What is a Real Estate Investment Trust

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What is a Real Estate Investment Trust?

• A REIT is a
• Publicly or privately held company that that owns
  real estate equity or real property debt
• Passes most of its earnings and capital gains
  onto shareholders
• Only retained earnings are taxed, PROVIDED REIT
  meets
• Ownership requirements
• Management requirements
• Asset requirements
• Income requirements
• Distribution requirements
• Trade Association National Association of Real
  Estate Investment Trusts (www.nareit.com)

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REITs
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REITs
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Requirements

• Ownership
• 5 or fewer entities may not own 50 or more of
  the outstanding shares (the 5/50 Test)
• No one shareholder owns more than 9.9 (pension
  funds excluded)
• REIT shares must be transferable and held by at
  least 100 persons
• Must be managed by a board of directors or
  trustees
• Must be incorporated in one of the 50 states or
  DC as a taxable entity

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Requirements

• Management
• REIT managers must be passive
• REIT trustees, directors or employees may not
  actively engage in managing or operating REIT
  properties (includes providing service and
  collecting rents from tenants).
• Managers may set policy rental terms, choose
  tenants, sign leases, make decisions about
  properties.
• REITs allowed to own 100 of a Taxable REIT
  Subsidiary (TRS).
• REIT Modernization Act of 1999 (effective 2001)
• TRS can provide services to REIT tenants and
  others (previously, this was not allowed).
• Debt and rental payments from TRS to REIT are
  limited to ensure that the TRS actually pays
  income taxes.

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Requirements

• Assets
• 75 of assets must be real estate, cash, and
  govt. securities
• other REIT shares are considered real estate
  assets, but not more than 20 of its assets can
  be stocks in taxable REIT subsidiaries
• not more than 5 of assets can be stock in
  non-real estate corporations
• may not have more than 10 of voting securities
  of any corporation other than another REIT,
  Taxable REIT Subsidiary (TRS) or subsidiary whose
  assets and income are owned by the REIT for
  federal income tax purposes

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Requirements

• Income
• 95 of gross income must be from dividends,
  interest, rents, or gains from sale of certain
  assets (real estate, cash, or govt securities).
• The 95 rule includes income from dividends and
  non-real estate sources (e.g. bank deposit
  interest)
• Implication less than 5 of REIT income can come
  from service fees

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Requirements

• Income
• No more than 30 of gross income can be derived
  from
• sale or disposition of any securities held less
  than 6 months
• sale or disposition of real estate held for less
  than 4 years, except those involving
  foreclosures.
• properties held for sale in the normal course of
  business (anti-dealer provision)

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Requirements

• Compliance
• Company must make a REIT elective by filing IRS
  Form 1120-REIT.
• Company must mail letters to shareholders of
  record requesting details of REIT benefits
• Source http//www.investinreits.com/learn/formin
  gareit.cfm

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Requirements

• Distributions
• must distribute 90 of all taxable income to
  investors
• mandates fairly low retained earnings policy
• has important implications for financing growth
• Note prior to 2001, minimum distribution
  requirement was 95.

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Tax Treatment

• Accelerated depreciation is allowed for
  determining taxable income
• 40 year asset life required for calculating
  income available for distribution to investors
• Shareholders dividends may exceed REITs taxable
  income (because of depreciation, amortization)
• REIT distributions
• Dividends taxed as ordinary income
• Return of capital reduces shareholders tax basis

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Tax Treatment

• REIT Management has Considerable Flexibility
• Tax treatment of leasing commissions
• Tax treatment of financing fees
• Tax treatment of tenant improvements
• Straight-line graduated lease payments
• That influence analysts performance evaluation.

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REITs
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REITs
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REITs
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REITs
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REITs
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Equity REITs
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Debt REITs
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Umbrella Partnership REITUPREIT

• REIT formed by consolidating limited-partnerships
• Partnership interests known as Operating
  Partnership (OP) units
• REIT owns property indirectly through OP
• Partnerships allocated REIT shares based on
  appraised value of partnership property
• Property owners can swap RE investments for OP
  units using IRS tax deferred exchange rule 731
• REIT issues shares to the public and purchases
  properties owned by the OP
• First UPREIT created by Taubman in 1992

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Taubman UPREIT
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(No Transcript)
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DownREIT

• Like an UPREIT, a DownREIT acquires property on a
  tax deferred basis by issuing partnership units
• DownREIT can own multiple partnerships
• Can form partnerships with each acquisition
• More flexible than an UPREIT
• DownREIT can own assets at both the REIT and OP
  levels

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REITs in Market Indexes
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REITs in Market Indexes
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REITs in Market Indexes
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REIT ValuationEPS v. FFO

• Earnings per share (EPS) is an accounting number
• REIT must distribute at least 90 of EPS
• Funds from operations (FFO) is REIT cash flow (no
  depreciation/amortization)
• FFO means net income (computed in accordance with
  GAAP), excluding gains (or losses) from debt
  restructuring and sales of property, plus
  depreciation and amortization of assets uniquely
  significant to the real estate industry, and
  after adjustments for unconsolidated entities in
  which the REIT holds an interest. Adjustments
  for these entities are to be calculated to
  reflect FFO on the same basis.
• Moreover, NAREIT believes that items classified
  by GAAP as extraordinary or unusual are not meant
  to either increase or decrease reported FFO.

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REIT ValuationHow to Calculate FFO

• Revenues
• Operating expenses
• Depreciation amortization
• Interest expense
• General Administrative expense
• NET INCOME (GAAP)
• Net Income
• Profit from real estate sales
• Depreciation amortization
• FFO

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REIT ValuationHow to Calculate FFO
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REIT ValuationKey Parts (DA)

• Legitimate add-backs
• real property depreciation
• amortization of capitalized leasing expenses
• amortization of tenant allowances and
  improvements
• Add-backs not allowed
• amortization of deferred financing costs
• depreciation of computer software
• depreciation of company office improvements

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REIT ValuationAdjusted FFO

• FFO minus
• Recurring capital expenditures (e.g. painting,
  carpets, etc.)
• Amortization of tenant improvements
• Amortization of leasing commissions
• Adjustment for rent straight-lining
• Adjusted FFO (AFFO)

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REIT ValuationImpact on FFO

• Depending upon managements strategy with respect
  to capitalizing or expensing items, calculated
  FFO and percentage of payout of net income can
  vary widely
• Kimco Realty (KIM) expenses everything they can
  -- reduces measured NOI -- increases amount they
  can retain (65 payout ratio - lowest in
  industry)
• Large group of about 10 has payout ratios over
  95 -- capitalize aggressively -- raises FFO --
  reduces what they can retain

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Financial Analysis
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Financial Analysis
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Financial Analysis
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Financial Analysis
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Financial Analysis
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Financial Analysis
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Financial Analysis
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Economies of ScaleMinimum 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

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Economies of ScaleWhat will 1,000,000 buy?

• for an apartment REIT, a 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

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Economies of Scale10 billion REIT

• same 50/50 debt-equity ratio and 8 yield on
  equity for a 10 billion REIT
• implied income of about 400,000,000
• 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
• thats a good-sized garden apt complex, 1/5th of
  a large regional mall, or a couple of
  decent-sized warehouses or industrial sites.

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Economies of Scale10 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

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REIT Advisors

• Prior to 1986, REITs
• Passive investment vehicles
• Day to day business decisions (property
  management and investment decisions) conducted by
  3rd party external advisors
• Advisors frequently had conflicts of interest
• Were property owners trying to sell the REIT
  property
• Were advisors to other (competing) REITs
• 1986 Tax Reform Act
• A REIT may directly select, hire and compensate
  those independent contractors who will provide
  customary services that may be provided by a REIT
  in connection with the rental of property, rather
  than hiring an independent contractor to hire
  other independent contractors.
• Allowed REITs to be self-advised/self-managed.

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REIT Advisors
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REIT Growth

• Grow income from existing properties
• Raise rents
• Reduce vacancy
• Increase Operating Efficiency
• Acquisitions
• Purchase properties _at_ positive spreads between
  property yields and WACC
• Swap shares in REITs to take advantage of tax
  provisions
• New construction
• Financial Engineering
• Manipulate Funds from Operations
• Leverage
• Change payout ratio
• Most REITs finance expansion with additional
  stock offerings