Chapter 24

Chapter 24: The Role of Real Estate Investment Trusts (REITs)

Andrew DavidsonAnthony B. SandersLan-Ling WolffAnne Ching

Chapter 24

REITs

Real estate investment trusts (or REITs) are essentially closed-end funds that hold real estate in their portfolios instead of stocks and bonds. As a consequence, they represent an alternative form of

securitization. REITs can hold real property (e.g., shopping center, hotels and

office buildings); shareholders in the REIT then share in the cash flows to the REIT as well as capital appreciation (upon sale of the asset).

Hence, REITs represent one of the earliest example of securitizing real properties into securities.

Chapter 24

Real Estate Investment Trusts (REITs)

Primary Advantages: REITs are not subject to double taxation limited liability to shareholders REITs allow investors liquidity and

diversification Primary Disadvantages:

income is portfolio income tax losses do not pass through to the

shareholders REITs must meet substantial operating

restrictions

Chapter 24

A Closer Look at Real Estate Investment Trusts (REIT)

A (REIT) is a corporate form of ownership engaged in real estate investment, but with no taxation at the corporate level.

Basic operations REITs invest primarily in real property

and mortgages.

Chapter 24

Qualifying as a REIT

A REIT is a trust legally established to raise capital from investors (in the form of common stock and bond issuance) and borrow from lenders in order to buy income-producing properties or make mortgage loans in varying maturities.

A REIT is allowed a special tax status; that is, it is only taxed at corporate rates on its retained earnings (annual) if it meets the following general conditions:(1) A REIT is legally required to pay virtually all of its taxable income (90 percent) to its shareholders every year. (2) A REIT’s assets are primarily composed of real estate held for the long term, (3) A REIT’s income is mainly derived from real estate,

Chapter 24

Tax Ramifications for REITs

Generally, most REITs will adhere to the above rules to reduce taxes in the event operating income is realized during a particular year.(1) It should be pointed out that since some REITs own properties, they are entitled to depreciate them and consequently may show an operating loss for the year for tax purposes, while producing actual cash available for distribution. However, since REITs are tax-exempt, the value of this deduction is questionable.(2) Tax laws allow REIT’s to distribute any losses to shareholders to the extent of showing a zero net income for the year.

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Types of REITs

Equity Trusts Mortgage Trusts Hybrid Trusts Specialized Trusts

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REIT Structures UPREIT

An UPREIT is an Umbrella Partnership REIT. In an UPREIT structure, the partners of the existing

partnerships and a newly-formed REIT become partners in a new partnership which is termed “The Operating Partnership.”

The partners contribute the properties from the existing partnership and the REIT contributes the cash proceeds from its public offering.

Typically, the REIT is the general partner and the majority owner of the Operating Partnership Units.

DownREIT A DownREIT is structured in a similar fashion to an UPREIT,

however the REIT owns and operates properties directly rather than only its interest in a controlled partnership that owns and operates separate properties.

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Constituent Companies and Relative Weights in the NAREIT Index for May 1, 2002

Equity Market Capitalization1

Number Millions of Percent of of REITs Company dollars Total Summary by Property Sector

and Subsector

34 Industrial/Office 48,697.1 28.5891 19

Office 29,699.9 17.4362

7 Industrial 9,594.1 5.6325 8 Mixed 9,403.1 5.5204 42 Retail 36,870.5 21.6459 27 Shopping Centers 17,815.3 10.4590 10 Regional Malls 16,491.7 9.6819 5 Free Standing 2,563.4 1.5049 24 Residential 33,350.8 19.5796 19 Apartments 30,822.6 18.0953 5 Manufactured Homes 2,528.2 1.4842 20 Diversified 13,747.6 8.0709 16 Lodging/Resorts 10,291.2 6.0417 3 Self Storage 5,864.2 3.4428 12 Health Care 8,509.4 4.9957 8 Specialty 6,934.4 4.0711 20 Mortgage 6,069.4 3.5632 13 Home Financing 4,247.5 2.4936 7 Commercial Financing 1,822.0 1.0696 179 Industry Totals 170,334.7 100.0000

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Largest REITs in the Office Sector Equity Market Capitalization1 Ticker Millions of Percent of Percent of Property Sector: Industrial/Office Symbols dollars Subsector Total 1 Equity Office Properties Trust EOP 11,868.5 39.9616 6.9678 2 Boston Properties, Inc. BXP 3,538.6 11.9146 2.0775 3 CarrAmerica Realty Corporation CRE 1,994.0 6.7139 1.1706 4 Mack-Cali Realty Corporation CLI 1,867.1 6.2865 1.0961 5 Arden Realty Group, Inc. ARI 1,795.8 6.0466 1.0543 6 Highwoods Properties, Inc. HIW 1,487.3 5.0078 0.8732 7 Prentiss Properties Trust PP 1,281.2 4.3139 0.7522 8 HRPT Properties Trust HRP 1,118.1 3.7645 0.6564 9 SL Green Realty Corp. SLG 1,054.5 3.5505 0.6191 10 Brandywine Realty Trust BDN 848.9 2.8583 0.4984 11 Alexandria Real Estate Equities, Inc. ARE 738.7 2.4873 0.4337 12 Glenborough Realty Trust Incorporated GLB 618.3 2.0817 0.3630 13 Koger Equity, Inc. KE 389.0 1.3099 0.2284 14 Parkway Properties, Inc. PKY 338.8 1.1407 0.1989 15 Corporate Office Properties Trust OFC 307.0 1.0336 0.1802 16 Great Lakes REIT GL 267.9 0.9020 0.1573 17 Prime Group Realty Trust PGE 131.1 0.4415 0.0770 18 AmeriVest Properties, Inc. AMV 41.2 0.1387 0.0242 19 Maxus Realty Trust Inc. MRTI 13.7 0.0462 0.0081 19 Subsector Totals 29,699.9 100.0000 17.4362

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Largest REITs in the Industrial Sector

Equity Market Capitalization1 Ticker Millions of Percent of Percent of Property Sector: Industrial Symbols dollars Subsector Total 1 ProLogis Trust PLD 3,932.7 40.9910 2.3088 2 AMB Property Corp. AMB 2,360.0 24.5982 1.3855 3 First Industrial Realty Trust, Inc. FR 1,309.9 13.6535 0.7690 4 CenterPoint Properties Trust CNT 1,250.1 13.0293 0.7339 5 EastGroup Properties, Inc. EGP 401.1 4.1804 0.2355 6 Keystone Property Trust KTR 278.3 2.9003 0.1634 7 Monmouth Real Estate Investment Corp. MNRT.A 62.1 0.6474 0.0365 9,594.1 100.0000 5.6325

Chapter 24

Relative Performance of REITs

0.00

500.00

1,000.00

1,500.00

2,000.00

2,500.00

3,000.00

3,500.00

4,000.00

4,500.00

Dec

-71

Dec

-73

Dec

-75

Dec

-77

Dec

-79

Dec

-81

Dec

-83

Dec

-85

Dec

-87

Dec

-89

Dec

-91

Dec

-93

Dec

-95

Dec

-97

Dec

-99

Dec

-01

S&P 500 NAREIT Equity

Chapter 24

A closer look at relative performance

0

100

200

300

400

500

600

700

NAREIT Equity S&P 500

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REIT initial public offering history Time Period Initial Return t-stat Observations

Ave First Week Volume in 1,000’s

Entire Sample 2.00% 4.34 205 1980-1988 -1.61% -2.09 49 790 1990-1994 2.70% 4.95 98 3,073 After 1994 3.87% 3.63 58 5,117 By Year 1980 -4.69% . 1 . 1981 . . 0 . 1982 0.62% . 1 786 1983 6.45% . 1 259 1984 -7.82% -1.12 4 317 1985 -2.42% -2.33 21 1,172 1986 -0.26% -0.30 8 389 1987 -0.30% -0.63 5 1,101 1988 0.52% 1.38 8 299 1989 . . 0 . 1990 . . 0 . 1991 -0.63% -1.00 3 582 1992 1.03% 1.10 7 1,525 1993 2.68% 3.52 48 3,847 1994 3.26% 3.42 40 2,621 1995 2.07% 1.25 8 1,627 1996 0.74% 0.21 6 3,606 1997 7.26% 4.01 25 7,010 1998 1.11% 0.71 18 4,104 1999 2.06% . 1 10,012

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Real Estate Returns, February 1990 to December 2001

Country Mean Std Dev Skew [p-val] Ex Kurt [p-val] Australia 0.879 4.701 -0.315 0.27 0.522 0.40 Belgium -0.105 4.859 -0.292 0.28 1.757 0.19 France 0.328 4.618 -0.040 0.47 0.457 0.41 Germany 0.381 6.510 -0.019 0.49 3.525 0.04 Hong Kong 0.909 11.533 -0.066 0.45 2.817 0.08 Italy 0.236 7.693 1.108 0.01 2.652 0.09 Japan -0.702 10.328 -0.021 0.48 0.904 0.33 Netherlands -0.065 3.628 -0.214 0.33 0.257 0.45 Singapore -0.244 12.964 -0.054 0.46 2.733 0.09 Spain 0.108 8.183 -0.304 0.27 0.589 0.38 Sweden -1.167 10.335 0.039 0.47 4.159 0.02 Switzerland 0.175 5.023 0.289 0.28 0.595 0.38 U.K. 0.200 5.369 -0.298 0.28 -0.292 0.44 U.S. 1.211 4.066 0.148 0.38 0.594 0.38 MSCI Global 0.595 4.079 -0.789 0.06 1.211 0.27

Chapter 24

International Real Estate Returns, February 1990 to December 2001

Country i

iw Adj 2R

Australia 0.354 0.559 ** 0.23

Belgium -0.562 0.259 ** 0.04

France -0.143 0.320 ** 0.08 Germany -0.011 -0.032 -0.01 Hong Kong 0.199 1.385 ** 0.24 Italy -0.275 0.499 ** 0.07 Japan -1.349 1.106 ** 0.19 Netherlands -0.523 0.264 ** 0.08 Singapore -1.047 1.799 ** 0.32 Spain -0.492 0.898 ** 0.20 Sweden -1.774 * 0.926 ** 0.13 Switzerland -0.276 0.229 * 0.03 U.K. -0.286 0.384 ** 0.08 U.S. 0.728 * 0.372 ** 0.14

Estimates from the single factor mode

Rit R ft i iw Rwt R ft it

are reported. The statistical significance of the coefficients is indicated beside each estimate. ** indicates significance at 1% level and * indicates significance at 5% level.

Chapter 24

REIT Valuation

As with most common stocks, the calculation of Net Income to Common Shareholder is a straightforward exercise (revenues less expenses). However, since the majority of REITs hold a large percentage of

their portfolio in depreciable assets (real property), the typical net income calculation will greatly understate the cash flows.

As a consequence, net income has to be adjusted for sales of property plus depreciation and amortization; the resulting calculation generates what is known as Funds from Operations (FFO). Stated differently, FFO is equal to net income, excluding gains or losses from sales of property, and with depreciation added back.

Chapter 24

REIT Valuation

The next step is calculated Cash Available for Distribution (CAD). CAD is a measure of the REIT's ability to generate cash and to distribute dividends to its shareholders. CAD is derived by subtracting nonrecurring expenditures.

A further refinement on the REIT’s cash flow is Adjusted Funds From Operations (AFFO). AFFO refers to a further adjustment by subtracting from Funds from

Operations (FFO) both (1) normalized recurring expenditures that are capitalized by the REIT and then amortized, but which are necessary to maintain a REIT's properties and its revenue stream and (2) “straight-lining” of rents (straightlining averages the tenant’s rent payments over the life of the lease).

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    12/31/04   12/31/03   12/31/02 Diluted net income per share $1.43  $0.89  $1.39    Add:   Depreciation and amortization  2.40   2.38   2.31    Less:  Gain on sale of properties  (0.79)  (0.25)  (0.58) Minority interest adjustment  0.20   0.26   0.30    Adjustment for share difference (2)  (0.15)  (0.21)  (0.21) Diluted funds from operations per share (1) $3.09  $3.07  $3.21  Diluted funds from operations available               to common shareholders, excluding               Preferred stock issuance costs $—  $0.14  $0.07    Impairment of real estate  0.04   0.12   0.04    HQ lease guarantees  —   0.01   0.14    Prepayment penalties on debt  0.08   —   —    $3.21  $3.34  $3.46  Diluted net income per common share, excluding              Preferred stock issuance costs $—  $0.15  $0.08    Impairment of real estate  0.05   0.14   0.05    HQ lease guarantees  —   0.02   0.17    Prepayment penalties on debt  0.09   —   —    $1.57  $1.20  $1.69  

Chapter 24

 From Carr Realty 2004 Annual Report     12/31/04     12/31/03     12/31/02  

Diluted net income per share   $ 1.43     $ 0.89     $ 1.39    

  Add:   Depreciation and amortization     2.40       2.38       2.31    

  Less:  Gain on sale of properties     (0.79 )     (0.25 )     (0.58 )  

Minority interest adjustment     0.20       0.26       0.30    

  Adjustment for share difference (2)     (0.15 )     (0.21 )     (0.21 )  

Diluted funds from operations per share (1)   $ 3.09     $ 3.07     $ 3.21    

Diluted funds from operations available                          

 to common shareholders, excluding                          

  Preferred stock issuance costs   $ —     $ 0.14     $ 0.07    

  Impairment of real estate     0.04       0.12       0.04    

  HQ lease guarantees     —       0.01       0.14    

  Prepayment penalties on debt     0.08       —       —    

    $ 3.21     $ 3.34     $ 3.46    

Diluted net income per common share, excluding                       

  Preferred stock issuance costs   $ —     $ 0.15     $ 0.08    

  Impairment of real estate     0.05       0.14       0.05    

  HQ lease guarantees     —       0.02       0.17    

  Prepayment penalties on debt     0.09       —       —    

    $ 1.57     $ 1.20     $ 1.69