1

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)

2

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

3

REITsEquity REITs, SNP 500, Russell 2000

1978:12-2007:10

0.00

1,000.00

2,000.00

3,000.00

4,000.00

5,000.00

6,000.00

7,000.00

Dec

-78

Dec

-79

Dec

-80

Dec

-81

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-82

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-83

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-84

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-86

Dec

-87

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-95

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Dec

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Dec

-00

Dec

-01

Dec

-02

Dec

-03

Dec

-04

Dec

-05

Dec

-06

Month

Inde

x 1

978:

12 =

100

SNP 500 (12.7%)

Equity REITs (14.0%)

Russell 2000 (12.4%)

4

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

5

RequirementsManagement

– 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.

6

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

7

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

8

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)

9

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

12

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

0

50

100

150

200

250

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

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1999

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Year

TotalEquityMortgageHybrid

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REITs

REIT Market Cap

0

50

100

150

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300

350

1971

1974

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1980

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1986

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1992

1995

1998

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2004

Year

Bill

ion

$$$

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REITs

REIT Percent Market Cap by Type

0.0%10.0%20.0%30.0%40.0%50.0%60.0%70.0%80.0%90.0%

100.0%

1971 1976 1981 1986 1991 1996 2001

Year

EquityMortgageHybrid

16

REITs

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

YearTotal

Number IPO Secondary Equity Secondary DebtCommon Preferred Unsecured Secured

1998 474 17 216 81 145 151999 205 2 29 71 69 342000 114 0 11 31 70 22001 127 0 58 21 44 42002 187 3 85 25 71 32003 228 8 82 64 68 62004 266 29 79 61 97 02005 259 11 71 36 105 362006 165 5 56 34 67 3

17

REITs

Equity REIT Sectors ( % Market Cap)

Health Care 5.2%

Self Storage 3.9%

Lodging/Resorts 7.3%

Diversified 7.6%

Residential 18.7%

Retail 26.3%

Industrial/Office 26.7%

Specialty 4.3%

18

Equity REITs

Sector REIT SymbolPrice

(12/3/2007)Market Cap

(billions) D/E Beta P/EApartments

Equity Residential NYSE: EQR $37.22 $10.09 1.85 1.70 8.82Apartment Investment & Management Co. NYSE: AIV $38.82 $3.71 3.62 1.41 65.57UDR, Inc. NYSE: UDR $22.00 $2.95 3.48 1.48 23.53

DiversifiedVornado Realty Trust NYSE: VNO $88.49 $13.54 2.03 1.18 26.52Duke Realty Corp. NYSE: DRE $26.59 $3.87 1.57 0.99 17.35

Health CareHealth Care REIT, Inc. NYSE: HCN $44.36 $3.62 1.15 1.57 36.51Nationwide Health Properties Inc. NYSE: NHP $31.42 $2.92 0.96 1.46 10.81

HotelStarwood Hotels & Resorts Worldwide Inc.NYSE: HOT $53.44 $10.64 1.22 0.69 19.29Hospitality Properties Trust NYSE: HPT $36.35 $3.40 1.09 1.01 11.13

IndustrialPrologis NYSE: PLD $64.93 $16.72 1.29 1.50 13.57AMB Property Corp NYSE: AMB $60.70 $6.01 1.23 1.10 20.75First Industrial Realty Trust NYSE: FR $36.81 $1.64 2.04 0.97 14.87

OfficeBoston Properties Inc NYSE: BXP $97.41 $11.62 1.24 1.32 9.18SL Green Realty NYSE: SLG $101.67 $6.02 1.41 1.18 10.47Mack-Cali Realty Corp. NYSE: CLI $35.04 $2.38 1.22 1.42 14.43

RetailSimon Property Group NYSE: SPG $97.24 $21.69 4.57 1.56 41.12General Growth Properties, Inc. NYSE: GGP $47.05 $11.47 15.95 1.45 38.47Taubman Centers, Inc. NYSE: TCO $54.10 $2.85 1.13 65.50

19

Debt REITs

Sector REIT SymbolPrice

(12/3/2007)Market Cap

(billions) D/E Beta P/ECommercial

Annaly Mortgage NLY $17.10 $6.870 9.93 0.70 14.77Capstead Mortgage Corp. CMO $12.26 $0.379 13.78 1.37 naCapital Trust CT $30.96 $0.542 5.20 0.98 7.63Allied Capital ALD $24.07 $3.720 0.63 0.18 23.12

ResidentialThornburg Mortgage Asset TMA $10.43 $1.360 15.68 0.63 naAnworth MTG Asset CP ANH $7.18 $0.329 9.96 0.86 na

BothRedwood Trust, Inc. RWT $30.40 $0.853 73.87 1.35 184.2RAIT Financial Trust RAS $8.74 $0.533 11.45 2.31 naNewcastle Investment Corp NCT $12.84 $0.678 9.24 2.01 10.66

20

Umbrella Partnership REITUPREIT

• 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

21

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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23

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

24

REITs in Market Indexes

S&P 500 IndexREIT Ticker EnteredAIMCO AIV 3/13/2003Archstone-Smith ASN 12/17/2004Boston Properties BXP 3/31/2006Equity Residential EQR 11/1/2001Kimco Realty Corporation KIM 4/3/2006Plum Creek Timber, Inc. PCL 1/16/2002ProLogis PLD 7/16/2003Public Storage, Inc. PSA 8/18/2005Simon Property Group SPG 6/25/2002Vornado 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 IndexREIT Ticker EnteredAMB Property Corporation AMB 1/27/2003Developers Diversified Realty Corp. DDR 9/30/2004Highwoods Properties, Inc. HIW 10/7/2003Hospitality Properties Trust HPT 10/1/2001Liberty Property Trust LRY 12/11/2002The Macerich Company MAC 7/1/2005Mack-Cali Realty Corporation CLI 3/19/2003New Plan NXL 10/1/2001Rayonier RYN pre-REITRegency Centers REG 4/25/2005United Dominion Realty Trust UDR 1/27/2003Weingarten Realty Investors WRI 11/10/2004

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

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REITs in Market IndexesS&P 600 Small Cap Index

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

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

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REIT ValuationEPS 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.

28

REIT ValuationHow 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

29

REIT ValuationHow 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.

31

REIT ValuationAdjusted 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)

32

REIT ValuationImpact 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

33

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

34

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

35

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

36

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

37

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

38

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

39

Financial AnalysisExample: 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

40

Economies of ScaleMinimum 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

41

Economies of ScaleWhat 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

42

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.

43

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

44

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.

45

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

46

REIT Growth1. 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