R.43 Publicly Traded Real Estate Securities Flashcards
Types of Publicly Traded Real Estate Securities
1. Real estate investment trusts (REITs)
- Equity REITs are tax-advantaged entities that own and operate income-producing real estate property. Mortgage REITs make loans secured by real estate. They are less common than equity REITs.
2. Real estate operating companies (REOCs)
- REOCs are taxable real estate ownership companies. They are located in countries that do not have provisions for tax-advantaged REIT entities.
3. Mortgage-backed securities (MBS)
- An MBS is an asset-backed debt obligation that is securitized with mortgage loans.
REITs
- Structure
- Investment Characteristics
- Advantages
- Public over Private real estate securities
- REITs over public REOCs
- Advantage of REOCs over REITs
- Disadvantages of Publicly Traded Equity Real Estate Securities
Structure
- structured to tax-efficiently acquire properties by avoiding the recognition of taxable income from appreciated property.
- UPREITs (common in US) have controlling interest and serves as the general partner
- DOWNREIT structure, the REIT owns more than one partnership.
Investment Characteristics
- Exempt from income taxes at corporate level provided a majority of the assets are income-producing properties, and virtually all the taxable income is distributed to the shareholders.
- Dividend yields > most publicly traded equities.
- Reported income has low volatility → b/c from rents and interest.
- REITs have frequent secondary offerings because they cannot retain earnings to finance growth. This allows investors to evaluate future investments.
Advantages
1. Public over Private real estate securities
- Greater liquidity – allows for flexibility in realizing gains and losses and lower transaction costs
- Lower investment requirements – fractional interests can be purchased
- Limited liability – can lose at most the original investment
- Access to superior quality and range of properties – some real estate investments are held for the long term by institutional investors
- Active professional management – scrutinized by the public
- Diversification – by geography and property type
2. REITs over public REOCs
Taxation
- REITs are typically exempt from double taxation because no taxes are payable by the REIT. A portion of the distribution to REIT shareholders is treated as a return of capital, which means it is not taxable when received.
Earnings predictability
- The focus on rental income makes the earnings somewhat predictable.
High income payout ratios and yields
3. REOCs over REITs
Operating flexibility
- REOCs can pursue any kind of real estate investment, including development activity. They can also retain more of the income for reinvestment. REOCs are allowed to use a wider range of capital structures and financial leverage.
Disadvantages of Publicly Traded Equity Real Estate Securities
Taxation - REITs and REOCs generally cannot pass on tax losses to investors to offset the investor’s taxable income. This can be done with direct property ownership.
Control – REIT shareholders have less control compared to direct property owners
Costs – the maintenance costs of a REIT are high
Stock market determined pricing and returns – REIT volatility is greater than the volatility for direct property owners, but that could be due to the smoothing of appraisal values for direct owners
Structural conflicts and related costs – the limited partners in a REIT could have different incentives than the REIT as a whole
Relatively moderate income growth potential
Potential for forced equity issuance at disadvantageous prices – because leverage is limited, especially during turbulent markets
Equity REITs: Property Subtypes
Economic Drivers of REITs
Subtypes
Shopping Center/Retail REITs
- large spaces that sell higher-priced discretionary goods.
- Tenants usually pay a fixed minimum plus a percentage of sales.
- Anchor retailers have long-term leases that are fixed.
Office REITs
- long-term with rates that increase periodically. Tenants often pay a share of the operating expenses and property taxes. It
- takes a long time to construct office buildings, so supply may lag demand.
Industrial REITs
- warehouses and distribution centers. These tend to be
- less cyclical because they have long-term leases and require a short time to build.
- Location is very important.
Multi-family/Residential REITs
- typically less than one year.
- Rental apartment demand is relatively stable, but the competition can drive the rent rates up and down. Local demographics are important.
Storage REITs
- gross leases on a monthly basis.
- ease of entry into this market has led to overbuilding.
Health Care REITs
- REITs are not allowed to operate these facilities.
- exposed to demographic trends and changes in government funding programs.
Hotel REITs
- not allowed to operate them to retain their tax-advantaged REIT status.
- cyclical because it is exposed to the business-cycle.
Diversified REITs
- Diversified REITs own and operate more than one type of property. They are more common in Europe and Asia than United States.
Economic Drivers of REITs
- National GDP growth is the most important economic driver for REITs of all property types.
- Retail sales growth → retail and industrial REITs
- Job creation → multi-family, office, and hotel REITs
- Population growth → multi-family, storage, and healthcare REITs
Valuation to REITs
Broad approaches
- Asset value estimates
- Price multiple comparisons
- Discounted cash flow
Asset Value estimates
- formulas
- application
- issues w/ application
Broad approaches
- Asset value estimates
- Price multiple comparisons
- Discounted cash flow
Asset Value estimates
Formulas
- NAV = (NOI / Cap rate) + Cash + A/R - (Debt & other liabilities)
- NAVPS = NAV / Shares outstanding
Application
- used by investors that view REITs as liquid forms of commercial real estate ownership. Value-oriented investors look for REITs priced at a discount to their NAV.
- REITs should trade at premium to NAV if management performs well b/c 1) REIT investors have more liquidity than private investors; 2) REITs attract above average management b/c can afford to pay them well.
Issues problems using private tool on public REITS
- may not reflect the value to public equity investors
- private is long-term focused; public is short-term focused; drives wide premium/discount
- static calc ignores fact REIT is a going concern; calc is subject; difficult use with unique properties.
Price multiple (relative value) approach to equity REIT valuation
Relative Value Approach to Valuing REIT Stocks
Most common is P/FFO and P/AFFO. Less common is EV / EBITDA.
- P = price
- FFO = funds from operations
- more frequently reported
- excluses Deprcetion on real estate; Deferred tax charges; G/L from propert sales and debt restructuring (not sustainable)
- AFFO = adjusted funds from operations
- Superior to FFO. More accurate for current economic inome. Careful…adjustments can vary.
- removes 1. non-cash rent; and 2. maintenance type capital expenditures
- EV = economic value
- EBITDA = earnings before interest, taxes, depreciation, and amortization
Main drivers:
- Expecations growth in FFO/AFFO
- Risk associated with underlying real estate
- Risk w/ compan’s capital structures and access to capital
- As leverage increases multiple decreases
Benefits of using P/FFO and P/AFFO Multiples
- Widely accepted in global stock markets.
- Acceptance makes them easy to compare to investment alternatives.
- FFO estimates are readily available.
- Multiples can be used with expected growth and leverage levels to deepen understanding.
Drawbacks of using P/FFO and P/AFFO
- Multiples may not capture all intrinsic value, such as for empty buildings.
- It is tough to adjust for the right recurring capital expenditures.
- Income statement rules have changed, which makes it tougher to calculate FFO and AFFO.
