REAL ESTATE INVESTMENT TRUSTS (REIT) Definition: A limited-liability single tax entity created by Congress in 1960 as a vehicle for pooling funds to make real estate investments. REITs typically hold equity real estate (Equity REITs), mortgages and mortgage backed securities (Mortgage REITs), or both (Hybrid REITs). Dividends: Dividends paid by REITs are deductible from its taxable income, so REITs usually pay no Federal income tax. They are therefore single tax entities because the tax liability falls only on the dividends paid to the shareholders. Restrictions on REIT organization and income dispersal:
It must pay out at least 95% of its ordinary taxable income as dividends. It must be organized as a corporation or business trust. It must be managed by a board of directors or trustees. It must have fully transferable shares. It must have a minimum of 100 shareholders. No more than 50% of the shares can be held by five or fewer individuals during the last half of each taxable year. (Five-or-fewer rule) At least 75% of the total assets must be invested in real estate assets. At least 75% of gross income must be derived from rents or mortgage interests.
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No more than 30% of gross income can be derived from the sale of properties held less than four years, securities held less than six months or other prohibited transactions.
Organizational Structure and Control: REIT activities are supervised by either a board of directors or trustees. Day-to-day management of the REIT may be handled either internally (a self-administered) REIT or contracted to an external advisor.
Umbrella Partnership REIT (UPREIT): REIT that owns shares in an operating partnership, which in turns controls real estate investments. REIT serves as the general partner of and has an interest in the operating partnership that owns, operates, manages, and controls each of the real estate assets. This structure is currently used because it avoids the ownership concentration restrictions of the REIT tax laws. Down-REIT Partnership Structure Operating Partnerships created for the sole purpose of acquiring properties from potential sellers seeking to defer taxes on their capital gains. This structure facilitates the acquisition of partnerships or properties by the exchange of limited partnership units (i.e. allows sellers to convert ownership interests into partnership shares, not a taxable event) Reduces mismatch between the interests of the REIT and the interest of the limited partners because their position is usually not as large as those found in UPREITs. May be lock-out provisions form property sales or debt repayment which reduces the REITs ability to fully manage its assets “Paired-Share” REIT A structure that involves both a real estate investment trust and an operating company or C Corporation. Under this structure, the shares of common stock of both the REIT and the operating company are cojoined and traded
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under one ticker symbol. REIT shareholders own equal shares of the real estate investment trust and the C Corporation and receive tax benefits of the REIT as well as additional earnings generated by the operating company. “Paper-clip” REIT A structure in which the shares of the REIT and the operating companies are traded separately under different ticker symbols. The REIT shareholders are not equal shareholders in the “paper-clip” C Corporation, however, investors may choose to purchase stock in either the REIT or the “paper-clip” to mitigate potential investment risks associated with this structure. Advantages: REIT can conduct operating businesses and still preserve their special tax status. REIT can participate in more aggressive investments to achieve higher yields. Disadvantages: Difficulties for management operating two companies with potential conflicts of interest. More difficult to accurately depict cash flows and leverage of the REIT, because there are no consolidated reporting requirements.
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Funds from Operations (FFO)
Original definition (1991): Supplemental measure of a REITs profitability, provides additional information for net income under generally accepted accounting principles (GAAP). Defined as: “Funds from Operations means net income (computed in accordance with generally accepted accounting principles), excluding gains (or losses) from debt restructuring and sales of property, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures.”
Importance of FFO
There is an important difference between REIT earnings per share and FFO per share: Example Assumed 10 Outstanding Shares of REIT Stock REIT REIT Cash income Flow statement Rent $100 $100 - Operating 40 40
Expenses Net operating Income - Deprec. Net Income Cash Flow EPS FFO per share
60 40 20 $2 -
60 60 $6
Problems with FFO: 1) the addback of non-real estate-related amortization to net income and the manipulation of interest rates. FFO is computed by adding amortization back to NOI, the intent was to exclude the amortization of nonrecurring or intangible costs, but it has been used more broadly. Many REITs, have taken deferred financing costs (usually prepaid
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interest) capitalized this as an asset and amortized over the life of the loan. 2) accounting for the real depreciation of real estate FFO is computed by adding back depreciation to NOI. However, because there is a certain amount of real depreciation, which requires capital expenditures to protect the current and future cash flows from the real estate assets, adding all the depreciation exaggerates the FFO NAREIT’s proposals to redefine FFO reporting requirements: 1. REITs accounting for unconsolidated joint ventures should be extended from partnerships to include unconsolidated corporations. 2. REITs provide a reconciliation of the addbacks to GAAP net income to arrive at FFO. 3. REITs provide further disclosure of capital expenditures on an aggregate basis with detail on tenant improvements and allowances for retail, office and industrial properties and capitalized carpet and appliance expenditures. 4. REITs disclose the noncash effect of straight-lining of rents. Equity REITs Issues in Accounting and Financial Disclosure Issue Usual Interpretation Tenant improvements paid by landlord are Tenant Improvements and Free often capitalized and then depreciated - thus Rents: Effects on FFO
Use of Straight Line Rents Lease Guarantees Terms of Mortgage Debt and Obligations Existence of Ground Leases Lease Renewal Options Percentage Leases
cash flow for tenant improvements are not included in FFO because FFO earnings are before depreciation. Leases with step-ups are often reported as the mean rent over the holding period. Usually involves the REIT sponsor guaranteeing the rental income on space that is currently vacant. Are there participating mortgages, is the debt floating or fixed? Rights of reversion may belong to landowner, may be subordinated or indexed. How much exists and at what terms. No standard of measurement “mall store sales” “Large space users”
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Occupancy Numbers
Leased space or occupied space.
CASE: GENERAL GROWTH PROPERTIES REIT: Are active portfolio management strategies possible under current ownership and distribution rules?
Historical context for the IPO
Savings and Loan failures and weakness in the commercial banking industry. Curtailment of all forms of commercial real estate lending. Severe overbuilding in many real estate sectors - high vacancy rates. High quality regional malls experienced fairly stable cash flows and maintained their value during late 1980’s and early 1990’s. Many IPO’s in late 1992 - 1993 were enclosed-mall shopping center companies (eg. Taubman, Macerich, Crown, DeBartolo, Simon, Urban)
Portfolio strategy for the original Bucksbaum partnership
Develop and manage enclosed-mall shopping centers Anchor malls with high volume merchandisers (See Table) Carefully manage tenant base and lease structure of malls
Management objectives in move from partnership to public corporation (REIT)
Refinance mortgage debt during “credit crisis” of early 1990’s (See Pro Forma) Estate Planning for General Partners (Martin and Matthew Bucksbaum) Need for greater access to capital markets to achieve growth objectives (10% per annum) Make new acquisitions
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New development Expansions and redevelopment of existing properties Dynamic management of tenant mix and leasing structure
Original REIT Structure
Self administered Real Estate Investment Trust UPREIT Structure (See Chart) 59.6% General Partnership interest in Operating Partnership held by REIT shareholders 40.4% Limited Partnership interest in Operating Partnership held by: Bucksbaum brothers, members of their families trusts for the benefit of their families Total ownership interest held by Bucksbaums 5.8% of common shares in REIT (See Chart) 39.7% LP interest Aggregate if exchange of partnership units for shares of common stock - (.058*60.3%)+39.7% 43.2% External management company (General Growth Management, Inc.) 55% owned by employees and 45% owned by Bucksbaums
What do you see as the potential positives and negatives of this structure? For REIT shareholders? For LP’s?
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Purpose of UPREIT:
Designed to facilitate a public offering for a privately held portfolio without triggering a tax liability for the sponsors based on “built-ingain”. “Built-in-gain” is the difference between fair market value and the current tax basis - usually equal to total capital invested less accumulated tax depreciation. When would the tax liability come due for the LP’s?
Outcome of IPO (April, 1993)
Sold 18,975,000 shares of common stock Received $383 M in net proceeds (Share price $22) 21 enclosed regional malls (18 from original Bucksbaum portfolio and 3 from the IBM retirement fund managed by Equitable Life Insurance Co.) 13.2 M square feet of GLA Average occupancy rate = 87% Sale per square foot (GLA) = $180
GGP Strategy after the IPO
1. In less than one year later acquired 40% interest in $1 B. Centermark portfolio ( 19 enclosed malls from Prudential Insurance Co. - See Table) 2. In less than 18 months, began development of two new regional malls: West Valley Mall - Tracy, CA 500,000 sq. ft Anchored by Target, Gottschalks, JC Penny. Opened last year Eagle Ridge Mall - Winter Haven, FL 700,000 sq. ft Anchored by Sears, JC Penny and Dillard Opened last year Funded by 100% debt (line of credit and construction loans) 3. Within 24 months, $15 M spent on renovations and expansions of existing properties.
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Financial Performance:
Distributed approx. 84% of FFO High 1993 Q2 Q3 Q4 1994 Q1 Q2 Q3 Q4 1995 Q1 Q2 $26.00 24.75 23.50 $21.50 $22.00 $22.63 $22.63 $22.63 $21.75 Low $23 $22.13 $19.25 $19.63 $19.25 $19.50 $19.25 $20.38 $19.38 Dividends .31 .37
.39 .39 .39 .41 .41
FFO per share was $1.58 in 1993 and increased by 16% to $1.83 in 1994, most of the growth from the Centermark portfolio Based on conservative capitalization rate, the $182 million initial investment in Centermark increased by $100 M. and including distributions of cash flow, the IRR on deal over 40%.
Look at Strategy from the Balance Sheet
After IPO, debt was 35% of total market capitalization and $50 M was in the bank Made total of $235 M of new investments ($182 M Centermark, $38 M new development and $15 M on new expansions. Floating rate debt exposure increase $90 M to approx. $300 M. (Protected only by out-of-the-money LIBOR caps ) Cash position - $0; $15 M unused portion of their line of credit
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Capital Requirements going forward into 1995
More significant growth opportunities through portfolio acquisition. Develop two additional malls with preleasing commitments. Additional expansion and redevelopment within the portfolio Believed returns on these opportunities greater than 15%
Market Perceptions of the REIT 1995
GGP had delivered nearly all IPO growth promises (Acquisition, expansion, development) Little stock price appreciation - with an initial annual dividend of $1.48 per share and initial price of $22 gave dividend yield of 6.75% where most recent IPO’s produced 150 - 200 bp. more. Debt now 52% of total market capitalization (most REITs covenanted to 55% debt level) Over $300 M in commercial-bank floating rate debt, interest rate risk exposure too high. GGP was not self-managed.
Management Alternatives for “Going Forward” Strategy
Obtain additional debt conventional secured financing with 60 - 70% LTVs adverse affects on stock prices
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Hybrid debt/Equity Instrument Perpetual and/or convertible preferred stock placed privately with institutional investors Needed to yield 8.25% on the common stock plus capital gains terms were very unattractive Issue new common stock Dividend yield of 8.25% and all-in floating rate debt of 8% Underwriting fees of 5.3% and expenses of $650,000 - only 94% of the gross proceeds received by GGP 4,500,000 shares at $20.75/share - net proceeds of $87,772,500 If used to reduce floating rate debt interest payment ($7,802,000), dividend on 4,500,000 at $1.64/share would be $7,380,000 or $422,000 savings. Total shares and operating partnership units would increase from 37.5 M to 42.5 M (13% increase)
Which strategy would you recommend? Why? Newest Venture: Homart Transaction (Sear’s retail real estate portfolio)
This is the largest U.S. Real Estate transaction ($1.85 billion dollars) ever. It is a joint venture between GGP, Goldman Sachs, Whitehall Real Estate Fund and Westfield.
Real Estate Portfolio (retail anchored by Sears stores)
The vacancy rate is 18%, which is the below average for regional malls. Sales per square foot is $240, which is the average for GGP properties. GGP will have 26 additional completed regional malls, 2 malls under construction, 5 community shopping centers, five community shopping centers under construction (approx. 25 million square feet total). Also, 190 acres of undeveloped land surrounding the existing malls.
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Portfolio has not had recent capital improvements . The two malls under construction will require about $250 million.
Debt
GGP will assume $720 million in debt. Most of this is to be refinanced, currently insurance companies are offering 120 to 130 over Treasuries, so an assumed 8% all-in interest rate not unreasonable.
Equity
Cash contribution to sale is $480 million. GGP’s 20% share is $96 million and the remaining $384 million will be raised privately. GGP’s total investment is thus $240 million ($144 million assumed debt and $96 million draw from credit lines).
Financing
Anticipate $650 million in proceeds from sale of community shopping center business and the Natick Mall in Massachusetts (this is the most high end mall in the portfolio)
Intuition behind the deal
Good old-fashioned leverage effect from use of debt and the joint venture structure. A $96 million investment will allow GGP to control a $1.2 billion portfolio. $650 million will be generated from the sale of the community mall business and the sale (for $501 million) of the Natick Mall. Will attempt to decrease the current vacancy rate. Will aggressively use kiosk and temporary tenants. Salomon Analysis of Outcomes Three Scenarios: Most likely: assumes an initial capitalization rate of 8.5% on $1.2 billion purchase, interest on assumed debt of 8.5%, asset management fees of 30 basis points, $.09 increase in share prices Aggressive: assumes an initial capitalization rate of 8.75% on $1.2 billion purchase, interest on assumed debt of 8%, asset
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management fees of 50 basis points, $.16 increase in share prices Conservative: assumes an initial capitalization rate of 8% on the $1.2 billion purchase, interest on assumed debt of 8%, asset management fees of 25 basis points, $.04 increase in share prices
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