5.4 / 17 - Listed Versus Unlisted Real Estate Investments

Question 1

LO 17.1 Demonstrate knowledge of unlisted real estate funds.

Answer 1

• Describe unlisted open-end real estate funds. • Describe unlisted closed-end real estate funds. • Describe unlisted real estate funds of funds. • State four key advantages and three key disadvantages of unlisted real estate funds.

Question 2

UNLISTED REAL ESTATE FUNDS

Answer 2

privately held RE Funds, 3 types: Open-end fund closed-end fund funds of funds

Question 3

OPEN-END REAL ESTATE FUNDS

Answer 3

indefinite lives and allow investment and redemptions at any time typically have a lockup period valuation is based on quarterly appraisals, which can be problematic - Lower Risk Assets - Tax Free?

Types include:

• Property Unit Trusts (PUTs) - both of:
  
  • unauthorized PUTs sold to qualified exempt investors, and
  • authorized PUTs sold to retail investors
• Property Authorized INvestment Funds (PAIFs) - in the United Kingdom

Question 4

CLOSED-END REAL ESTATE FUNDS

Answer 4

issue a limited # of shrs to investors - can only be traded or redeemed on the secondary market classified as unlisted securities quite illiquid typical lifespan of 15 years Typically structured as Limited Partnership Some are structured as LLC in United States - Tax Neutral - HIgher Risk, PE type assets

Question 5

closed-end real estate mutual funds (CEMFs)

Answer 5

Exchange-traded mutual funds that issue a fixed number of shares to investors that cannot be redeemed or bought directly from the CEMF, but instead are traded on organized exchanges and are classified as listed securities. - May trade at premium or discount to NAV, although closed-end RE funds often trade at large discount to NAV. - Invest in both REITs and properties

Question 6

REAL ESTATE FUNDS OF FUNDS

Answer 6

-invest in other real estate funds - expensive due to double layer of fees.

Question 7

4 Key Advantages of Unlisted Real Estate Funds

Answer 7

1. Diversification - provide instant Divctn, giving investors access to a div/d portfolio with relatively small minimum investment 2. Skilled Mmgmt - can generate superior returns at reduced risk. Expertise may be based on geographic regioin or property type 3. Access to Specific Subsectors - Several unlisted RE funds offer potentital to invest in specific RE subsectors or geographic regions 4. Tax Advantage - Unlisted RE funds offer investors the potential to earn tax-exempt income

Question 8

3 Key Disadvantages of Unlisted Real EState Funds

Answer 8

1. Cash Drag - mgrs have to keep cash on hand to finance real estate investment opportunities 2. Fees - Annual fund fees range from 20 bps to 200 bps. Funds may also charge perf fees, and often use derivatives which may increase the risk of these assets 3. Leverage and J-Curve - subject to J-curve effect, may need to substantially outperform the mkt in later years to account for poor early performance, to meet or exceed long term mkt performance. Funds often use leverage which can increase return but increases risk.

Question 9

LO 17.2 Demonstrate knowledge of listed real estate funds.

Answer 9

• Describe real estate investment trusts (REITs) and real estate operating companies (REOCs). • Describe real estate index-based exchange-traded funds (ETFs). • Compare and contrast the investment characteristics of REITs, ETFs, and listed funds and mutual funds. • Recognize six key advantages and two key disadvantages of listed real estate funds. • Discuss the global real estate securities market, focusing on global REITs. • Describe non-traded REITs. • Compare and contrast traded REITs with non-traded REITs across five major distinguishing characteristics

Question 10

LISTED REAL ESTATE FUNDS (and types)

Answer 10

• publicly traded on exchanges - includes Real Estate INvestment Trusts (REITS), real estate operating companies (REOCs), and index-based real estate exchange-traded funds (ETFs)

Question 11

REITs (REAL ESTATE INVESTMENT TRUSTS)

Answer 11

• must pass through large portion of income it receives as dividends to investors (90% min in USA) - may deduct dividends from income when determining corporate tax liability (if it meets requirements of REIT) - Investor pays income taxes on dividends received. - Large REITs are professionally managed and typically vertically integrated vehicles

Question 12

REOCs (Real Estate Operating Companies)

Answer 12

• similar to REITs, but reinvest their income in the company rather than pay out as dividends - Wider range of investment types than REITs

Question 13

EXCHANGE TRADED FUND (ETF)

Answer 13

• Liquid, tax-efficient investment vehicle that can invest in a range of investments, including stocks, bonds commodities, and RE. - Typically tracks an index - ETFs typically trade very close to NAVs, since value differences can be arbitraged

Question 14

REAL ESTATE ETFs

Answer 14

• can track global real estate values, global regions, broad U.S. exposures, U.S. sectors, and U.S. mortgages. - can be leveraged, have short exposures, and invest in REITs.

Question 15

6 Key Advantages of listed RE Funds

Answer 15

1. Diversification 2. Liquidity and Divisibility - traded liquid investments that allow investors to invest in small/specific amounts tailored to their needs 3. Instant exposure to RE - avoid cash drag problem 4. Information Discovery - bound by public disclosure requirements, including financial statements. Provides information to investors 5. Access to specific subsectors 6. Tax Advantage - offer tax benefits, including exemption from corporate taxes

Question 16

2 Key Disadvantages of Listed RE Funds

Answer 16

1. Trading away from NAV - especially REITs may trade at stignificant discounts or premiums to their NAV e.g. between 1990 and 2010, US REITs traded at 20 to 40% discount to NAV (possibly due to valuation lag from smoothed data). 2. High correlation with equities - tends to follow public equity market returns, rather than returns of the underlying real estate

Question 17

Global REITs

Answer 17

• primary tool for gaining International Diversification - Unlike U.S. REITs which can use unlimited amounts of debt, REITs in other countries have debt ceilings, such as the 3-to-1 debt to equity ratio ceiling in Australia - Often excempt from corporate taxes similar to US - high correlation with international equities reduces diversification benefits

Question 18

Non-Traded REITs

Answer 18

• have existed in the US since 1990 - Typical time to maturity of 10 years - similar to traded REITs, pay out 90% of income. - Up-front fees can range from 12 to 15% - Tend to have smoothed pricing. 4 life cycle Stages: 1) Capital Raising 2) Property Acquisition 3) Asset Management Phase 4) Distribution Phase

Question 19

LO 17.3 Demonstrate knowledge of market-based versus appraisal-based returns

Answer 19

• Compare and contrast the historical investment performance characteristics from the returns of an appraisal-based real estate index (NPI) with those from the returns of a market-based real estate index (REIT Index) over a given period. • Summarize four explanations of the observed relationship between the volatilities of appraisal-based real estate indices and market-based real estate indices. • Discuss the importance of accurate pricing and risk estimation.

Question 20

Four Possible Explanations Why Private Real Estate Returns show lower standard deviation than REITs

Answer 20

1. Lower Accuracy - Appraisal-based RE pricing is less acurate than market values. REIT returns exhibit greater informational efficiency. Generally not possible to arbitrage Private RE, but can short sell REITs. 2. Risk Differences - There is a true difference in the riskiness of the underlying assets of the two indices. This is unlkiely because the equity REITs in the REIT index contain extremely similar assets to NPI. 3. Leverage - Most REITs use leverage, which is reflected in index returns, but increases volatility. REITs use 40% leverage, but REIT index is 4x more volatile. 4. Volatility - Equity mkt vol and liquidity risks ad vol to REIT markets that are unrelated to the tru vol of hte underlying property values.

Question 21

LO 17.4 Demonstrate knowledge of arbitrage, liquidity, and segmentation with regard to real estate funds

Answer 21

• Distinguish between securitization and the pooling of securities. • Discuss the mechanics and trading of ETFs, and how these characteristics facilitate arbitrage. • Explain how listed real estate positions can be used to hedge unlisted real estate positions. • Discuss two views of the effectiveness of relying on REITs as indicators of private real estate positions. • Describe financial market segmentation. • Explain how turnover, dealer sales, and agency costs affect REIT market values. • Discuss how real estate price volatility and liquidity affect the effectiveness of short-term REITs as risk management tools. • Interpret historical evidence regarding whether REITs are effective as short-to intermediate-term hedging vehicles for appraised real estate values. • Discuss whether real estate can serve as an effective diversifier.

Question 22

POOLING OF SECURITIES

Answer 22

Any collection of securities held by an entity, such as a mutual fund. - The underlying securities in a pooling are already publicly traded (ETFs are pooling, not securitization, because the underlying is already traded).

Question 23

SECURITIZATION

Answer 23

The pooling of non-publicly traded assets and converting them into publicly traded securities (taking mortgages and creating mortgage-backed securities). - REITs are forms of securitization where the underlying assets are not publicly traded

Question 24

Two Proposed Explanations for Extreme Volatility of the REIT index relative to NPI during 2008 crisis

Answer 24

1. Movements in the REIT index accurately reflected the true changes in underlying property values. (If this is true, REITs can be used to hedge Private RE risk) 2. Movements in the REIT index were driven by factors unrelated to the true changes in the underlying property values, adjusted for leverage - chase the equities markets too closely (If this is true, REITs CANNOT be used to effectively hedge Private RE Risk.

Question 25

MARKET CLIENTELE

Answer 25

type of participant that dominates a market (institutional vs. individual). - markets differ because market clienteles differ

Question 26

MARKET SEGMENTATION

Answer 26

refers to similar assets trading at different prices in different markets. - RE markets may be segmented:

Question 27

DEALER SALES

Answer 27

Short-term transactions that experience unfavorate tax treatment relative to long-term investments. - example is if a REIT trades a certain percentage of properties within a specified time period, within a particular holding period, capital gains are fully taxed at the REIT level.

Question 28

AGENCY RELATIONSHIPS

Answer 28

• may help explain difference in returns between REITs and Private RE. - REITs are publicly traded with widely dispersed shareholder bases, vs LPs monitoring real estate partnerships.

Question 29

REIT Correlation with Russell 2000 VAlue Index

Answer 29

0.80 - highly correllated. REITs are not a good way to diversify.

Question 30

REIT Index Correlation with NPI (Private Real EState INdex)

Answer 30

Smoothed, unadjusted - 0.17 - not very correlated with private real estate. Unsmoothed Correlation is .42, significantly higher. Unsmoothed index also exhibits higher correlation with equity indices.

Question 31

NPI Correlation with Russell 3000

Answer 31

0.12 - very uncorrelated. VS. REIT index correlation of .61 against Russell 3000.

Question 32

If REITs are good diversifiers in a portfolio, investor must rely on two critical assumptions:

Answer 32

1. Underlying real estate values are not accurately reflected in equity REIT prices 2. U.S. stocks have low correlation with commercial real estate