Chapter 23 Real Estate Investment Trusts REITs 2014

Chapter 23: Real Estate Investment Trusts (REITs) © 2014 On. Course Learning. All Rights Reserved. 1

Way back in Chapter 1… Exhibit 1 -5: Major Types of Capital Asset Markets and Investment Products Public Private Markets: Equity Assets: Stocks REITs Mutual funds Real Property Private firms Oil & Gas Partnerships Debt Assets: Bonds MBS Money Bank loans Whole Mortgages Venture Debt instruments © 2014 On. Course Learning. All Rights Reserved. 2

Ch 23 intro… “Macro-level valuation” Valuation of aggregates of numerous individual properties, e. g. , portfolios, indices, funds, REITs… The spectrum of macro-level R. E. equity investment entities: Indirect investment in property, actively-managed entities. Direct, passive investment in property Static Portfolios, Indices Funds Unit Trusts LPs REITs REOCs Property-Level Valuation Entity-Level Valuation The valuation question… • Static portfolios (private assets) Value estimation (measurement). • REITs (publicly-traded assets) Value determination (causal). © 2014 On. Course Learning. All Rights Reserved. 3

23. 1: Introduction to REITs… What are Real Estate Investment Trusts? • Operating companies that own, develop and manage commercial real estate • Chartered as a corporation or business trust • Elective choice under tax code creates pass-through of income • Revenue must primarily come from real estate investments • Required to distribute at least 90 percent of their taxable income • Taxation of income is passed through to shareholder level © 2014 On. Course Learning. All Rights Reserved. 4

What Makes a REIT Different? • 75 percent of assets must be invested in: • Equity ownership of real property • Mortgages • Other REIT shares • Government securities and cash • 75 percent of revenue must come from: • Rents from real property • Mortgage interest • Gains from sales of real property © 2014 On. Course Learning. All Rights Reserved. 5

Exhibit 23 -2 (Section 23. 1) © 2014 On. Course Learning. All Rights Reserved. 6

Public REITs are … Like typical industrial/service/information companies traded on the stock exchanges, except: • Exempt from corporate income tax • Restricted to real estate investment related activities • Restrictions on “merchant building” • Must pay out 90% of earnings in dividends So REITs are “different animals” – somewhat passive (compared to other stocks), “pure plays” (in real estate). But also different from direct private market investment in real estate, as their equity is traded in the public stock exchange. This imparts some differences in risk & return behavior, as well as some lead/lag relationship in price discovery, caused purely by the differences in the functioning (and clienteles) across the two asset market arenas (private vs public). Creates liquidity. Enhances ownership by small passive investors w/out special expertise or knowledge. © 2014 On. Course Learning. All Rights Reserved. 7

Big-picture fundamentals in Ch 7 (sect. 7. 1. 3)… Exhibit 7 -1: UNDERLYING ASSETS vs INVESTMENT PRODUCTS, an Example from traditional corporate finance: Underl. Asset: ABC Widgets Corporation (Collection of Physical, Human, & Legal Assets & Relationships) Invest. Products: Invest. Product: Call Options on ABC Stock (Contingent claims) - High Risk - High Total Return - Zero Cur. Yield Invest. Products: ABC Common Stock (Subordinated claims) - Moderate Risk - Moderate Total Return - Low Cur. Yield ABC Corporate Bonds (Senior claims) - Low Risk - Low Total Return - High Cur. Yield Various Mutual Funds (owning various different types of claims on ABC & other assets) - Various Risk, Return, & Cur. Yield Configurations © 2014 On. Course Learning. All Rights Reserved. 8

Underlying assets directly traded in a well functioning asset market… Exhibit 7 -2: A REAL ESTATE EXAMPLE of the Investment System Underl. Asset: (Priv. Traded) "Bricks & Mortar" (e. g. , Grump Family Shopping Centers) (Rent-producing Real Properties ) Private Invest. Products: e. g. , Ltd Partnerships (or CREFs, Priv. REITs, etc) Own equtiy in properties: LP Shares (units) privately held & privately traded if at all Public Invest. Products: Investors: individual, institutional REITs “UPREIT” Owns LP Units, Issues publicly traded shares. (May also directly own Underl. Asset, or Mortgs & CMBS) Small & Large Investors Commercial Mortgages Senior (debt) claims: Privately held & traded ("whole loans") CMBS publicly traded securities based on a pool of mortgs Large Investors (Wealthy Individuals, Developers, Institutions) © 2014 On. Course Learning. All Rights Reserved. Small & Large Investors 9

The “UPREIT” Public Investors (Stockholders) Private Investors (Partnership Unit-holders) Structure REIT Umbrella Partnership (“Operating Partnership”: OP) Property Partnership Property © 2014 On. Course Learning. All Rights Reserved. 10

23. 1. 1: Tax Status & Regulatory Constraints… To retain REIT tax status (dividends deductible from corporate taxable income), REITs must continually pass 4 tests: 1. Ownership Test: “Five or Fewer Rule. ” REIT cannot be a closely held corporation: no five or fewer individuals may own more than 50% of REIT’s stock, and there must be at least 100 different shareholders. (“Look-Through Provision” enacted 1993: pension funds not limited by the five-or-fewer rule. ) 2. Asset Test: >= 75% of a REIT’s total assets must be real estate, mortgages, cash, or federal government securities, and 75% or more of the REIT’s yearly gross income must be derived directly or indirectly from real property (including mortgages, partnerships, and other REITs). No more than 20% of its assets can consist of stock of a Taxable REIT Subsidiry (TRS). 3. Income Test: >= 75% of income from primarily passive sources like rents and mortgage interest. Cannot be “merchant builders” developing properties for quick sale, or flipping properties. Property sales must obey: held for at least four years and the aggregate adjusted basis of the property sold per year does not exceed 10% of the aggregate basis of all assets of the REIT as of the beginning of the year. 4. Distribution Test: At least 90% of a REIT’s annual taxable net income must be distributed to shareholders as dividends each year. © 2014 On. Course Learning. All Rights Reserved. 11

Exhibit 23 -4: © 2014 On. Course Learning. All Rights Reserved. 12

Historical growth of the REIT industry (“Modern REIT Era” dates from 1990 s)… 23. 1. 2 The 1990 s REIT Boom and Modern REIT Era EXHIBIT 23 -3 Size of U. S. Equity REIT Sector, 1985– 2011 Source: Based on data from the National Association of Real Estate Investment Trusts (NAREIT). © 2014 On. Course Learning. All Rights Reserved. 13

Magnitude of REIT market… Based on equity REITs only. © 2014 On. Course Learning. All Rights Reserved. 14

Magnitude of REITs in private CRE market… Exhibit 7 -3: These shares are probably a bit larger by now. © 2014 On. Course Learning. All Rights Reserved. 15

Magnitude of REITs in private CRE market… Exhibit 23 -1: © 2014 On. Course Learning. All Rights Reserved. 16

REIT Investors… e. g. , Green Street Cohen-Steers Vanguard Etc… Yield-oriented Value-oriented Small-Mid cap Note: This mix has varied considerably in recent years. Recall: Different types of investors have different objectives, constraints, concerns, horizons, income-vs-growth preferences, risk preferences, etc… © 2014 On. Course Learning. All Rights Reserved. 17

REIT stock mkt performance in the “Modern REIT Era” (1990 -2011)… Overall good record but particularly big hit in Financial Crisis. © 2014 On. Course Learning. All Rights Reserved. 18

REITs are a major component of the Small-Cap Value group of stocks… (May benefit some from “Fama-French Factors”? . . . ) 1990 -2011: Particularly big hit in Financial Crisis, but good recovery since. © 2014 On. Course Learning. All Rights Reserved. 19

23. 2 REIT Analysis & Valuation REIT shares are valued in the same way as other public equities, but with a twist because of the unique Real Estate asset base … • Dividend Discount or DCF Models Share price equals PV of expected future dividends • Earnings Multiple Shortcuts to DCF Share price equals a multiple of REIT earnings/cash flow REITs viewed as operating companies like other publiclytraded firms • Premium to Net Asset Value (NAV) of a REIT’s Properties Build an estimate of public REIT equity value starting with the private mkt value public private of a REIT’s assets in place, then adjust for growth opps and other factors. Share price equals a “warranted” premium (or discount) to REIT NAV The three approaches are certainly related, but may at times provide different indications of value, depending on the general economic environment as well as conditions in the public stock and bond markets, and the private real estate market. © 2014 On. Course Learning. All Rights Reserved. 20

23. 2: REIT Analysis & Valuation It’s all about valuation, and fundamentally there are two ways to value a REIT: 1. As a collection of assets; 2. As a stream of cash flows. Property acquisition requires consideration from both perspectives. © 2014 On. Course Learning. All Rights Reserved. 21

23. 2. 1: REIT Earnings Measures. Exhibit 23 -5: *Direct property EBTCF is not directly available to a passive investor, whereas REIT AFFO is. EXHIBIT 23 -5 Widely Used Direct Property vs. REIT Income Measures © 2014 On. Course Learning. All Rights Reserved. 22

Widely Used Direct Property vs REIT Income Measures PGI “straight-lined” in GAAP accrual accounting used by REITs, not cash flow. OE includes prop mgt & other items that may be profit centers for some REITs “FFO” typically excludes “extraordinary” items such as major asset sales. “Also adjust for other noncash-flow effects such as rent straight-lining. *Direct property EBTCF is not directly available to a passive investor, whereas REIT AFFO is. EXHIBIT 23 -5 Widely Used Direct Property vs. REIT Income Measures © 2014 On. Course Learning. All Rights Reserved. 23

On avg REITs pay out 73% of FFO in dividends. Lately a bit less… © 2014 On. Course Learning. All Rights Reserved. 24

23. 2. 1 REIT Earnings Measures The Problem: How to compare REIT earnings with those of other corporations (e. g. , so as to compare share price/earnings multiples on an “apples vs apples” basis. • Real estate investment & ownership (the “REIT business”) is very capital intensive: • REITs have abnormally high depreciation expenses, which reduce “official earnings” (GAAP net income), the standard measure of corporate earnings on Wall Street. • Yet REIT assets do not actually depreciate in the sense that “samestore” property cash flows and values typically do not decline in nominal terms (because the real depreciation rate in property is typically matched or even exceeded by the general monetary inflation rate). Hence (so the argument goes): GAAP earnings don’t present a “fair” or “accurate” measure of REIT earnings. © 2014 On. Course Learning. All Rights Reserved. 25

In the early 1990 s, the REIT industry (through NAREIT) came up with an alternative measure of earnings that the industry tried to promulgate as a substitute for GAAP net income for the REIT industry: “Funds From Operations” FFO (“Funds From Operations”) Start with GAAP net income, then Add back: Real property depreciation expense. Add back: Preferred stock dividends and distributions to OP unit- holders. Deduct: Net gains from property sales & extraordinary items. FFO ≈ Aggregate (i. e. firm level) NOI - interest © 2014 On. Course Learning. All Rights Reserved. 26

This was further supplemented by another measure that more closely reflected cash flow actually available for external distribution: “Adjusted Funds From Operations” AFFO (“Adjusted Funds from Operation”) – aka “Funds Available for Distritution (FAD) Start with FFO, then: Deduct: Recurring capital improvement expenditures (CI). Adjust for: Straight-line rents. Deduct: Amortization of debt principle (AMORT). AFFO ≈ Aggregate (i. e. firm level) EBTCF Terminology Alert! In common parlance it is often not clear exactly what measure is being referred to when people use the terms “FFO” and “AFFO”. © 2014 On. Course Learning. All Rights Reserved. 27

FFO is often spoken of as the analogy at the REIT level of the “NOI” at the property level. But what is an important difference between these two measures of earnings? FFO is a firm-level measure that is net of interest payments on the REIT’s debt. NOI is a property-level measure that is free and clear of debt. AFFO is the firm-level analog to the EBTCF (Equity Before-Tax Cash Flow) measure at the property level. Typical P/E ratios based on AFFO have varied between 8 and 12 in recent years for most REITs, while dividend yields have averaged 6% to 8%. A simple (and somewhat simplistic) method of REIT valuation of a property acquisition would be to compare the property price / EBTCF multiple (based on the REIT’s target capital structure debt applied to the property) with the REIT’s current stock market share price/earnings multiple based on AFFO. If the latter exceeds the former, the acquisition may seem feasible (and/or “accretive” if the REIT multiple exceeds the property multiple). However, you are more sophisticated than this simplistic approach, aren’t you! © 2014 On. Course Learning. All Rights Reserved. 28

Problems with FFO, AFFO, etc. , The principle underlying “The FFO Movement” is valid: Cash flow matters more than accounting numbers. However, in practice several problems arose with the use of FFO: • The REIT industry could never agree on a single, mandatory standard definition of how to define and measure FFO (or AFFO, or any of the other cash-oriented earnings measures). • There arose a profusion of different measures and definitions, with each REIT tending to customize its own measure (e. g. , REITs that made substantial money from property sales didn’t like FFO’s removal of extraordinary earnings due to asset sales; they said their “operations” included “asset sales”). • There was a substantial loss in credibility (based perhaps more on perception than reality), which was exacerbated with the general corporate “Pro-Forma Earnings Scandal” of the early 2000 s, associated with the stock market crash. For all its faults, GAAP net income has the one great advantage that it is uniformly and precisely defined, the same for everyone. © 2014 On. Course Learning. All Rights Reserved. 29

23. 2. 2 Valuing REITs as a Stream of Cash Flows: the Gordon Growth Model The Stock market is highly integrated. REIT equity shares are traded in the stock market. So REITs are valued essentially like other stocks (DCF, Ch. 10): DIV = Annual entity (firm) level equity cash flow to stockholders (“Dividends”). r = Stock Mkt’s required ex ante total return to firm-level equity (REIT’s avg equity cost of capital “COE”). PV = Value of REIT’s equity (per share stock price). More common short-cut is: Based on constant-growth perpetuity math formula. Analogous to “cap rate” in RE, “Direct Capitalization” method of property valuation. “Gordon Growth Model” (GGM) (Based on forward-looking long-run average r and g. ) g* = Long-run avg future growth rate in dividends. © 2014 On. Course Learning. All Rights Reserved. 30

GGM REIT Value = f ( DIV 1 , g* , r ). Based on three values. DIV 1 PBTCF – DS – G&A – plowback (holdings & sales, less plowback) = EBTCF – G&A – plowback = AFFO – plowback : • Analyze firm’s current property operations & financing. • Firm can temporarily pay out more cash than it earns from operations by the use of sales of its assets or by the use of financing techniques, but GGM requires longrun average values (avoid or stabilize “extraordinary” sources of dividends). g* r is very important ( 1 pt Δg* > ≈ 20% ΔPV ). Reflects: • LR growth in EBTCF (sustainable “same store growth”(as levered) + “plowback”). • LR ability of REIT mgt to generate “growth opportunities” (NPV>0 projects). This is the toughest part (and why we add the * to the g). = Firm’s avg equity OCC = rf + RP = y + g* , in the firm’s equity: Based on Stock Mkt’s perception & evaluation of firm-level risk. Two major traditional approaches to estimate E[RP]: CAPM & GGM. (Best applied to a class or type of stocks, adjust for subj firm’s leverage. ) Most volatility in REIT prices due to changes in mkt expectns about g* & r. © 2014 On. Course Learning. All Rights Reserved. 31

Also requires serious consideration of required return… GGM REIT Value = f ( DIV 1 , g* , r ). Based on three values. DIV 1 PBTCF – DS – G&A – plowback (holdings & sales, less plowback) = EBTCF – G&A – plowback = AFFO – plowback : • Analyze firm’s current property operations & financing. • Firm can temporarily pay out more cash than it earns from operations by the use of sales of its assets or by the use of financing techniques, but GGM requires longrun average values (avoid or stabilize “extraordinary” sources of dividends). g* r is very important ( 1 pt Δg* > ≈ 20% ΔPV ). Reflects: • LR growth in EBTCF (sustainable “same store growth”(as levered) + “plowback”). • LR ability of REIT mgt to generate “growth opportunities” (NPV>0 projects). This is the toughest part (and why we add the * to the g). = Firm’s avg equity OCC = rf + RP = y + g* , in the firm’s equity: Based on Stock Mkt’s perception & evaluation of firm-level risk. Two major traditional approaches to estimate E[RP]: 3 -Factor CAPM & GGM. Fama-French 3 -factor may enhance Can be tautological; CAPM better theoretically. (Best applied to a class or type of stocks, adjust for subj firm’s leverage. ) Most volatility in REIT prices due to changes in mkt expectns about g* & r. © 2014 On. Course Learning. All Rights Reserved. 32

22. 4 The simple 1 -factor CAPM has trouble empirically within asset classes. Fama-French: CAPM by itself doesn’t work very well within the stock market: Recall from Ch. 22… REITs tend to have high B/M (“HML”), low Beta. Cross-sectionally, P/NAV ≈ M/B: Low P/NAV (high HML) high return. Enhance the basic model with additional factors that are more “tangible” than beta: (i) Stock’s Size (mkt cap), & (ii) Stock’s Book/Market Value Ratio. The market apparently associates these with “risk”. © 2014 On. Course Learning. All Rights Reserved. 33

GGM shortcut may be applied to earnings rather than to dividends. And earnings may be defined in various ways: (GAAP, FFO, AFFO, …) g = Long-run growth rate in dividends per share (includes effect of “plowback”). g. E = Long-run growth rate in earnings (AFFO) of pre-existing (“same-store”) assets. DIV 1 = (1 -p)AFFO 1 = (1 -p)y. EPV 0, where p is the “plowback ratio”, and : y. E = equity income yield from firm’s underlying asset equity [=AFFO/PV, or @ property level ≈ EBTCF/(V-D)], PV 0 = firm’s underlying asset equity value at the beginning of Year 1. Then: DIV 2 = (1 -p)y. EPV 1 = (1 -p)y. E[(1+g. E)PV 0 + py. EPV 0] = (1 -p)y. E(1+g. E+py. E)PV 0 = (1+g. E+py. E)DIV 1. g = g. E + py. E , g. E = g – py. E. Note: For a REIT, in the absence of growth opportunities (all acquisitions @ NPV=0), PV 0 is essentially based only on the firm’s assets in place, and y. E is the current equity yield of those assets. Thus, g. E is essentially the long -run growth rate in“same store” earnings (same-store EBTCF as levered). © 2014 On. Course Learning. All Rights Reserved. 34

Analysis Tip: The GGM can be applied either to dividends or to earnings: The firm’s equity OCC ( r ) is the same*, but you have to be careful about the relevant growth rate in the denominator: • g = Long-run growth rate in dividends per share (includes effect of “plowback”). • g. E = Long-run growth rate in pre-existing assets’ earnings per share (for REITs, usually growth rate in levered “same store” earnings, over the long run). Note: g. E = g – py. E , where p = Plowback Ratio (fraction of earnings retained for reinvestment, not paid out as dividends: p = 1 – (DIV / AFFO ). Thus, normally: g > g. E. DIV 1 = (1 -p)AFFO 1 = (1 -p)y. EE 0, where p is the “plowback ratio”, and : y. E = equity income yield from firm’s underlying asset equity [=AFFO/E, or @ property level ≈ EBTCF/(V-D)], E 0 = firm’s underlying asset equity value at the beginning of Year 1. Then: DIV 2 = (1 -p)y. EE 1 = (1 -p)y. E[(1+g. E)E 0 + py. EE 0] = (1 -p)y. E(1+g. E+py. E)E 0 = (1+g. E+py. E)DIV 1. g = g. E + py. E , g. E = g – py. E. Note: For a REIT, in the absence of growth opportunities (all acquisitions @ NPV=0), E 0 is essentially based only on the firm’s assets in place, and y. E is the current equity yield of those assets. Thus, g. E is essentially the long-run growth rate in“same store” earnings (EBTCF as levered). Reality Check: In long run (in absence of NPV > 0 growth opportunities): High Price/Earnings Ratio Either low r, or high same-store levered g. E. How sustainable is a low r? ; How realistic is a high same-store levered g. E? ; Where does NPV > 0 come from? © 2014 On. Course Learning. All Rights Reserved. 35

Recall… g is very important ( 1 pt Δg > ≈ 10% ΔE ). Reflects: • LR growth in EBTCF (sustainable “same store growth” + “plowback”). • LR ability of REIT mgt to generate “growth opportunities” (NPV>0 projects). Same store growth (existing property cash flow growth) is pretty mundane: • Easy to quantify, Easy to predict, • Usually not very exciting (R. E. “bricks & mortar” are “cash cows”, not “growth stars”, though use of leverage can make more exciting). Plowback (NPV=0 acquisition of assets) is more uncertain: • How long can firm find new acquisitions at NPV=0? • But analyst can “short-cut” around this question by using AFFO version of GGM. Growth opportunities (NPV>0 actions) is the more interesting source of g : • More uncertain & difficult to predict (how realistic? , How sustainable? ), • More volatility in mkt expectns about magnitude of NPV>0 opportunities. Growth opportunities: Micro (property) level: Buy Low or Sell High Deals; “Arbitrage” betw publ & priv mkts; Entrepreneurial/Innovative Devlopment; Creative Mgt of Operations. Macro (firm) level: Economies of Scale; Franchise Value; Rental Mkt Dominance; etc. © 2014 On. Course Learning. All Rights Reserved. 36

Consider a basic challenge facing REITs… • REITs tend to be “value stocks”, not “growth stocks”. • But stock mkt is “Land of Growth”, penalizes value stocks (like REITs). • This may be good for REIT investors (high returns), but it is tough for REIT managers (low stock valuations, high cost of equity capital). • Fundamental challenge is REITs are real estate, and real estate is “cash cows”, not growth plays. Real estate assets (including land) trade in well-functioning markets (private prop mkt), making NPV > 0 hard to find. • How can REITs play in the “growth show” that is the stock mkt arena? . . . • Consider three ways REITs can grow share price… © 2014 On. Course Learning. All Rights Reserved. 37

Three ways REITs can grow price/share… 1. Leverage… 2. Plowback… 3. Positive NPV acquisitions… © 2014 On. Course Learning. All Rights Reserved. 38

Leverage… Recall from fall course (Ch 13, basics of leverage) that leverage typically skews the equity return components relatively away from income and towards growth. Consider effect of leverage on static portfolio of assets (pre-existing, “same store” assets)… Suppose assets produce $50/yr net cash flow, growing @ 2%/yr, and OCC (req’d return unlevered) is 7%. Then portf of assets worth 50/(. 07 –. 02) = $1000. (Note: Inflation might be 3%/yr; property depreciates in real terms 1%/yr…) © 2014 On. Course Learning. All Rights Reserved. 39

Leverage… Now suppose REIT applies leverage of 50%. . . REIT has $500 equity, $500 debt (IO). Suppose debt interest rate = 5%/yr: $25/yr. As levered, “same-store” REIT returns are (apply WACC inverted to solve for equity): • Total return: r. E = r. D + (r. P – r. D)LR = 5%+(7%-5%)2 = 9% • Growth: g. E = g. D + (g. P – g. D)LR = 0%+(2%-0%)2 = 4% • Same-store cash flow yield rate is: y. E = 9% – 4% = 5%. Leverage applied to same-store assets gives REIT 4%/yr growth instead of 2% w/out levg. REIT net cash flow (“FAD” or “AFFO”) is $50 – $25 = $25/yr. © 2014 On. Course Learning. All Rights Reserved. 40

Plowback… Now consider effect of “plowback” (retained earnings). REIT net cash flow (“FAD” or “AFFO”) is $50 – $25 = $25/yr. Suppose REIT retains 20%, pays $20 dividends: Dividend yield is 4% (not 5% cash yld rate of assets). Reinvests $5, combined w $5 new debt (keep D/E ratio)… Asset holdings from last year to now: • $1000 grew to $1020 (2%). Allows $20 new debt (keep D/E). • Reinvest new debt + plowback = $30, assets now $1050. • Debt is now $525, so equity is now $525. © 2014 On. Course Learning. All Rights Reserved. 41

Plowback… REIT equity has grown from $500 to $525: 5% growth rate. No new shares have been issued, so: • • • REIT yield = 4% (= $20 divs / $500 starting equity). REIT growth = 5% (= (525 -500)/500. ) REIT total return = 4% + 5% = 9%. No “free lunch”, 9% is fair return, =OCC, given risk. Changing plowback does not change share price (only growth rate), as long as NPV=0 (Modigliani-Miller, GM book p. 600 -601). Effect of plowback adds 1%/yr of growth (subtracts 1% from yield). (This on top of effect of leverage: added 2% to growth without affecting yield so added 2% to total return, due to increased risk (RP +2%)) © 2014 On. Course Learning. All Rights Reserved. 42

Leverage & Plowback… In this example (typical): Leverage adds 2% to growth without affecting yield so adds 2% to total return, due to increased risk ( r = rf + RP, RP increased 2%). Plowback adds 1%/yr of growth (subtracts 1% from yield), doesn’t affect OCC or PV. REIT share price (& dividends) now growing @ 5%/yr while its properties (& their cash flow) are only growing @ 2%/yr same-store (less than 3% inflation). All this with only NPV = 0. No new shares issued. No NPV <> 0 acquisitions. REIT Price/Earnings = Eq/AFFO = 500/25 = 20. (Approx same as levered same-store assets Eq/EBTCF). © 2014 On. Course Learning. All Rights Reserved. 43

Leverage & Plowback… REIT can also grow in scale (mkt capitalization) by issuing new shares or increasing D/E ratio. But increasing debt will increase equity risk. Issuing new shares adds to the “float” (number of shares outstanding), but does not in itself change the price/share, assuming only NPV=0 investments. Neither adding equity nor adding debt will by themselves change share price in absence of NPV <> 0 investment. No change in P/E. (Modigliani-Miller) (Possible exception: if scale itself adds value? . . . Then NPV > 0. ) Or other “special effects: signaling? Or COFD if they borrow too much? . . . 44

Third source of share price growth: Positive NPV acquisitions, or entity-level value addition… Typical sources of “growth opportunities” (NPV > 0) in REITs (if any): · Developable land already owned. · Entrepreneurial abilities (in devlpt, or possibly other activities). · Macro-level abilities (scale economies? , franchise value? , econ of scope? . . . ). · Differential property asset valuation in stock vs private property markets. Any of these may be like “call options” (or “real options”). Add value (PV) to the stock, w/out providing earnings (currently). In our example, Price/Earnings > 20. © 2014 On. Course Learning. All Rights Reserved. 45

These three sources of share price growth must (mathematically) account for the difference in growth between REITs and direct private property price appreciation (same-property)… REITs: 7%/yr Property: 4%/yr CAVEAT: These two graphs are a little bit “apples vs oranges”, as the types of properties held by REITs differ a bit from those held by pension fu nds in the NCREIF index (but they are similar). © 2014 On. Course Learning. All Rights Reserved. 46

REITs also have generally provided cash yields at least as high as direct private property (though again: this may partly be apples-vs-oranges in terms of types of properties)… REITs: 8%/yr Property: 6%/yr This can occur in principle by the use of leverage that is “positive” in the yield (cash pmt rate on the debt is lower than equity yield rate in the underlying properties, e. g. , int-only dbt with int rate < cap rate – capex/Val in properties: y. D < y. P). Or maybe REITs are more effective at property mgt, or purchase properties at higher © 2014 On. Course Learning. All Rights Reserved. 47

Fundamental Growth Opportunities Are REITs growth stocks or income stocks? Beneficial of Boston (BOB): An “income REIT”… Owns properties that pay $100 million / yr, in perpetuity, no debt. OCC = r = 10%; g = 0. Using GGM, BOB’s equity is worth: © 2014 On. Course Learning. All Rights Reserved. 48

Sioux Realty (Sioux): A “growth REIT”… Sioux owns stabilized operating properties like BOB’s that pay $50 million / yr in perpetuity, no debt, plus: Land on which a completed project worth $3000 million in one year can be built, at a cost of $2400 million construction. Due to the risk in this development project (note the operational leverage), the OCC for this project is 20%. Thus, Sioux’s value is: © 2014 On. Course Learning. All Rights Reserved. 49

BOB’s and Sioux’s Price/Earnings multiples are: If they pay out all their income as dividends, what are the current yields of these two REITs? Answer: BOB yield = 10%, Sioux yield = 5%. Why is Sioux a “growth REIT”? Is it because Sioux “does development projects”? Suppose Sioux did not already own the land (and were similar to the “second best developer” on the site)? © 2014 On. Course Learning. All Rights Reserved. 50

Growth stocks have positive NPV opportunities. Value of Firm = Value of Existing Assets in Place (less debt) Equity (E) + Net Value of Growth Opportunities Value of assets in place less debt Collapsing it into the GGM framework: g* is larger than g without growth opportunities. NPV >0 growth opps. result in high REIT price to earnings multiples … © 2014 On. Course Learning. All Rights Reserved. 51

Typical sources of growth (NPV > 0) opportunities in REITs (if any): · Developable land already owned. · Entrepreneurial abilities (in devlpt, or possibly other activities). · Macro-level abilities (scale economies? , franchise value? , econ of scope? ). · Differential property asset valuation in stock vs private property markets. “Most REITs are not growth stocks most of the time, but some REITs are growth stocks most of the time, and most REITs are growth stocks some of the time. ” Last case is possible because of… © 2014 On. Course Learning. All Rights Reserved. 52

23. 2. 3: Valuing REITs as Collections of Assets: NAV-Based Valuation What is REIT “NAV” ? Net Asset Value = REIT Assets Value (as valued in property market *) – REIT Liabilities** ÷ No. Shares Outstanding * As estimated by REIT analyst, e. g. : “mass appraisal”: • Divide REIT holdings into major market segments (e. g. , Offices in Boston, Warehouses in Chicago); • Identify NOI (like EBITDA) associated with each segment; • Estimate current property mkt prevailing “cap rates” in each segment; • Apply estimated cap rates to estimated NOI to estimate asset value in each segment. • Add and adjust for: (i) Land holdings & construction in progress; (ii) Non-assetbased earnings (e. g. , prop. mgt fees) using estimated P/E ratio. ** Theoretically should be market value of debt (often book value used in practice). Comparison of resulting NAV with the stock mkt based share price: Stock Mkt / Property Mkt Valuation Differential, Stock Value – NAV = NPV of REIT Growth Opportunities (as valued by the stock mkt); &/or… Errors or omissions in the NAV estimation process. 53

23. 2. 4 REIT Public/Private Arbitrage: Public versus Private Market Pricing of Real Estate Equity … REIT Share Price Premium to NAV © 2014 On. Course Learning. All Rights Reserved. 54

23. 2. 4 REIT Public/Private Arbitrage: The point is. . . • REIT-based valuations & private property mkt-based valuations appear to be different much of the time. • These differences do not appear to be explainable by differences in the underlying operating cash flows of the REITs vs the private properties; nor are they explainable entirely by purely firm-level considerations (e. g. , debt financing, entity-level mgt, trading, etc. ). • Thus, at least part of these differences appear to be micro-level valuation differences, differences in the two markets’ perceptions of the values of the same underlying properties as of the same point in time (“micro-level” = “bricks & mortar”, underlying assets as opposed to firm-level effects). • There is some evidence that REIT valuations tend to be a bit more volatile, and to lead the private property market valuations in time (based on timing of major cyclical turning points, the lead may be up to 3 years. ) © 2014 On. Course Learning. All Rights Reserved. 55

Another perspective on this same point (from Chapter 12) Exhibit 12 -3: Equity REIUT Share Prices Versus Private Property Net Asset Values (NAVs) © 2014 On. Course Learning. All Rights Reserved. 56

Two types of micro-level valuation differences: Longitudinal & Cross-sectional Longitudinal (across time) difference: • REIT mkt in aggregate leads private market in aggregate (not perfectly, but…): • Info flows from Public Private (mkt as whole) (Public mkt more informationally “efficient”. ) Cross-sectional (across REITs) difference: • Private Mkt NAVs contain information (again, not perfect, but…) • Low P/NAV REITs tend to rise, & vice versa. (Public mkt tends to “tar all with same brush”. ) • Info can flow from Private Public (specific REITs, based on asset holdings) © 2014 On. Course Learning. All Rights Reserved. 57

Regarding the longitudinal (aggregate) relationship: • Traditional wisdom (and historical evidence) suggests REITs lead Private (REIT Private). • But 2001 -04 period indicated greater contemporaneous link, possibly followed by a disconnect as private equity may have “bubbled” (2004 -07). • Closer linkage betw the two mkts may be related to REITs owning a larger share of properties in many mkt segments, such that private investors in the direct property market are more influenced by REIT capital. • REIT fall in 2007 preceded that in the private market by only a few months, but was swifter and sharper. • Private mkt derivatives pricing (NCREIF swaps, CMBX) was consistent with (and nearly contemporaneous with) REIT share fall. © 2014 On. Course Learning. All Rights Reserved. 58

If Public Private, then: • Public > Private when values are rising; • Private > Public when values are falling. © 2014 On. Course Learning. All Rights Reserved. 59

Two types of micro-level valuation differences: Longitudinal & Cross-sectional Longitudinal (across time) difference: • REIT mkt in aggregate leads private market in aggregate (not perfectly, but…): • Info flows from Public Private (mkt as whole) (Public mkt more informationally “efficient”. ) Cross-sectional (across REITs) difference: • Private Mkt NAVs contain information (again, not perfect, but…) • Low P/NAV REITs tend to rise, & vice versa. (Public mkt tends to “tar all with same brush”. ) • Info can flow from Private Public (specific REITs, based on asset holdings) © 2014 On. Course Learning. All Rights Reserved. 60

Third source of share price growth: Positive NPV acquisitions (or entity-level value addition)… Typical sources of “growth opportunities” (NPV > 0) in REITs (if any): · Developable land already owned. · Entrepreneurial abilities (in devlpt, or possibly other activities). · Macro-level abilities (scale economies? , franchise value? , econ of scope? . . . ). · Differential property asset valuation in stock vs private property markets. These may be like “call options” (or “real options”). Add value (PV) to the stock, w/out providing earnings (currently). In our example, Price/Earnings > 20. © 2014 On. Course Learning. All Rights Reserved. 61

When REIT valuation > Private valuation (positive REIT premium to NAV): • REITs have growth opportunities (NPV>0, “accretion”) from buying in the private market. • REITs raise capital by issuing stock in the public mkt, use proceeds to buy properties. When REIT valuation < Private valuation (negative REIT premium to NAV): • REITs are no longer “growth stocks”, and their shares are re-priced accordingly in the stock market (price/earnings multiples fall, REITs are priced like “value stocks”, or “income stocks”). • In the extreme, REITs may become “shrinking stocks”, maximizing shareholder value by selling off property equity (or debt) and paying out proceeds in dividends. The 2 mkts swing between these 2 conditions, also with periods when they are nearly equal valued. Little “arbitrage trading” occurs when the 2 mkts are within 5%-10% of each other’s valuations (due to transaction costs, firm-level effects). Arbitrage trading tends to keep valuation differences to less than 15%20%, but occasionally greater differences have briefly occurred. © 2014 On. Course Learning. All Rights Reserved. 62

How can a REIT “remain a public REIT in business”, and still maximize shareholder value during times when the stock market valuation of real estate is less than the private property market valuation? IVREIT < MVPRIV • Sell into the private market most but not all of the equity in many of their properties (e. g. , sell properties into a partnership controlled by the REIT, with passive equity partners), paying out proceeds in extraordinary dividends (or stock purchases), while retaining effective operational control over the assets (e. g. , sell to passive partners, such as pension funds): REIT retains scale & operational product. • Issue secured debt (mortgages) collateralized by the excess of MVPRIV over IVREIT , paying out proceeds as extraordinary dividends. ( Risky. ) • Sell some of their properties outright into the private market (paying proceeds as dividends or stock purchase), but subject to contracts to retain the REIT as property manager (TRS). • If private market valuations are sufficiently high (and expected to remain so), consider going into development projects with most financing coming from external private equity and debt sources: Use the REIT’s entrepreneurial capability; Use developable land already owned; Maximize leverage of private market valuation. (Note: Though tempting, this strategy is risky at the peak of a private market cycle. ) • Reinvest proceeds from domestic private market sales into international real estate assets where valuations are lower (yields are higher). © 2014 On. Course Learning. All Rights Reserved. 63

23. 3 Some Considerations of REIT Management Strategy The traditional real estate cliché about the “ 3 determinants of value”: “Location, location”. The modern REIT cliché about the “ 3 determinants of value”: “Management, management”. Six major strategies or strategic considerations… 1) Financial strategy: “Caught between a rock and a hard place”… - REITs don’t have traditional C-corp income tax-based rationale for use of debt financing. But REITs often need external capital (R. E. is capital-intensive, and REITs must pay out 90% of earnings). Various considerations enter the REIT capital structure equation: · Stock market wants growth; · Real estate is not a growth asset without lots of leverage (maximized by short-term or floating-rate debt); · Stock market doesn’t like REITs to be highly levered (especially with shortterm or floating-rate debt). Solution: walk the tightrope carefully. © 2014 On. Course Learning. All Rights Reserved. 64

23. 3 Some REIT Strategic Management Considerations (cont. ) 2) Specialize (know your market): · Be a “residential REIT” or a “retail REIT”, etc… · Sometimes some combinations are “OK” (e. g. , office & industrial) · Geographical specialization is “less cool” (you gotta get scale economies somehow!) 3) Build “franchise value” (brand name recognition? ): ·Improve tenant service with increased geographical and product scope. 4) Consider “vertical integration”: ·Land, Devlpt, Asset ownership, Property Mgt, Leasing, Tenant Svcs (logistics, communications, etc), Information (databank); ·Allows REIT to ride through periods when stock market undervalues real estate assets relative to the property market (sell most asset ownership into property market, retain control and ancillary functions, possibly develop new buildings); ·During periods of low property market asset valuation relative to the stock market, buy existing properties and bank buildable land). © 2014 On. Course Learning. All Rights Reserved. 65

23. 3 Some REIT Strategic Management Considerations (cont. ) 5) Take advantage of Economies of Scale (such as they are): · Are there scale economies in REIT administrative costs? … · Are there scale economies in REIT capital costs? … · Where are the limits of such economies? … · Are there economies of scope in REIT service provision? … 6) Try to develop some market power (“monopoly control”) in local space markets: · Buy (or build) most of the space of a given type in a given local submarket; · But beware, rare is the submarket that has no potential close substitute in the same metro area. © 2014 On. Course Learning. All Rights Reserved. 66

REIT consolidation (to gain scale economies)… © 2014 On. Course Learning. All Rights Reserved. 67

23. 4 Some REIT investor considerations… 1) Choosing between public (REIT) versus private (direct property) investment in real estate… · Direct investment in private R. E. has problems regarding illiquidity, need for active management and specialized local expertise, and lumpy scale (capital constraints). · But REITs provide less diversification in a stock-dominated portfolio, and have more volatile, less-predictable returns. Small investors without specialized expertise should probably stick with REITs. Large investors or those with specialized expertise can benefit from direct private investment (albeit also with some REIT investment for tactical or strategic portfolio management). © 2014 On. Course Learning. All Rights Reserved. 68

23. 4 Some REIT investor considerations… 2) REIT behavior in the stock market… · On average REITs tend to be high-yield, low-beta stocks ( 0. 5, typically a small-to-mid cap value stock); · REITs tend to exhibit higher beta during market downswings than during upswings ( 0. 8 in down-markets, 0. 3 in up-markets – typical of value stocks); · REITs may be useful as a tactical tool for taking advantage of asset market cycles in the private property market (which is more predictable than the stock market). © 2014 On. Course Learning. All Rights Reserved. 69

Exh. 23 -8: Correlation of Equity REIT Returns with Common Stock Returns (60 month moving average) © 2014 On. Course Learning. All Rights Reserved. 70

REIT Acquistion Evaluation: Recall from Chapter 12 (sect. 12. 3. 3)… Using WACC to avoid a common mistake. . . The "Weighted Average Cost of Capital" (WACC) Formula. . . r. P = (L/V)r. D + [1 -(L/V)]r. E Suppose REIT A can borrow @ 6%, and REIT B @ no less than 8%. Then doesn’t REIT A have a lower cost of capital than REIT B? Answer: Not necessarily. Suppose (for example): REIT A: D/E = 3/7. D/V = L/V = 30%. REIT B: D/E = 1. D/V = L/V = 50%. & suppose both A & B have cost of equity = E[r. E] = 15%. Then: WACC(A) =(0. 3)6% + (0. 7)15% = 1. 8% + 10. 5% = 12. 3% WACC(B) =(0. 5)8% + (0. 5)15% = 4% + 7. 5% = 11. 5% So in this example REIT A has a higher cost of capital than B, even though A can borrow at a lower rate. (Note, this same argument applies whether or not either or both investors are REITs. ) You have to consider the cost of your equity as well as the cost of your debt to determine your cost of capital. Corporate WACC tells OCC of average corp asset. © 2014 On. Course Learning. All Rights Reserved. 71

But Corp avg WACC is not nec = acquisition OCC… 12. 3. 3: Risk is in the object not in the beholder. (Remember from Ch. 10: Match disc. rate to the risk of the investment whose CFs are being discounted. ) Property "X" has the same risk for Investor "A" as for Investor "B". Therefore, oppty cost of cap (r) is same for “A” & “B” for purposes of evaluating NPV of investment in “X” (same discount rate). Unless, say, “A” has some unique ability to alter the risk of X’s future CFs. (This is rare: be skeptical of such claims!) © 2014 On. Course Learning. All Rights Reserved. 72

Example. . . REIT A has expected total return to equity = 12%, Avg. debt int. rate = 7%, Debt/Total Asset Value Ratio = 20% What is REIT A’s (firm-level) Cost of Capital (WACC)? Ans: (0. 2)7% + (1 -0. 2)12% = 1. 4% + 9. 6% = 11%. REIT B has no debt, curr. div. yield = 6%, pays out all its earnings in dividends (share price/earnings multiple = 16. 667), avg. div. growth rate = 4%/yr. What is REIT B’s Cost of Capital? [Hint: Use “Gordon Growth Model”: r = y + g. ] Ans: 6% + 4% = 10%. © 2014 On. Course Learning. All Rights Reserved. 73

Example (cont. ). . . Property X is a Boston Office Bldg, in a market where such bldgs sell at 8% cap rates (CF / V), with 0. 5% expected LR annual growth (in V & CF). It has initial CF = $1, 000/yr. How much can REIT A afford to pay for Prop. X, without suffering loss in share value? Answer: $12, 500, 000 = $1, 000 / 0. 08 = Init. CF/ (OCC- g) = $1, 000 / (8. 5% - 0. 5%). Note: • Prop. X value for REIT is not equal to: $1, 000 / (11% - 0. 5%) = $9, 524, 000. • OCC relevant for valuing Prop. X purchase for REIT is not 11% (REIT A’s firm level WACC). © 2014 On. Course Learning. All Rights Reserved. 74

Example (cont. ). . . Property X is a Boston Office Bldg, in a market where such bldgs sell at 8% cap rates (CF / V), with 0. 5% expected LR annual growth (in V & CF). It has initial CF = $1, 000/yr. How much can REIT B afford to pay for Prop. X, without suffering loss in share value? Answer (same): $12, 500, 000 = $1, 000 / 0. 08 = Init. CF/ (OCC- g) = $1, 000 / (8. 5% - 0. 5%). Note: • Prop. X value for REIT is not equal to: $1, 000 / (10% - 0. 5%) = $10, 526, 000. • OCC relevant for valuing Prop. X purchase for REIT is not 10% (REIT B’s firm level WACC). © 2014 On. Course Learning. All Rights Reserved. 75

Appendix 23: Agency Costs & Conflicts of Interest Some major issues to watch out for… 1) Transaction bias in UPREITs: ·Due to tax-based conflict (different cost basis for LP investors vs public stock investors)? 2) Real estate interests outside the REIT: ·Do REIT managers have other real estate interests that compete with the REIT’s properties or for the managers’ time & energy (other properties not in the REIT, other interests such as brokerage or management firms)? 3) Potential for “self-dealing”: ·Do REIT managers have incentives to have the REIT engage in “Sweatheart” deals with brokerage, management, development firms in which they have interests? 4) Take-over difficulties re “ 5 -or-Fewer Rule”: · REIT governance often makes hostile takeovers particularly difficult, in part due to 5 -or-Fewer Rule. © 2014 On. Course Learning. All Rights Reserved. 76

The “UPREIT” Public Investors (Stockholders) Private Investors (Partnership Unit-holders) Structure REIT Umbrella Partnership (“Operating Partnership”: OP) Property Partnership Property © 2014 On. Course Learning. All Rights Reserved. 77