT is a trust legally established to raise
  capital from investors (in the form of common
  stock and bond issuance) and borrow from lenders
  in order to buy income-producing properties or
  make mortgage loans in varying maturities.
• A REIT is allowed a special tax status that is,
  it is only taxed at corporate rates on its
  retained earnings (annual) if it meets the
  following general conditions
• (1) A REIT is legally required to pay virtually
  all of its taxable income (90 percent) to its
  shareholders every year.
• (2) A REITs assets are primarily composed of
  real estate held for the long term,
• (3) A REITs income is mainly derived from real
  estate,

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Tax Ramifications for REITs

• Generally, most REITs will adhere to the above
  rules to reduce taxes in the event operating
  income is realized during a particular year.
• (1) It should be pointed out that since some
  REITs own properties, they are entitled to
  depreciate them and consequently may show an
  operating loss for the year for tax purposes,
  while producing actual cash available for
  distribution. However, since REITs are
  tax-exempt, the value of this deduction is
  questionable.
• (2) Tax laws allow REITs to distribute any
  losses to shareholders to the extent of showing a
  zero net income for the year.

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Types of REITs

• Equity Trusts
• Mortgage Trusts
• Hybrid Trusts
• Specialized Trusts

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REIT Structures

• UPREIT
• An UPREIT is an Umbrella Partnership REIT.
• In an UPREIT structure, the partners of the
  existing partnerships and a newly-formed REIT
  become partners in a new partnership which is
  termed The Operating Partnership.
• The partners contribute the properties from the
  existing partnership and the REIT contributes the
  cash proceeds from its public offering.
• Typically, the REIT is the general partner and
  the majority owner of the Operating Partnership
  Units.
• DownREIT
• A DownREIT is structured in a similar fashion to
  an UPREIT, however the REIT owns and operates
  properties directly rather than only its interest
  in a controlled partnership that owns and
  operates separate properties.

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Constituent Companies and Relative Weights in the
NAREIT Index for May 1, 2002
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Largest REITs in the Office Sector
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Largest REITs in the Industrial Sector
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Relative Performance of REITs
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A closer look at relative performance
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REIT initial public offering history
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Real Estate Returns, February 1990 to December
2001
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International Real Estate Returns, February 1990
to December 2001
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REIT Valuation

• As with most common stocks, the calculation of
  Net Income to Common Shareholder is a
  straightforward exercise (revenues less
  expenses).
• However, since the majority of REITs hold a large
  percentage of their portfolio in depreciable
  assets (real property), the typical net income
  calculation will greatly understate the cash
  flows.
• As a consequence, net income has to be adjusted
  for sales of property plus depreciation and
  amortization the resulting calculation generates
  what is known as Funds from Operations (FFO).
  Stated differently, FFO is equal to net income,
  excluding gains or losses from sales of property,
  and with depreciation added back.

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REIT Valuation

• The next step is calculated Cash Available for
  Distribution (CAD). CAD is a measure of the
  REIT's ability to generate cash and to distribute
  dividends to its shareholders. CAD is derived by
  subtracting nonrecurring expenditures.
• A further refinement on the REITs cash flow is
  Adjusted Funds From Operations (AFFO).
• AFFO refers to a further adjustment by
  subtracting from Funds from Operations (FFO) both
  (1) normalized recurring expenditures that are
  capitalized by the REIT and then amortized, but
  which are necessary to maintain a REIT's
  properties and its revenue stream and (2)
  straight-lining of rents (straightlining
  averages the tenants rent payments over the life
  of the lease).

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•     12/31/04   12/31/03   12/31/02 Diluted net
  income per share 1.43  0.89  1.39    Add   Dep
  reciation and amortization  2.40   2.38   2.31    
  Less  Gain on sale of properties  (0.79)  (0.25) 
   (0.58) Minority interest adjustment  0.20   0.26 
    0.30    Adjustment for share difference
  (2)  (0.15)  (0.21)  (0.21) Diluted funds from
  operations per share (1) 3.09  3.07  3.21  Dil
  uted funds from operations available
                to common shareholders,
  excluding               Preferred stock issuance
  costs   0.14  0.07    Impairment of real
  estate  0.04   0.12   0.04    HQ lease
  guarantees     0.01   0.14    Prepayment
  penalties on debt  0.08          3.21  3.34  
  3.46  Diluted net income per common share,
  excluding              Preferred stock issuance
  costs   0.15  0.08    Impairment of real
  estate  0.05   0.14   0.05    HQ lease
  guarantees     0.02   0.17    Prepayment
  penalties on debt  0.09          1.57  1.20  
  1.69  

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