Chapter 24 Chapter 24: The Role of Real Estate Investment Trusts (REITs) Andrew Davidson Anthony B. Sanders Lan-Ling Wolff Anne Ching

Chapter 24 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.

Chapter 24 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

Chapter 24 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.

Chapter 24 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 REIT’s assets are primarily composed of real estate held for the long term, (3)A REIT’s income is mainly derived from real estate,

Chapter 24 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 REIT’s to distribute any losses to shareholders to the extent of showing a zero net income for the year.

Chapter 24 Types of REITs Equity Trusts Mortgage Trusts Hybrid Trusts Specialized Trusts

Chapter 24 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.

Chapter 24 Constituent Companies and Relative Weights in the NAREIT Index for May 1, 2002

Chapter 24 Largest REITs in the Office Sector

Chapter 24 Largest REITs in the Industrial Sector

Chapter 24 Relative Performance of REITs

Chapter 24 A closer look at relative performance

Chapter 24 REIT initial public offering history

Chapter 24 Real Estate Returns, February 1990 to December 2001

Chapter 24 International Real Estate Returns, February 1990 to December 2001

Chapter 24 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.

Chapter 24 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 REIT’s 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 tenant’s rent payments over the life of the lease).

Chapter 24 12/31/04 12/31/03 12/31/02 Diluted net income per share $1.43 $0.89 $1.39 Add: Depreciation and amortization Less: Gain on sale of properties (0.79) (0.25) (0.58) Minority interest adjustment Adjustment for share difference (2) (0.15) (0.21) (0.21) Diluted funds from operations per share (1) $3.09 $3.07 $3.21 Diluted funds from operations available to common shareholders, excluding Preferred stock issuance costs $— $0.14 $0.07 Impairment of real estate HQ lease guarantees — 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 HQ lease guarantees — Prepayment penalties on debt 0.09 — — $1.57 $1.20 $1.69

Chapter 24 From Carr Realty 2004 Annual Report 12/31/04 12/31/03 12/31/02 Diluted net income per share $1.43 $0.89 $1.39 Add: Depreciation and amortization Less: Gain on sale of properties (0.79) (0.25) (0.58) Minority interest adjustment Adjustment for share difference (2) (0.15) (0.21) ) Diluted funds from operations per share (1) $3.09 $3.07 $3.21 Diluted funds from operations available to common shareholders, excluding Preferred stock issuance costs $— $0.14 $0.07 Impairment of real estate HQ lease guarantees — 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 HQ lease guarantees — Prepayment penalties on debt 0.09 — — $1.57 $1.20 $1.69