REIT Performance Evaluation: A Case Study of Washington Real Estate Investment Trust (WRIT) Thanks to Jay Sa-Aadu (University of Iowa) for providing this case study.

Washington Real Estate Investment Trust (WRIT) -- diversified REIT WRIT owns and operates 10 retail centers, 23 office buildings, 9 apartment and 15 industrial properties, all in the Washington-Baltimore metropolitan region. WRIT prefers to hold local assets rather than distant ones for which it has a relative information disadvantage. It considers markets to be local if they are within a two-hour drive time radius of its Rockville, Maryland headquarters. WRIT investment strategy according President and CEO Edmund B. Cronin, Jr., “is to acquire and manage real estate investments in markets we know well and protect our assets from single property-type value fluctuations through diversified holdings”. WRIT looks for property investments to produce a return on invested capital (ROIC) of 10-15%. WRIT hopes to achieve these returns by targeting strategically-located properties in the Washington-Baltimore metropolitan region with value-added potential as well as stabilized properties that offer future upside growth potential. To this end, WRIT looks for well located properties, particularly those that they find to be poorly managed and needing new mechanical systems, cosmetics and so on, permitting them to reposition the property in its market place, raise rents and reduce operating costs. The CEO further comments, “WRIT acquires assets at an attractive price relative to replacement cost, and putting these assets to new higher-valued uses than anyone had formerly perceived”. WRIT typically seeks investment that vary in size between $5 and $25 million. WRIT is unique in that it is one of the only five publicly traded US REITs that is A-rated by S&P and BAA-1 by Moody’s.

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REIT Performance Evaluation Net Income (Earnings) Net Income per share increased from $1.23 to $1.26, a 2.4% annual increase The net income is, on average, about 34% to 37% of real estate revenues Net income is after depreciation, and therefore not a good measure of how much cash flow a REIT generates or consumes One way to fix this problem is to estimate the firm’s funds from operation (FFO), as defined by National Association of Real Estate investment Trusts (NAREIT) This procedure is shown in Exhibit 3

REIT Performance Evaluation Funds From Operation (FFO) and Funds Available for Distribution (FAD) WRIT’s FFO is about 126% to 142% its net income This compares to a ratio of about 154 to 155% of adjusted net income This latter calculation implies that depreciation adds about (1.55-1.00)/1.55 = 35% to REITs FFO However there are two problems here FFO does not account for capital expenditures and amortization of principal FFO does not quite accurately reflect real estate revenues because accountants straight-line rents The solution is to calculate funds available for distribution (FAD) For WRIT FAD is about 76% of FFO

REIT Performance Evaluation Problems with FAD Does not take account of the following: Capital spending on new investments Changes in REIT’s operating working capital Cash inflows due new debt (or new equity) The latter reduces the firm’s cash flow to equity, which reduces the REITs stock value Free Cash Flow (FCF) to equity It is easy to correct these problems by calculating the firms free cash flow to equity (FCF), which is shown in Exhibit 5 FFC per share is about $1.27 in 2000 This equates to about 71% of FFO and 93% of FAD

Evaluation of REIT Financial Health Exhibit 5 shows the analysis of REIT financial health Debt/Total Assets The ratio of long-term debt outstanding to total capitalization is about 35% to 42% -- conservative debt policy by US standards REITs typically use long term debt proceeds to repay advances on lines of credit, finance acquisitions and capital improvement Interest Coverage Interest coverage is the amount of earnings available to pay interest expense It provides a sense of how far operating profits could fall before the company would experience difficulty servicing its debts WRIT’s interest coverage in 2000 was 3.4:1, which is extremely safe

Evaluation of Financial Health of REITs Profitability In 2000 WRIT’s Net Income = $45M, Total Assets = $632M, and Shareholder Equity = $260M Thus, ROA = 7.1%; ROE = 17.3% Dividend Payout Policy In 2000 WRIT’s paid out about 95% of net income in dividends, or $1.2 per share, which meets the 90% payout ratio for US REITs In practice many US REITs pay more than their earnings in dividends – HOW? Dividend Yield In 2000 the P/E ratio or earnings multiple for WRIT was 20x This suggest a price per share of $25.2 based on 2000 EPS of $1.26 Hence dividend yield = 4.8% (1.2/25.2)

Do You Believe in Magic? The FFO Magic !!! How is it possible for REITs to pay more than their earnings in dividends? The answer lies in FFO, which is calculated by adding back depreciation and amortization to net income For WRIT in 2000 EPS = $1.26, while FFO per share = $1.79 WRIT could pay 90% of FFO or $1.61 per share in dividends, which is 128% of earnings per share In this case the investor needs only report $1.26 for federal income tax purposes The difference between the dividends paid ($1.61) and EPS ($1.26) or $0.35 is considered recovery of capital (ROC) The ROC of $0.35 serves to reduce the cost basis of the share acquired by the REIT investor This tax treatment allows the REIT investor to receive part of the dividend ($0.35) “tax free” until the stock is sold