What is a Real Estate Investment Trust?

A REIT is a:
• Publicly or privately held company that that owns real estate equity or
real property debt

• Passes most of its earnings and capital gains onto shareholders

• Only retained earnings are taxed, PROVIDED REIT meets

– Ownership requirements
– Management requirements
– Asset requirements
– Income requirements
– Distribution requirements

Trade Association: National Association of Real Estate Investment Trusts

(www.nareit.com)

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 REITs
 Performance vs Equities over past 28 years
 REIT Requirements
 Tax Treatment
 Types of REITS
o Equity, Debt, Hybrid
o Sector Specific (Office, Retail, Residential,
Hotel, Self Storage, Diversified, Specialty)
o Market specific (e.g. just NYC office)
o UPREIT, DownREIT
 Representation in Market Indices
 REIT Valuation
o FFO, Adjusted FFO, CAD
 Economies of Scale
 REIT Advisors
 REIT Growth
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 Index 1978:12 = 100

1,000.00
2,000.00
3,000.00
4,000.00
5,000.00
6,000.00
7,000.00

0.00
Dec-78
Dec-79
Dec-80
Dec-81
Dec-82
Dec-83
Dec-84
SNP 500

Dec-85

Russell 2000
Dec-86
Equity REITs

Dec-87
Dec-88
Dec-89
(12.4%)
(14.0%)
(12.7%)

Dec-90
Dec-91
Dec-92
REITs

Month
Dec-93
1978:12-2007:10

Dec-94
Dec-95
Dec-96
Equity REITs, SNP 500, Russell 2000

Dec-97
Dec-98
Dec-99
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
3

Dec-06
 Requirements

Ownership

– 5 or fewer entities may not own 50% or more of the

outstanding shares (the “5/50 Test”)
– No one shareholder owns more than 9.9% (pension funds
excluded)
– REIT shares must be transferable and held by at least 100
persons
– Must be managed by a board of directors or trustees
– Must be incorporated in one of the 50 states or DC as a
taxable entity

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 Requirements
Management

– REIT managers must be passive

• REIT trustees, directors or employees may not actively engage
in managing or operating REIT properties (includes providing
service and collecting rents from tenants).
• Managers may set policy: rental terms, choose tenants, sign
leases, make decisions about properties.

– REITs allowed to own 100% of a Taxable REIT Subsidiary (TRS).

• REIT Modernization Act of 1999 (effective 2001)
• TRS can provide services to REIT tenants and others (previously, this
was not allowed).
• Debt and rental payments from TRS to REIT are limited to ensure that
the TRS actually pays income taxes.

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 Requirements
Assets

– 75% of assets must be real estate, cash, and govt. securities

• other REIT shares are considered real estate assets, but
not more than 20% of its assets can be stocks in taxable
REIT subsidiaries
– not more than 5% of assets can be stock in non-real estate
corporations
– may not have more than 10% of voting securities of any
corporation other than another REIT, Taxable REIT
Subsidiary (TRS) or subsidiary whose assets and income
are owned by the REIT for federal income tax purposes

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 Requirements

Income

– 95% of gross income must be from dividends,

interest, rents, or gains from sale of certain assets
(real estate, cash, or govt securities).
– The 95% rule includes income from dividends and
non-real estate sources (e.g. bank deposit interest)
– Implication: less than 5% of REIT income can come
from service fees

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 Requirements

Income

– No more than 30% of gross income can be derived

from
• sale or disposition of any securities held less
than 6 months
• sale or disposition of real estate held for less
than 4 years, except those involving foreclosures.
• properties held for sale in the normal course of
business (anti-dealer provision)

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 Requirements

Compliance

– Company must make a REIT elective by filing

IRS Form 1120-REIT.
– Company must mail letters to shareholders of
record requesting details of REIT benefits

Source:
http://www.investinreits.com/learn/formingareit.cfm

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 Requirements

Distributions

– must distribute 90% of all taxable income to investors

• mandates fairly low retained earnings policy
• has important implications for financing growth

– Note: prior to 2001, minimum distribution requirement was

95%.

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 Tax Treatment

• Accelerated depreciation is allowed for determining

taxable income
• 40 year asset life required for calculating income
available for distribution to investors
• Shareholders dividends may exceed REITs taxable
income (because of depreciation, amortization)
• REIT distributions
– Dividends taxed as ordinary income
– Return of capital reduces shareholder’s tax basis

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 Tax Treatment

REIT Management has Considerable Flexibility

• Tax treatment of leasing commissions

• Tax treatment of financing fees
• Tax treatment of tenant improvements
• Straight-line graduated lease payments

That influence analysts’ performance evaluation.

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 REITs
Number of Publicly Traded REITs

250
Total
200 Equity
Mortgage
150 Hybrid

100

50

0
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
Year
13
 Billion $$$
19

0
50
100
150
200
250
300
350
71
19
74
19
77
19
80
19
83
19
86
19
REITs

89

Year
19
REIT Market Cap

92
19
95
19
98
20
01
20
04
14
 REITs
REIT Percent Market Cap by Type

100.0%
90.0%
80.0% Equity
70.0% Mortgage
60.0% Hybrid
50.0%
40.0%
30.0%
20.0%
10.0%
0.0%
1971 1976 1981 1986 1991 1996 2001
Year
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 REITs

Historical Offerings of Securities (As of 10/31/2006)

Total
Year Number IPO Secondary Equity Secondary Debt
Common Preferred Unsecured Secured
1998 474 17 216 81 145 15
1999 205 2 29 71 69 34
2000 114 0 11 31 70 2
2001 127 0 58 21 44 4
2002 187 3 85 25 71 3
2003 228 8 82 64 68 6
2004 266 29 79 61 97 0
2005 259 11 71 36 105 36
2006 165 5 56 34 67 3

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 REITs
Equity REIT Sectors ( % Market Cap)

Self Storage Specialty

Health Care 3.9% 4.3%
5.2%
Industrial/Office
26.7%
Lodging/Resorts
7.3%

Diversified
7.6%
Retail
26.3%
Residential
18.7%

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 Equity REITs
Price Market Cap
Sector REIT Symbol (12/3/2007) (billions) D/E Beta P/E
Apartments
Equity Residential NYSE: EQR $37.22 $10.09 1.85 1.70 8.82
Apartment Investment & Management Co. NYSE: AIV $38.82 $3.71 3.62 1.41 65.57
UDR, Inc. NYSE: UDR $22.00 $2.95 3.48 1.48 23.53
Diversified
Vornado Realty Trust NYSE: VNO $88.49 $13.54 2.03 1.18 26.52
Duke Realty Corp. NYSE: DRE $26.59 $3.87 1.57 0.99 17.35
Health Care
Health Care REIT, Inc. NYSE: HCN $44.36 $3.62 1.15 1.57 36.51
Nationwide Health Properties Inc. NYSE: NHP $31.42 $2.92 0.96 1.46 10.81
Hotel
Starwood Hotels & Resorts Worldwide Inc. NYSE: HOT $53.44 $10.64 1.22 0.69 19.29
Hospitality Properties Trust NYSE: HPT $36.35 $3.40 1.09 1.01 11.13
Industrial
Prologis NYSE: PLD $64.93 $16.72 1.29 1.50 13.57
AMB Property Corp NYSE: AMB $60.70 $6.01 1.23 1.10 20.75
First Industrial Realty Trust NYSE: FR $36.81 $1.64 2.04 0.97 14.87
Office
Boston Properties Inc NYSE: BXP $97.41 $11.62 1.24 1.32 9.18
SL Green Realty NYSE: SLG $101.67 $6.02 1.41 1.18 10.47
Mack-Cali Realty Corp. NYSE: CLI $35.04 $2.38 1.22 1.42 14.43
Retail
Simon Property Group NYSE: SPG $97.24 $21.69 4.57 1.56 41.12
General Growth Properties, Inc. NYSE: GGP $47.05 $11.47 15.95 1.45 38.47
Taubman Centers, Inc. NYSE: TCO $54.10 $2.85 1.13 65.50
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 Debt REITs

Price Market Cap

Sector REIT Symbol (12/3/2007) (billions) D/E Beta P/E
Commercial
Annaly Mortgage NLY $17.10 $6.870 9.93 0.70 14.77
Capstead Mortgage Corp. CMO $12.26 $0.379 13.78 1.37 na
Capital Trust CT $30.96 $0.542 5.20 0.98 7.63
Allied Capital ALD $24.07 $3.720 0.63 0.18 23.12
Residential
Thornburg Mortgage Asset TMA $10.43 $1.360 15.68 0.63 na
Anworth MTG Asset CP ANH $7.18 $0.329 9.96 0.86 na
Both
Redwood Trust, Inc. RWT $30.40 $0.853 73.87 1.35 184.2
RAIT Financial Trust RAS $8.74 $0.533 11.45 2.31 na
Newcastle Investment Corp NCT $12.84 $0.678 9.24 2.01 10.66

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 Umbrella Partnership REIT
UPREIT

• REIT formed by consolidating limited-partnerships

• Partnership interests known as Operating Partnership
(OP) units
• REIT owns property indirectly through OP
• Partnerships allocated REIT shares based on appraised
value of partnership property
• Property owners can swap RE investments for OP units
using IRS tax deferred exchange rule 731
• REIT issues shares to the public and purchases
properties owned by the OP
• First UPREIT created by Taubman in 1992

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 Taubman UPREIT

UPREITS such as Taubman Centers, Inc. are structured to

contain two distinct parts: A publicly traded corporation
and a real estate partnership. The publicly traded
corporation, TCO, owns units in the TRG real estate
partnership. It is this partnership that actually houses the
UPREIT's assets, primarily shopping malls. Investors can
purchase common stock in the corporation, while investors
with direct ownership in the real estate partnership hold
preferred shares in the TCO corporation. Each share
represents the same fractional ownership of the underlying
assets, and has the same voting power.
Source: http://www.AndersonEconomicGroup.com

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22
 DownREIT

• Like an UPREIT, a DownREIT acquires

property on a tax deferred basis by issuing
partnership units
• DownREIT can own multiple partnerships
– Can form partnerships with each acquisition
– More flexible than an UPREIT
• DownREIT can own assets at both the REIT and
OP levels

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 REITs in Market Indexes

S&P 500 Index

REIT Ticker Entered
AIMCO AIV 3/13/2003
Archstone-Smith ASN 12/17/2004
Boston Properties BXP 3/31/2006
Equity Residential EQR 11/1/2001
Kimco Realty Corporation KIM 4/3/2006
Plum Creek Timber, Inc. PCL 1/16/2002
ProLogis PLD 7/16/2003
Public Storage, Inc. PSA 8/18/2005
Simon Property Group SPG 6/25/2002
Vornado Realty Trust VNO 8/11/2005

As of October 2, 2006; www.nareit.com

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 REITs in Market Indexes

S&P 400 Mid Cap Index

REIT Ticker Entered
AMB Property Corporation AMB 1/27/2003
Developers Diversified Realty Corp. DDR 9/30/2004
Highwoods Properties, Inc. HIW 10/7/2003
Hospitality Properties Trust HPT 10/1/2001
Liberty Property Trust LRY 12/11/2002
The Macerich Company MAC 7/1/2005
Mack-Cali Realty Corporation CLI 3/19/2003
New Plan NXL 10/1/2001
Rayonier RYN pre-REIT
Regency Centers REG 4/25/2005
United Dominion Realty Trust UDR 1/27/2003
Weingarten Realty Investors WRI 11/10/2004

As of October 2, 2006; www.nareit.com 25

 REITs in Market Indexes
S&P 600 Small Cap Index
REIT Ticker Entered
Acadia Realty Trust AKR 5/25/2005
Colonial Properties Trust CLP 10/1/2001
EastGroup Properties, Inc. EGP 5/27/2005
Entertainment Properties Trust EPR 6/3/2004
Essex Property Trust ESS 4/24/2002
Inland Real Estate Corporation IRC 10/2/2006
Kilroy Realty Corporation KRC 10/1/2001
Lexington Corporate Properties Trust LXP 9/4/2003
LTC Properties, Inc. LTC 2/14/2006
Mid-America Apartment Communities, Inc. MAA 8/22/2006
New Century Financial Corporation NEW pre-REIT
Parkway Properties PKY 10/29/2004
PS Business Parks, Inc. PSB 7/27/2006
Senior Housing Propeties Trust SNH 8/22/2006
Sovran Self Storage SSS 7/8/2004

As of October 2, 2006; www.nareit.com

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 REIT Valuation
EPS v. FFO

• Earnings per share (EPS) is an accounting number

– REIT must distribute at least 90% of EPS
• Funds from operations (FFO) is REIT cash flow (no
depreciation/amortization)
• FFO means net income (computed in accordance with
GAAP), excluding gains (or losses) from debt restructuring
and sales of property, plus depreciation and amortization of
assets uniquely significant to the real estate industry, and
after adjustments for unconsolidated entities in which the
REIT holds an interest. Adjustments for these entities are
to be calculated to reflect FFO on the same basis.
• Moreover, NAREIT believes that items classified by GAAP
as extraordinary or unusual are not meant to either increase
or decrease reported FFO.

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 REIT Valuation
How to Calculate FFO

Revenues
– Operating expenses
– Depreciation & amortization
– Interest expense
– General & Administrative expense
= NET INCOME (GAAP)

Net Income
– Profit from real estate sales
+ Depreciation & amortization
= FFO

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 REIT Valuation
How to Calculate FFO

Ten shares outstanding

REIT REIT
Income Cash
Statement Flow

Rent $ 100 $ 100

- Operating Expenses 40 40
Net Operating Income 60 60
- Depreciation/amortization 40
Net Income 20
Cash Flow 60
EPS $ 2
FFO Per Share $ 6

Example from Brueggeman and Fisher, page 631.

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 REIT Valuation
Adjusted FFO

FFO minus:
– Recurring capital expenditures (e.g. painting, carpets, etc.)
– Amortization of tenant improvements
– Amortization of leasing commissions
– Adjustment for rent straight-lining

= Adjusted FFO (AFFO)

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 REIT Valuation
Impact on FFO

• Depending upon management’s strategy with

respect to capitalizing or expensing items,
calculated FFO and percentage of payout of net
income can vary widely
• Kimco Realty (KIM) expenses everything they can --
reduces measured NOI -- increases amount they can
retain (65% payout ratio - lowest in industry)
• Large group of about 10 has payout ratios over 95% --
capitalize aggressively -- raises FFO -- reduces what
they can retain

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 Financial Analysis

REIT Financial Ratios

Earnings per Share, EPS = Net income/shares outstanding

Funds from Operations, FFO = Net Income plus Depreciation

& Amortization

Return of Capital, ROC = Dividends minus Earnings

Cash Retention, CR = FFO minus Dividends

Book Value, BV = Assets minus Liabilities

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 Financial Analysis

Example: Midwestern Property Trust

Summary

Properties: 5 million square feet

Original Cost: $300 million
Depreciated Cost: $170 million
Mortgage Debt: $ 80 million
Annual Interest Rate: 8%
Term: 10 years
Number of Common Shares: 5 million

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 Financial Analysis

Example: Midwestern Property Trust

Operating Statement

Net Revenue $ 70,000,000

less Operating Expenses 30,000,000
Deprecation and amortization 15,000,000
General and administrative 4,000,000
Management expenses 1,000,000
Income from Operations $ 20,000,000
less interest expense 6,400,000
Net income (loss) $13,600,000

Net income (loss) per share $ 2.72

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 Financial Analysis

Example: Midwestern Property Trust

Balance Sheet: Assets

Cash $ 500,000
Rents Receivable 1,500,000
Properties @ cost 300,000,000
less accumulated depreciation 130,000,000
Properties-net 170,000,000
Net Assets $ 172,000,000

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 Financial Analysis

Example: Midwestern Property Trust

Balance Sheet: Liabilities

Short term $ 2,000,000

Mortgage debt 80,000,000
Total debt 82,000,000

Shareholders’ equity 90,000,000

Total Liabilities and equity $ 172,000,000

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 Financial Analysis

Example: Midwestern Property Trust

Profit Summary $ Amount Per Share

Earnings $ 13,600,000 $ 2.72

NOI $ 35,000,000 $ 7.00

FFO $ 28,600,000 $ 5.72

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 Financial Analysis
Example: Midwestern Property Trust

Other Financial Data and Ratios

Market price per share of common stock (given) $ 75.00

Dividend per share (given) $ 4.00
Recovery of Capital per share $ 4.00 - $ 2.72 = $ 1.28
Cash retention per share $ 5.72 - $ 4.00 = $ 1.72

Earnings yield $2.72/$75.00 = 3.62%

FFO yield $5.72/$75.00 = 7.62%
Dividend yield $4.00/$75.00 = 5.33%

Current earnings multiple $75.00/$2.72 = 27.6x

Current FFO multiple $75.00/$5.72 = 13.1x
Net assets per share $172M/5M = $ 34.00
Equity or book value per share $90M/5M = $ 18.00 39
 Economies of Scale
Minimum Efficient Firm Size

• Typical REIT IPO from 1993

– $100,000,000 firm with 50/50 debt-equity ratio,
yielding 8% on equity
– implies roughly $4,000,000 in income
– even with relatively low payout ratio of 75% of
earnings, can retain only $1,000,000

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 Economies of Scale
What will $1,000,000 buy?

– for an apartment REIT, a good-sized garden apt. complex

costs $20-$25 million, retaining the added $1,000,000 adds
little flexibility with respect to acquiring properties for
portfolio.
– from broad capital market perspective, this firm probably
should increase payout ratio (this is what happened in
reality)
• shareholders received high dividend yield, firm had to
repeatedly go to the capital markets to fund acquisitions

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 Economies of Scale
$10 billion REIT

– same 50/50 debt-equity ratio and 8% yield on

equity for a $10 billion REIT
– implied income of about $400,000,000
– if firm chooses not to aggressively expense, it
will have a relatively high payout ratio
• if that ratio is 95%, implies the firm can retain
$20,000,000
• that’s a good-sized garden apt complex, 1/5th
of a large regional mall, or a couple of decent-
sized warehouses or industrial sites.

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 Economies of Scale
$10 billion REIT

– if firm chooses to aggressively expense items to

reduce accounting earnings and lower its required
payout under the REIT tax law, the situation is
markedly different
– assume its payout ratio falls to 75%:
• ratio implies retention of $100,000,000
• which will buy a portfolio of any property type
except regional malls and downtown office
buildings

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 REIT Advisors

• Prior to 1986, REITs

– Passive investment vehicles
– Day to day business decisions (property management and
investment decisions) conducted by 3rd party external advisors
– Advisors frequently had conflicts of interest
• Were property owners trying to sell the REIT property
• Were advisors to other (competing) REITs

• 1986 Tax Reform Act

– A REIT “may directly select, hire and compensate those
independent contractors who will provide customary services that
may be provided by a REIT in connection with the rental of
property, rather than hiring an independent contractor to hire other
independent contractors.”
– Allowed REITs to be self-advised/self-managed.

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 REIT Advisors

Number (and %) of REITs by Type of Advisor

Advisor Style 1996 1998 2000

External 100 87 25
(35%) (30%) (9%)

Internal 186 194 244

(65%) (70%) (91%)

Total 286 281 269

Source: Real Estate Investment Trusts, by Chan Erickson and

Wang, Oxford, 2003, p.58
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 REIT Growth
1. Grow income from existing properties
– Raise rents
– Reduce vacancy
– Increase Operating Efficiency

2. Acquisitions
– Purchase properties @ positive spreads between property yields and
WACC
– Swap shares in REITs to take advantage of tax provisions

3. New construction

4. Financial Engineering
– Manipulate Funds from Operations
– Leverage
– Change payout ratio

Most REITs finance expansion with additional stock offerings

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