Real Estate Securities Lecture U of Iowa MBA Class

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Real Estate Securities LectureU of Iowa MBA Class

• Eric M. Lohmeier, CFA
• 21/10/03
• elohmeier_at_ncpinconline.com

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• PART I - Real Estate Securities Defined
• Generally recognized as a specific asset class
  (Stocks, Fixed Income, Commodities)
• Home Ownership represents largest age of
  individual savings in the US
• Individual ownership also common in multi-family
  and free standing retail
• Forget everything you think you know about real
  estate from the above sources (for todays
  lecture, anyway)

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• Institutional Real Estate Ownership and Assets
• Corporations, Pensions and Insurers are a
  significant direct owner of institutional
  real-estate
• Institutional direct ownership in the past
  primarily dependant upon size and the ability to
  achieve appropriate economies of scale
• Internally managed vs external advisor

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• Out of the Rubble, a Market is Born
• Real Estate laws written in the 70s were finally
  institutionalized in the early 90s to clean up
  an overbuilt and illiquid institutional real
  estate market from the 80s (Think tech stocks in
  00)
• A liquid and deep institutional real estate
  market was created for the first time using Wall
  Street (vs Commercial Banks and Pensions)
• Pre-Modern REIT days, Institutional real estate
  was exclusive OR disastrous (LPs!)

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• REIT Structure
• REIT Real Estate Investment Trusts Companys
  assets are held in the trust and owned by the
  shareholders of the company
• Beauty of the structure is the income from the
  real estate portfolio passed through the
  corporation to the shareholders tax-free in
  dividend income (90 RULE)
• Dividend Income taxed at an individual (entity)
  ordinary income rate vs Cap Gains

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• Why did this Structure click - Retail?
• Retail, Individuals could own this asset class
  efficiently for the first time
• Income, diversification and the liquidity (NYSE
  listed stocks) found a home
• Wall Street incentive (Capital Intensive Sales
  Force Real Estate characteristics Fees, Fees,
  Fees)

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• Why did this Structure click - Institutional?
• Under a certain size it was very difficult to
  invest in the asset class directly to take
  advantage of the correlation aspects of RE vs
  other asset classes
• Arguably at any level real estate is less
  efficiently managed even with adequate through
  direct investment (I disagree)
• Wall Street incentive (Capital Intensive Sales
  Force Real Estate characteristics Fees, Fees,
  Fees)

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• Market Depth
• Approximately a 200 billion equity market
  capitalization in REITs
• 50 of this market held institutionally / 50 -
  held by individuals
• Of Institutional Ownership, approximately ½ held
  by mutual funds (a significant percentage are
  real estate dedicated funds)
• Pensions / Insurers participate in the other ½ to
  represent a portion of their real estate
  dedicated asset class investments (CALPERs)

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• PART II Real Estate Securities Specifics and
  Valuation
• Institutional RE Asset Classes (Broad)
• Multi-Family / Apartments
• Retail (Malls, Strip Centers, Free Standing)
• Office (CBD, Suburban)
• Hotels
• MHCs (Manufactured Home Community)
• Self Storage

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• Valuations and Risk
• In Real Estate, assets are bought and sold using
  Capitalization Rates (Inverse of a multiple)
• Cap Rates are applied to a RE assets Net
  Operating Income (NOI)
• NOI is a proxy for a RE assets recurring cash
  flow
• Value NOI / Appropriate Cap Rate

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• Specifically
• Property NOI Revenues LESS (RE related expenses
  Real Estate Taxes Management Expense)
• For a COMPANY Net Asset Value simply apply the
  same formula of the Property NOI but use all
  recurring income (Other, etc) and count S, G A
  as your Management Expense (in addition to any
  other mgmt expenses STORY on external vs
  internal mgmt)
• Yes Real Estate related taxes are an operating
  expense!

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• REIT Income Statement Jargon
• REITs use their own proxy for Real Estate
  Earnings (Non-GAAP think pro-forma)
• FFO Funds From Operations
• FFO GAAP EPS plus (Real Estate related
  Depreciation / Amortization) less (Gains /
  (losses) on sale of Real Estate assets)
• Unfortunately, there isnt a STANDARD definition
  of FFO b/c it is non GAAP and companys truly
  use (or abuse) this to their advantage! (FFO is
  about as meaningful per company as CSCOs
  pro-forma earnings, for example)

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• Helpful Hints for Evaluating FFO
• AFFO Adjusted Funds From Operations
• AFFO FFO less (Recurring capital expenditures)
• AFFO is a truer picture of a REITs recurring cash
  flows cap ex discussion
• A back of the envelope method for estimating
  recurring cap ex is 50 of depreciation
• The BEST method for measuring recurring cap ex is
  industry sourced per square foot actual cap ex
  expense

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• Cap Rate Specifics
• The market assigns cap rates to the various
  sectors of the real estate market based upon a
  variety of factors including stability of asset
  class, lease terms, credit worthiness of tenants,
  fungibility, and barriers to new supply
• Remember High cap rates higher risks,
  lower value (inverse for low cap rates)

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• Average Asset Class Valuations per Specific Cap
  Rates
• 5 to 7 Shopping Malls, MHC
• 7 to 9 Class A Office, Multi-family, Strip
  center retail, self-storage
• 9 Class B (or -) Office, Hotels,
  Self-standing retail
• These are current market AVERAGE estimates
  over time these have and will change again!
  (Discussion)

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• PART III Random Miscellaneous
• The real estate security diversification argument
  holds significant water when measuring both
  public RE equities as well as private RE against
  large cap stock market and fixed income indexes
• HOWEVER Public REITs have a high correlation
  with the Russell 2000 index! (VERY sensitive
  subject in REIT world)
• FFO pro-forma earnings Use either one at
  your own risk

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• Continued
• If valuing real estate equities, INCORPORATE an
  NAV value to your projections as opposed to
  market multiple crap
• B/C of liquidity, cash inflows / outflows
  (generalist fund manager ) and other market
  structure issues, NAVs of public real estate
  equities DO in fact de-couple from private Market
  Value! (99/00 vs Today) this market
  inefficiency means opportunity

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• Continued
• Dividend Yields and long term volatilities are
  attractive in the public real estate markets,
  however DO your NAV calculations AND AFFO
  dividend coverage ratios (Current Events example)
• Office and Multifamily current issues (negative
  dividend coverage!)
• Broad market interest valuation disparity?

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• Continued
• Sell-side research (my former profession)
  mandatory that you maintain healthy skepticism!
  This research can be an excellent topographic
  map, but it is NOT an objective one
• In addition to location, location, location pay
  attention to leverage, leverage, leverage! The
  market sometimes fails to (rarely discriminates
  per equity valuations) I think you should )
• CMBS, Agencies HUGE implications but save that
  one for another class, another day!

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• Conclusion / QA
• Please feel free to open this up and fire
  away. Over the last 7 years I have worked in
  equity research, investment banking and asset
  management. I would be happy to share any of
  these experiences (in addition to real estate
  related) with the class. I promised Dirk that I
  wouldnt share Iowa City based MBA stories with
  the class, however - sorry about that, there are
  some pretty good ones.