Minimum Efficient Firm Size Typical REIT IPO from 1993 –$100,000,000 firm with 50/50 debt-equity ratio, yielding 8% on equity –implies roughly $4,000,000 in income –even with relatively low payout ratio of 75% of earnings, can retain only $1,000,000

What will $1,000,000 buy? –for apartment REIT, good-sized garden apt. complex costs $20-$25 million, retaining the added $1,000,000 adds little flexibility with respect to acquiring properties for portfolio. –from broad capital market perspective, this firm probably should increase payout ratio (this is what happened in reality) shareholders received high dividend yield, firm had to repeatedly go to the capital markets to fund acquisitions

Now consider $10 billion firm Some now exist: –same 50/50 debt-equity ratio and 8% yield on equity –implied income of about $400,000,000

$10 billion REIT –if firm chooses not to aggressively expense, it will have a relatively high payout ratio if that ratio is 95%, implies the firm can retain $20,000,000 that’s a good-sized garden apt complex, 1/5th of a large regional mall, or a couple of decent-sized warehouses or industrial sites.

$10 billion REIT –if firm chooses to aggressively expense items to reduce accounting earnings and lower its required payout under the REIT tax law, the situation is markedly different assume its payout ratio falls to 75%: –ratio implies retention of $100,000,000 –which will buy a portfolio of any property type except regional malls and downtown office buildings

If you can retain this amount, you do not have to go to Wall Street to fund every portfolio purchase –increases flexibility so that you can quickly take advantage of targets of opportunity and avoid investment banker fees

–achieving such internal financing capabilities is goal of many firms given REIT tax law, fairly large scale is required average firm size is too small at the moment –suggests that consolidation in the public markets will continue in the next few years

–how consolidation occurs still is unknown REIT management's have implemented various types of anti-takeover provisions –5 or fewer rule itself provides a natural defense mechanism lack of truly independent boards a problem

mergers difficult because acquired firm inevitably has to be willing to hold the paper of acquiring firms –requires common vision to make it work in the absence of aggressive board intervention However, mergers are now becoming more regular as the REIT industry consolidates.

What could stop consolidation in the public markets? Discovery of fundamental diseconomies of scale –if real estate is inherently small scale business because of the need to master local market details, then really large firms are not feasible they will have lower returns on average than local firms

REIT Research Q: Are REITs real estate or stocks? –important implications for portfolio diversification –do REITs provide a real estate index A: REIT returns lag real estate cap rates REIT returns and unsecured real estate returns share a common component that reflects real estate fundamentals REIT returns are noisy.

Net Asset Value REIT Investment Analysis