1. Session Plan Chapter Twelve: REITs as investment alternative
QQD of REITs
REIT Valuation Techniques
The Send-Off

2. Origins of REITs Massachusetts Trust (19th Century until 1935)
Filled void for corporations owning RE
No federal tax, & no distributions tax for shareholders!!
Investment Company Act of 1940
Closed end mutual funds lobbied for equal treatment until tax law was amended in 1960
External management structure was required until 1986

3. Real Estate Investment Trusts (REITs)
First established in US in 1960
1971 Australia, 1985 Turkey, Canada 1993, Singapore 1999, Japan 2000, Hong Kong & France 2003, Germany in 2007
US Minimum Requirements
100 shareholders
75% of value of REIT assets in RE, cash, or gov’t securities
95% of gross income from dividends, interest, rents, or gains from sale of REIT assets
Shareholder distributions at least 90% of REIT taxable income annually
Additional European Requirements
Leverage is limited (50% in Germany, France, Spain; 20% for most Austrian REITs, a coverage ratio of 1.25x EBIT/Int in UK)
Limits for size of any one property (15% in G-REIT, 40% in UK)
EU REIT Strategies: Core/nuclear (low risk), Core-Plus/Value Added (medium risk) and Opportunity (high risk)

4. REIT Organizational Structures
UPREIT: Umbrella Partnership REIT
Established in 1992 to allow existing RE operating companies to bring property already owned under umbrella of REIT w/o capital gains tax
REIT owns controlling interest in limited partnership that owns the real estate
Owners of limited partnership can convert operating units into REIT shares, vote, & receive dividends

5. REIT Organizational Structures
Down REIT:
Formed after REIT goes public
Can own numerous partnerships at the same time
Down REIT owns property directly in REIT, but holds some properties in partnership with others
No tax liability until partnership units are converted into stock or sold

6. REIT Incentive Issues UPREIT: Down REIT:
Management could be reluctant to sell if they own operating units rather than REIT shares
Subject to tax when sold
Down REIT:
If management does not own operating units, could become “trigger happy” with sales given the lack of tax consequences from sale

7. REIT Taxation
Shareholders pay taxes on dividends received via form 1099
721 Exchange: Like Kind Exchange for REITs
Limited Partners of Up and Down REITs can exchange partnership units for interests in other RE via like kind exchange
Must be investment grade property
Investors receive operating units rather than property
Up and Down REITs have advantages for tax sensitive sellers

8. Types of REITS Mortgage REITs Equity REITs Hybrid REITs
Heyday in 1970s
Equity REITs
Most common form today
Hybrid REITs
Invest in both mortgages and equity
Mutual Fund REITs
Common for personal investors

9. Mutual Fund REITs First mutual fund in Netherlands in 1774
Modern mutual funds began in US in 1924
Was truly “mutual” as it was organized, operated, & managed by its own trustees
Alpha Fund: shareholders own funds which own management company
Omega Fund: Mgmt company shareholders own mgmt company which controls mutual fund owned by mutual fund shareholders
Mgmt company shareholder interests are introduced
Higher costs typically given competing goals of shareholder wealth creation & profit for external mgmt company

10. REIT Historical Performance
As you can see, mortgage REITs are historically more volatile than equity REITs

11. “Portfolio Mix” Strategy
Investors can review annual reports of REIT mutual funds to obtain information for how they allocate their investment dollars.
REIT 1
REIT 2
Office
38%
17.5%
Industrial
26%
5.9%
Apartments
20%
15.3%
Retail
15%
24.8%
Other 1%
36.5%
It looks like REIT 1 has more confidence in the office market but much less in retail than does REIT 2

12. “Quantity” Strategy
This strategy involves maximizing the gross potential income by keeping overall portfolio vacancy rates as low as possible.
REIT 1
REIT 2
Office
92%
Retail
86%
Industrial
87%
95%
Apartments
96%
97%
Weighted Avg.
91%
93%

13. Top 5 Tenants by Square Footage for REIT 1
“Quality” Strategy
Another portfolio diversification strategy is to concentrate on properties that have high quality, nationally known companies as tenants.
Top 5 Tenants by Square Footage for REIT 1
Industrial
Office
Retail
Wal-Mart
BHP Petroleum
Publix Supermarkets GE
Deloitte & Touche
Dick’s Sporting Goods
Regal West
Crowell & Moring
Restoration Hardware
Bank of NY Mellon
Ross Dress for Less
Kuehne & Nagel
Microsoft
Belk
See any problem companies here?

14. “Durability” Strategy
Let’s see how REIT 1 looks in terms of the durability of the lease income.
Type
2011
2012
2013
2014
2015
2016 & Beyond
Office
10.2%
6.8%
8.2%
11.9%
38.3%
Retail
9.8%
10.9%
7.6%
8.5%
36.6%
Industrial
12.9%
10.4%
17.3%
22.1%
22.8%
For Retail: low percentage of portfolio but long leases.

15. “Geographic Dispersion” Strategy
REITs (or wealthy investors) have the ability to reduce local market risk via diversification.
Below is how REIT 1 is diversified in this way...
East
West
South
Midwest
Foreign
Office
24.5%
17.5%
10.4%
1.2%
2.7%
Apartment
2.6%
6.2%
5.4%
0.0%
Industrial
1.3%
7.0%
4.1%
Retail
3.2%
0.9%
8.5%
0.3%
2.4%
Storage
0.2%
0.1%

16. “Geographic Dispersion” Strategy Continued
Another method of viewing this type of portfolio risk smoothing is by Metropolitan Statistical Area (MSA):
MSA
% of Total 1
Washington-Arlington-Alexandria-DC-VA-MD-WV
10.6% 2
Boston-Quincy MA
5.5% 3
Los Angeles-Long Beach-Glendale CA
5.4% 4
San Francisco-San Mateo-Redwood City CA
5.0% 5
Houston-Bay Town-Sugar Land TX
4.8%

17. REIT & The QQD Framework
Quantity Strategy
Strong dividends, maximize GPI, growth orientation purchased at discount
Focus strategy: less diversified
Diversified: higher expenses
Quality Strategy
Nationally known tenants, NNN REITs, Blue Chip REITs
Durability Strategy
Tenant rollover risk, length of leases, geographic dispersion

18. REIT & The QQD Framework
Lease Rollover Risk
Attempt to diversify via the duration of the income stream on associated properties.
Also based on the lack of a high concentration on any particular tenant for the total revenue
Business Risk
Attempt to diversify via the region or type of property in an effort to reduce concentration on one area or property type

19. REIT Valuation Techniques
Gordon Dividend Growth Model
Funds from Operations (FFO) Multiple
Net Asset Value (NAV)

20. Gordon Dividend Growth Model
Utilizes future dividend per share expected next year to calculate stock price as the present value of expected future dividends
Constant dividend growth is assumed
Begin with DCF based on projected revenue and expenses to estimate FFO for an assumed holding period
Add in reversion to obtain PV of firm
Divide by # of outstanding shares to obtain D1
V = D1
(k-g)
$50.00 = $3.00
( )

21. FFO Multiple Similar to the Price to Earnings Ratio
FFO: Net income (GAAP) excluding gains or losses from sales of property or debt restructuring adding back RE depreciation
Value = FFO/share * FFO Multiple
Multiple: Historical multiple for REIT or peer group
Only as good as the comparables!!

22. Net Asset Value (NAV) Value = Aggregate Stabilized NOI
Blended Cap Rate
Blended cap rate is difficult for diversified assets
Rather: Find value of specific properties and divide by property specific cap rates to obtain value of portfolio
Once find value, subtract out debt to obtain NAV
Shares quoted in terms of Net Asset Value (NAV)
Holding Period Return= NAVnow –NAVprior + Divholding period
NAVprior

23. Net Asset Value (NAV)

24. REIT Valuation Issues
Different classifications of recurring expenses for FFO
Tenant Improvements, Leasing Commissions
If categorize as expense, subtract from FFO
If categorize as capital improvement, amortized on balance sheet
Adjusted FFO (AFFO)
Adjusts FFO for expenses, while capitalized, which do not enhance property value
Eliminates straight lining of rents
FASB 13: Free rent or increases must be equalized (straight-lined) over term of lease

25. REIT Internationalization
International RE Investment is becoming more of an area of study
Historically International RE Investment focused on Blue Chip properties in well known cities
RE Investment becoming more frequent in Emerging Markets
RE Investment in Developing Countries typically centers around Tier I cities
REITs have been embraced by Islamic Finance given the verifiable nature of the assets included in the investment pool
The initial requirement for external management still exists in many countries…

26. Emerging Market Property Rights

27. The End? “One repays a teacher badly if one always remains a pupil…”
Thus Spoke Zarathustra, On the Gift Giving Virtue, pg. 78
Go forth and invest in Real Estate!!
Friedrich Nietzsche