Real Estate Securitization by leader6


									Real Estate Equity

    Understanding Real Estate
    Investment Trust (REITs)
           Session Six
The Investment System and Capital
   The Investment System has Two Parts
       Underlying Real Assets: a collection of physical,
       human, and legal assets and relationships that produce
       cash flow through the production and sale of goods
       and services
      Financial Assets: these are not directly productive (as
       real assets), but are direct or indirect claims on the
       directly productive underlying real assets
   The investment system matches heterogeneous investors
    (sources of financial capital) with heterogeneous
    productive assets (physical capital)
Exhibit 1: Capital Markets without Asset Securitization

                            (2)                                 (1)
                   Proceeds used to buy                  Firms sells securities
    Firms          assets for operation                  To raise capital           Financial
 operations                                                                         Markets
  (a bundle                                                                        (investors
of real assets                                                   (4a)                holding
     and                                                                            Indirect
                   Real assets generate
 receivables       positive cash flow                   Cash either reinvested     Financial
                                                        or returned to investors
                         (3)                                    (4b)

                                  Managerial Discretion?

 1. Underlying physical assets produce cash flows through products and sale of goods and commodities
 2. Financial assets do not directly generate cash flow, but are indirect claims on the productive
 real assets
 3. The investment system matches heterogeneous investors (sources of capital) with heterogeneous
 productive assets (physical assets and receivables)
     Exhibit 2: Financial Markets with Asset Securitization
                                 (2)                                         (1)
                        Proceeds used to buy                          Firms sells securities
       Firms            assets for operation                          To raise capital              Financial
     operations                                                                                     Markets
     (a bundle                                                                                     (investors
      of real                                                                 (4a)                   holding
      assets)                                                                                      Financial
                        Real assets generate
                        positive cash flow                           Cash either reinvested          Claims)
                                                                     or returned to investors

                               (3)                                           (4b)                  Investors
 Securitized                                           (5)                                       in securitized
                        For securitized assets specific cash flow goes directly to investors.        Assets
                        Securitized assets and their associated cash flows are in effect owned
                        directly by investors   ---- Limited Managerial Discretion
1.     Traditionally, investors in industrial firms “indirectly” own the underlying assets through ownership
       of financial claims, they do not own the underlying real assets directly; securitization has made it
       possible for investors to own directly the cash flows of specific assets or receivables of industrial and
       financial firms
2.     Real estate investors traditionally own “directly” the real assets ; asset securitization has made it
       possible for these investors to indirectly own real estate related assets

3.     In short asset securitization has changed the investments decision making
    Asset Securitization has Changed the
    Investment and Financing Decisions

   Asset securitization has made it possible for investors
    in real estate entities to own financial claims, (REIT,
    MBS, CMBS), on the real estate (indirect ownership)
    as well as own the real estate (direct ownership)
   Asset securitization has also made it possible for
    investors in industrial firms to own specific pieces of
    the firm’s cash flows or receivables through ABS
    (“direct ownership”), as well as hold financial claims
    on the underlying productive real assets of the firm
    (indirect ownership through shares and bonds)
    What is Asset Securitization?
   Generally speaking, this is the trend towards real assets,
    commodities, products, or receivables , etc, being
    transformed into liquid securities tradable in financial
      real estate investment trusts (REITs) vs. real property

      commercial mortgage backed securities (CMBS) vs.
       commercial mortgages
      residential mortgage backed securities (RMBS) vs.
       residential mortgages
      asset backed securities (ABS) vs. receivables (credit
       cards, auto loans, trade receivables, leases, royalties,
       telephones receivables, future flows, infrastructure
       projects, etc)
    Real Estate Investment Trusts (REITs) –
    An Equity Securitization

What is Real Estate Investment Trust (REIT)?
 A REIT is a special investment vehicle that invests in income producing
  real property – office buildings, apartments, shopping malls, other
  retail, warehouses, whole mortgages, etc
 A key regulatory provision associated with all REITs is that it must
  distribute to share holders substantially all of its earnings (income plus
    capital gains)
   In the US a REIT also has elected under certain tax provisions for the
    investments to qualify for single taxation, either at the entity level or
    the investor level
   Real property owner (sponsor) works with an investment bank to form
    a REIT which is initially capitalized with the proceeds of initial public
    offering (IPO) and other debt financing
   Shares of REITs are typically publicly traded, although there private
     Exhibit 3: General Structure of Real Estate
     Investment Trusts (REITs)

     Primary( Direct) Real Estate Capital Market       Secondary (Indirect) Real Estate Capital Market

                                                                Capital Market Investors
                        Sale Proceeds from
                                                                Subscribed in IPO allowing
                        IPO subscription used
                                                                REIT to raise capital
                        to purchase property
Property Owner/Seller
                                                    REIT                                         Investors
  Income Producing
     Real Estate                                   (Trust)                                   (Purchase Shares)
                         Rental Cash Flow                         Dividend income/
                                                                  Capital gains

                  Owner/Seller of Property
                     Sponsors REIT
    Other Typical Attributes of REITs
   REITs can be structured either as a corporation
    (US) or a unit trust (Australia)
   REIT can either be directly managed internally
    (US) or externally managed through a third party
    asset management company (Asian Countries)
   A REIT typically does not make market – i.e.
    investors cannot require the REIT to redeem their
    shares (they are closed-end funds)
   Listed REITs are typically set up to operate
    indefinitely, although they can be structured with
    finite life
    Key Requirements of US REITs

   Asset Test:
       At least 75% of a REIT’s asset value must come from real estate, cash, and
        government securities at the close of each quarter of taxable year
       No more than 5% of the value of the assets may consist of the securities of one
        issuer, and REIT may not own more than 10% of the outstanding shares of one
        issuer, if those securities are not includable in the 75% test
   Income Test:
       At least 95% of gross income must come from dividends, interests, rents, or gains
        from sale of certain assets
       No more than 30% of REITs gross income can be derived from sale of real estate
        held for less than fours years or securities held for less than six months
   Distribution Test:
       At least 90% of the REIT taxable income must be distributed to shareholders
   Stock and Ownership Test:
       REIT shares must be transferable and must be held by a minimum of 100 persons
       No more than 50% of REIT shares may be held by five or fewer persons
    Types of Real Estate Investment Trust

   Broadly speaking, there are three types of
    U.S. REITs:
   Equity REITs (EREITs)
       Invest primarily in equity property interests
   Mortgage REITs (MREITs)
       Hold predominantly mortgages
   Hybrid REITs
       Hold both property and mortgage interests
    U.S. REIT Property Sector and
   Industrial/Office (9%+21%)
        Office
        Industrial
        Mixed
   Retail (25%)
        Shopping Centers
        Regional Malls
        Free Standing
   Residential (19%)
        Apartments
        Manufactured Homes
   Diversified (8%)
   Others (18%)
        Lodging/Resorts
        Self Storage
        Health Care**
        Mortgages
              Home Finance
              Commercial Financing
    Investment Appeal of REITs (1)

   REITs offer individual investors fractional shares in
    investment grade and professionally managed income
    producing real estate investment – broaden investment
   Regular income stream and relatively high dividend yield
   The REIT vehicle creates liquidity because shares can be
    traded on organized exchanges, as opposed to direct
    ownership of the underlying property
   Liquidity in turn allows for easier entry and exit as market
    conditions dictate which reduces transactions costs
   Access to broad capital markets leads to market integration
    which can reduce cost of capital
       Investment Appeal of REITs (2)

   A REIT structure offers property owners a more efficient
    way of selling their properties to recoup capital investment
   REIT allows for orderly divestiture of real estate assets and
    redeploy capital on core business – corporate restructuring
   In many jurisdictions (US) REITs also offer tax advantages
    relative to other investment vehicles by removing double
    taxation ---????
   REIT conduit also offers strong corporate governance
    mechanisms as well as separation of ownership and control
   Overall REITs tend to act as defensive stock or provide a
    hedge in bad times
    Innovation in U.S. REITs
   Pre 1986 REITs – passive management
      Directors, trustees or employees of REITs were not
       allowed to actively manage REIT properties
      Independent contractors performed these functions

      REIT owns underlying physical assets directly

   Post 1986 REITs --- Modern REITs (active management)
      1986 Tax Reform Act relaxed management restrictions

      Allowed REITs to provide normal maintenance and
       other services for tenants
      Created vertically-integrated operating companies
       fundamentally different from passive REITs of pre-1986
     Umbrella Partnership REITs or
   REIT does not directly own the underlying properties
   Rather the REIT and other real estate owners own units
    (operating partnership units or OP units) in a
   The REIT and in real estate owners have contributed ort
    sold properties to the partnershipn
   OP units are convertible into shares of REIT, offering voting
    rights and dividends
   This complicated arrangement allowed property owners
    (developers) to “sell” their properties to the REIT without
    triggering taxable event
Exhibit 4: Umbrella REIT FORMATION

                          REIT Shareholders

 B has the option to
 convert OP units to              REIT
 shares of REIT
                                                A’s OP units are sold to REIT
      B                             A
                                                for cash or shares

   Umbrella Partnership Managed by A (formed by REIT)
          General Manager of Operating Partnership is REIT

  Property 1      Property 2            Property 3           Property 4
    The Innovation in UPREITs
   The UPREIT is a form of financial engineering or
    structured financing
       The structure is a tax-deferred mechanism through which real
        estate developers and other owners transferred properties in the
        form of a tax-exchange
       Since the transaction did not trigger a taxable event the REIT is
        able to acquire properties at better earning multiples
       Conceivably this resulted in shareholder wealth maximization
       The development of UPREITs resulted in massive growth in REIT
        equity market capitalization in 1990s
       These modern REITs feature active management so as to grow
        cash flows and portfolio size
U.S REITs versus U.S. REOC Structure

   What is REOC?
   (1) U.S REITs are prohibited from certain lines of
    business, e.g. hotel operations, parking
    operations, REOCs are not
   (2) REITs operating loss (OL) can be carried
    forward for 15 years not back, REOCs can carry
    loss back
   (3) REOCs may decide to retain all of its earnings
    to fund growth opportunities, REITs must pay
    90% of their earnings to shareholders to avoid
    double taxation
    Innovations in U.S. REITs Structure: Paired
    Share REITs
   It allows the REIT to enter into prohibited
    business and still avoid double taxation
        The process starts with an REIT acquiring an REOC
         engaged in active real estate business that the REIT
         cannot enter (e.g. parking operations, hotels, and
         health businesses)
        All properties acquired by the REIT are leased back to
         the REOC
        REOC in turn pays most of its income to the REIT in the
         form of rent
        REIT passes most of its income to shareholders and
         avoids double taxation
     International REITs Trend
   The growing demand for publicly traded real estate likely to be met by
    growth of REITs
   Two largest REIT markets in the world are in the United States and
   United States market commenced in the early 1960s. First Australian LPT
    IPO was in 1971
   Both markets grew very rapidly in the 1990s. This was after the property
    markets in both countries crashed in the early 1990s – Exhibit 4
   REIT markets also established in:
      Canada, UK, Italy, Belgium, France, Netherlands, Japan, New Zealand,
       Malaysia, Korea, Singapore, Hong Kong, Taiwan, to name a few
US and Australian REIT Markets
Exhibit 5: US and Australia saw explosive growth in the early 1990s

Size of markets
United States
           180                                                            400
                                                                          300            50                                                            80

            90                                                            200            40                                                            60
            60                                                                           30

                                                                          100                                                                          40
            30                                                                           20
             0                                                            0                                                                            20
                 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
                                                                                         0                                                             0
                                   M arket cap   No. of REITS                                 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

                                                                                                                  M arket cap   No. of t rust s

What REITs invest in
United States
                          Diversif ied                                                          Diversif ied
                                                    Ret ail
                             8%                                                                    25%
                        Ot her
                        18%                                                                     Ot her                          Ret ail
                                                                                                 2%                             43%
                                                                                              Indust rial
                     Indust rial
                       Resident ial              Of f ice
                          19%                                                                               Of f ice
        Exhibit 6: REIT Market Capitalizations
                                   REIT Equity Market Capitalization in US, Australia and Japan
                     US$ (in millions)




                                   NAREIT comp Index           Australian property trusts      Japanese listed REITs

Source: National Association of Real Estate Investment Trusts®, ASX, Bloomberg as of 31 March 2004
Institutional Ownership of U.S.
REITs has Grown

     Exhibit 7: Institutional and Non-Institutional Ownership of
                               U.S. REITs

   100%               82%
    60%                           47%                     Institutions
    40%                                                   Non-Institutions
               1980               2003
Institutional Ownership in All
U.S. Stocks (Equities)

            Exhibit 8: Institutional Ownership in All U.S. Stocks

      60%                                   45%             Institutions
      40%          27%                                      Non-Institutions

                   1980              2003
Growing US REIT Market Capitalization:
Now in Excess of US$260 billion

                          Exhibit 9: U.S. REIT Equity Market Capitilization
                          (Millions of US$, period ending March 31, 2004)
 capitalization (US$)


Over the past three and half decades
U.S. REITs have grown more than four

                        Exhibit 10: Number of U.S. REITs (1971-2004)

                  250                        226
                  200                              182   175
     # of REITs

                  150                138

                  100           76                               Number of REITs
                   50      34

                         1971 1981 1991 1994 2001 2004
Institutional Investment in

      Exhibit 11: Institutional Investment in U.S. REITs (Total
       Institutional Investment $124.5 billion, period ending
                            March 31, 2004)

                            6%   4%                         Banks
                                                            Insurance Co.
                                                            Mutual Funds
                                                            Pension Funds
Long Term Performance of REIT
vs. Other U.S. Benchmarks

                     Exhibit 12: Long-Term Performance of U.S. REITs vs.
                     Other U.S. Benchmarks (Compounded total returns,
                                 period ending March 31, 2004)
              60                                                                    3-Year
                                                                                    5-Year                 52.6
                    48.7                                                            10-Year

              40                                              37.8

              20                                                                                                  18.1

                                                                                                    11.7                 13
                                    10.4      10.99.7 10.4                 11.3
                       2.7                                        1.7
                                                                        -0.4                  0.6
                           Nasdaq            Russell 2000    Dow Jones Industrial               500
                                                                                             S&P-1.2        NAREIT Equity
      Global Real Estate Performance
        Exhibit: 13
                                                  EPRA/NAREIT Global Real Estate Index
                                        Performance Indexes of Publicly Traded Real Estate Companies


                  2,000.00                                                                      North America

                                                                                                                Global Composite















                                  Global Composite           North America               Asia                Europe

Source: National Association of Real Estate Investment Trusts®, as of June 2004
Exhibit 15: US Office REITS Traded at significant
Premium to NAV in late 1990s to 200os

  Crescent Real Estate Equities                                            90%

           Equity Office Properties                         56%

                Equity/Beacon (est.)                       53%

                  Beacon Properties                       48%

                          Arden Realty               35%

                   Boston Properties                31%

             Highwoods Properties               24%
                                                           REIT Office
                          CarrAmerica          20%
                                                           Average = 39%
            Cornerstone Properties             18%

 Source: Realty Stock Review ; LaSalle   0%   20%   40%    60%    80% 100%
 Advisors Investment Research
    Dual Models of REIT Value
   We earlier noted the existence of two parallel real estate
    asset markets
        The public market (stock market) where REITs trade
        The Private property market where the REITs’ underlying
         physical assets trade
   Three fundamental questions arise from this dual market
    model that are of interest to real estate investors
        (1) Which asset market to use for real estate investment decision?
        (2) Is there a possibility for arbitrage by trading between the two
         markets to make seemingly (or nearly) riskless profits?
        (3) Do the two markets value differently the same underlying
         physical asset?
   First, we focus on the third question dealing with
    differential valuation between the two markets
The Dual Market Nature of Real Estate Creates “Windows of Opportunity”

                                           Exhibit 16:
               End of Year Public vs Private Asset Mkt Com m ercial R.E. Values:
                        (Indexes set to have Equal Avg Values 1974-98)







          74     76    78     80    82    84     86   88   90    92    94   96    98   2000
                            NAREIT (Unlevered)                  NCREIF (Unsmoothed)
        Public versus. Private Market
        Real Estate Valuation
Consider a 20-building portfolio with 2.5 million rentable square feet
                              Total Portfolio      $/square foot
Gross Rent                       $40.0 million     $16.00
Less amortized concessions (15%) 6.0               2.40
Effective Rent                    $34.0 million    $13.60
  Less: Stabilized Vacancy (15%)   5.1              2.04
 Less: Expenses (36.8%)           12.5               5.00
Net Operating Income (NOI)         $16.4 million     $6.56 psf
Public Company Valuation (PCV) -- an IPO

                                Total Portfolio   $ per Square ft
Stabilized NOI                   $16.4 M               $6.56 psf
 Less Management expenses (75 bp) $1.2                  $0.48
     Subtotal                     $15.2                 $6.08
Dividend Payout ratio 90%
Dividend Cash Flow                 $13.7               $5.48 psf
Estimated Dividend Yield Range
       7.50% to 9.00%
Implied PCV Range              $182.7 M                $73.08 psf
                                $152.2                  $60.88
Average Public MV              $167.4 M                $66.98 psf
  Private Market Valuation (PMV)

                            Total Portfolio   $ per Square
Stabilized NOI                  $16.4 M         $6.56/PSF
Estimated cap rate range:
        9.75% to 11.25%
Implied Private Market
 portfolio valuation          $168.2 M         $67.28/PSF
                              $145.8             $58.31

Average PMV                 $157.0 M          $62.80/PSF
      Public Vs. Private Market
      Valuation Differentials

                       Total Portfolio   $ per Square ft
Average Public MV       $167.4M              $66.96/PSF
Average Private MV      $157.0                 $62.80

Absolute Difference:
 Public - Private        $10.4M                $4.16/PSF
 Percentage              6.21%                  6.21%
    Public vs. Private Valuation Differentials:
    Some Possible Explanations

   ( 1) The Public market ascribes value to more than just the
    underlying property assets
       Other factors include company management and its ability to
        identify and create investment opportunities through active
        management of the real estate
   (2) The public market valuation includes a premium for
    share liquidity
   (3) Are REITs closed-end mutual funds or operating
       Closed-end mutual funds model suggest REIT shares will generally
        trade at values below their NAVs -- closed-end mutual fund
       The Operating Corporation model suggests that REITs shares will
        generally trade at values above their NAVs – growth opportunities.
        Accounting and Financial Disclosure
        Issues associated with REITs
   Like other economic units REITs have considerable latitude
    when accounting for their operations.
   Effects of tenant improvements and free rent on FFO:
         tenant improvements are depreciated over time

         so cost is currently incurred but recovered over time

         FFO will not reflect this cost

         compare cost per square foot for tenant improvement

          say three years before IPO an a year before IPO
              additional amount could represent attempt to boost
               occupancy rate to make IPO attractive to investors.
    Accounting and Financial Disclosure
   Capitalizing of leasing commissions
           these costs are included as depreciation or amortization
           thus FFO, a measure of REIT profitability, will not reflect
            these costs
   Uses of Straight-Line Rents:
           long term leases have stipulated increases (step-up leases)
           if revenue is based on “straight line” reported rent is
            averaged over life of lease
           reported FFO will therefore be higher than actual in earlier
            years and lower than actual in later years
    Accounting and Financial Disclosure

   Lease Guarantee:
         in some cases sponsor may guarantee the lease to

          prevent vacancy from occurring in what is known as
             master lease
          the sponsor takes the risk of leasing to other tenants
          helps the sponsor obtain credit for space providing no

       Why should investors worry?
          guarantee might be for a short period

          guarantee may not have recourse

          they might be guarantee fees to be paid by the REIT
    Accounting and Financial Disclosure

   FFO and income from managing other Properties:
           income from managing other properties not owned by REIT
            may increase FFO
           but the income may be more variable than income from
            underlying properties because of third party cancellation.
           thus many REIT security analysts assign a lower multiple to
            portion of FFO from management income.
   Types of mortgage debt and other Obligations:
           watch for participating mortgages
           they may improve earnings in early years by will affect
            future operating performance and depress earnings growth
    More Financial Disclosure Issues
   Existence of ground leases:
       what is a ground lease?
         fixed lease payment advantage
         disadvantage of giving up ownership

         how should you discount cash flow from buildings with

          approaching expiration date of ground lease?
   Lease Renewal Options:
         what are the terms, particularly the rent?

   “Leased space” versus “occupied space”:

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