REITS / REAL ESTATE INVESTMENT TRUSTS

Transcription

1 Publications 07/17 No. 1 REITS / REAL ESTATE INVESTMENT TRUSTS INTRODUCTION INTO REITS Definition Trading Type A company that owns or finances income-producing real estate. REITs typically pay out all of their taxable income as dividends to shareholders. Most REITs are traded on major stock exchanges, but there are also public non-listed and private REITs. The two main types of REITs are Equity REITs and Mortgage REITs. Equity REITs: Generate income through the collection of rent on, and from sales of, the properties they own for the long-term. Mortgage REITs: Invest in mortgages or mortgage securities tied to commercial and/or residential properties. Sectors Financial Benefits Office REITs, Industrial REITs, Retail REITs, Lodging REITs, Residential REITs, Timberland REITs, Healthcare REITs, Self-Storage REITs, Infrastructure REITs, Data-center REITs, Diversified/Specialty REITs *Diversification Low Correlation with Broader Market Increases Return/Reduces Risk Completes Asset Allocation *Income Dividends & Wealth Accumulation Reliable Income Returns Reduce Portfolio Volatility *Inflation Protection Returns Consistently Outpace CPI Natural Inflation Hedge High & Low Inflation

2 *Performance Outperformed S&P Over Most Periods Better Returns vs. Corp. Bonds Deliver Growth/Income *Liquidity Bought & Sold Like Other Equities Tactical Asset Allocation Portfolio Rebalancing *Transparency Strong Corporate Governance Tax Transparency Market Transparency REITS MODELING 101 How Does Real Estate Property Modeling Differ from Normal Modeling? Consideration of Type of building: Entire apartment, office, or hotel Estimation of financials: Expenses, revenue, and the sale price. Think of property modeling as startup meets leveraged buyout : Over time, you will incur more expenses as you develop the property and eventually gain profit when tenants move in and charge rent. But just like in a leveraged buyout, you use a combination of equity (cash) and debt from investors to fund the development. Like a LBO model, you always need to sell the property in the future to realize a good return on your investment. Compared to normal financial modeling, here are the key differences: 1. Property modeling is much more granular you ll be thinking about individual parking spaces, rooms, square feet or square meters, and so on. If you re artistic, you might even get to draw a few pictures and diagrams along the way. 2. Timing is far more important. You can t just assume slightly different numbers each year you go down to individual months and make wildly different assumptions in different phases of the project. 3. Financing is different. You use different types of debt and equity, and the total funding required is often a far higher number than you expect because interest is capitalized while the property is under construction.

3 Property development progress: 1. First, you need to figure out how big your property is. You measure this in square feet or square meters, and occasionally in other units like acres. 2. Consider the proportion of land that you can rent out 3. So you calculate the gross area and rentable area (usually a percentage of the gross area, based on local zoning requirements), and then figure out how much everything will cost to develop. There are 5 big categories of expenses with properties: Hard Costs: Actually building walls, floors, ceilings, doors, and so on. Soft Costs: Paying for legal advice, the services of architects, and lovely other professional services. Land Acquisition: Land costs money. A lot of money, especially in prime locations like Manhattan, downtown London, and so on. Furniture, Fixtures & Equipment (FF&E): Self-explanatory chairs, desks, tables, computers, and anything else the tenants all receive when they move in. Tenant Improvements (TIs): Sort of like FF&E, but these are custom items that tenants have requested. So let s say that you re giving everyone standard chairs, but one of your tenants has requested Aeron chairs for everyone that would be a tenant improvement. Once you ve estimated all these items, you can come up with a rough estimate of how much the property will cost to develop. Then, you deliver that estimate to your investors. The two main sources of funding for property development are equity (cash) and debt. Within equity, there s developer equity what you, the developer of the property are throwing in and then 3rd party investor equity what other investors are contributing to get a percentage of your property. Developer equity tends to be a much smaller percentage than 3rd party investor equity, and altogether both forms of equity take up a minority (often 20 30%) of the total funding. Similar to the leverage ratio in LBO models, you use the Loan-to-Cost (LTC) Ratio from similar developments in the market to figure out what percentages of debt and equity makes sense. Normally you start off with the assumption that the total debt and equity required equals the Hard Costs + Soft Costs + Land Acquisition Costs + FF&E + TIs. But once you go in and complete more of the model, you also need to add in capitalized interest and the operating deficit (i.e. how much the property loses before it starts turning a profit) to the total funds required. Timing is key: Time and location are both important factors in development. Once you ve figured out the total costs, next you need to divide the construction into phases. The three most common phases are preconstruction, construction, and post-construction, and they may last anywhere from 1-2 years (divided into months in your model) each depending on the complexity of the development. Pre-Construction: This is where you buy the land (Land Acquisition Costs) and where some of the Soft Costs (legal fees, permits, etc.) start coming up you need to pay for all those before construction begins. Construction: You incur many of the Hard Costs here, along with continued Soft Costs, and you may start paying for some of the FF&E and TIs toward the end.

4 Post-Construction: Soft Costs continue even after the building is constructed; you may also continue to incur FF&E and TI expenses here. Then, once you have a rough sketch for how much in development costs you ll incur each month in your timeline you can begin thinking about revenue, operating expenses, and property taxes. Property Revenue and Expenses Revenue categories depend on the type of property: for hotels, you d look at the Average Daily Rate (ADR) times the number of rooms times the average occupancy rate (and then look at other sources such as food & beverages, events, telecom, etc.). But for offices or retail, you d just estimate the rate per square foot or per square meter, multiply by the rentable area, and then multiply by the occupancy rate. For apartments, there are two big revenue sources: monthly rent and monthly parking fees. To estimate monthly rent, you would look at the rentable area of the property, figure out how much space you need for an individual apartment unit, and then determine how much to charge tenants. Let s say you have an apartment complex with 200 units, each of which is 50 square meters (~538 square feet). In a big city, you might get $2,500 per month for that, which gives you $6 million in rental income (200 * $2,500 * 12). You could calculate parking revenue by estimating how many parking spots are required for each unit, and then the monthly rates for each spot. You also have to net a vacancy allowance against this number to reflect the fact that not all your units will be filled at all times. A typical number might be in the 5-10% range. Once you ve done that, you can calculate annual net revenue. Then you need to calculate the operating expenses (maintaining the property, paying for insurance, utilities, and so on depending on the lease terms) and the property taxes (based on the zoning regulations in the area). Usually you estimate these on a per square foot or per square meter basis, based on similar properties in the area. Then you can take the net revenue and subtract operating expenses and property taxes to get. Net Operating Income (NOI) and Cap Rates NOI is similar to EBITDA for normal companies, because it excludes: Depreciation & Amortization Interest Income / (Expense) (from the debt financing, for example) Gains / (Losses) on Asset Sales Corporate Overhead (for REITs) Income taxes (you still take into account property taxes) Some people do include maintenance CapEx what it costs to maintain your property in its current condition, but it is never correct to include items like acquisitions, developments, or renovations because those represent growth in the property. Once you have the Net Operating Income (NOI), you can calculate the Capitalization Rate, also known as Cap Rate, or Yield in some countries (such as the UK):

5 Cap Rate = NOI / Property Value So let s say your new apartment complex will generate $6 million in annual net operating income, and you want to sell it for $100 million. The cap rate there would be 6%. Cap rates are the inverse of valuation multiples, because a higher cap rate means that the property is worth less; a 10% cap rate corresponds to a 10x multiple, but a 5% cap rate corresponds to a 20x multiple. Generally you see cap rates between 5% and 10% across all property types, with lower cap rates in big cities and higher cap rates in suburban areas. Financing the Construction and Selling the Property OK, so now you ve got the estimated monthly development expenses and your monthly NOI based on the net revenue minus operating expenses and property taxes. Next, you need to calculate how much funding you need to construct the property and operate it until it reaches profitability. Then, you gradually draw on equity until you ve hit the maximum allowed number (based on investor demand and what they re willing to pay), and then you start drawing on debt until you no longer need funding and the project reaches profitability. When drawing on the debt, you also need to capitalize the interest payments until you have enough cash flow to pay interest in cash; so that number will add to the total funds required in the beginning, creating a circular reference. Just like in a leveraged buyout model, you assume that the property is sold at the end of the period you re looking at, normally around 5 years, and you base this selling price on the cap rate for similar properties in the area and what your NOI is in year 5. Example: You draw on $20 million in equity in year 1 of the development. Then, you draw on $60 million in debt over years 2-4; by year 5 you ve already reached profitability so you no longer need to draw on debt. Your net operating income (NOI) in year 5 is $8 million. The going cap rate for similar properties in your area is 7%. Process: 1. So the sale price of the property would be $8 million / 7%, or approximately $114 million. 2. But you ve also drawn on $60 million of debt, which needs to be repaid so that brings your net proceeds down to $54 million (we re ignoring selling and transfer fees here). So, what happens when you invest $20 million in year 1 and then earn $54 million back in year 5? Using Excel, you can enter -20, then 0, another 0, another 0, and finally 54 and then use the IRR function to get your answer: it s a return of approximately 28%, which is very good by anyone s standards. In real life, property developments often have much lower returns because sale prices and cap rates are unpredictable; projects also tend to run over-budget and fall behind schedule.

6 Properties to REITs: How properties and REITs are connected? A real estate investment trust (REIT) owns dozens, hundreds, or thousands of properties. They can then do 4 things with these properties: 1. Operate and improve existing properties. 2. Develop new properties. 3. Acquire new properties. 4. Dispose of existing properties. So when you project a REIT, you use the cap rates, NOI, and property values of entire property segments to estimate what happens in each category above. Rental income across all the properties becomes the REIT s revenue, and then the operating expenses and property taxes of all the properties become (part of) the REIT s expenses. Other key expenses include corporate overhead and G&A, depreciation (ignored at the property-level, but extremely important at the corporate level), and interest expense (REITs need lots of debt to buy properties). Then, all the property itself shows up on the REIT s balance sheet as an asset, and line items like development, acquisitions, maintenance CapEx, and the sale of real estate assets show up on the cash flow statement under Cash Flow from Investing (CFI). So How Do REITs Work? That s how properties and REITs are connected, but there are other requirements for REITs: If they distribute 90% of their taxable income as dividends, they pay no corporate income taxes. 75% of gross income must come from real estate-related assets 75% of assets must be real estate-related. There must be over 100 shareholders and fewer than 5 shareholders cannot own over 50% of the company. These are the requirements for US-based REITs; they differ by country but they generally follow the guidelines above, sometimes with slightly different numbers. Now, think about what the above requirements mean: REITs need massive amounts of funding because they need expensive real estate assets on their balance sheets but they must give up 90% of their profits each year in the form of dividends. So they can never save up a huge amount of cash on their balance sheets. Instead, they must rely on constantly raising debt and equity and selling properties to properly fund their operations. REIT Income Statement Here s what a REIT s income statement might look like, from Revenue at the top to Net Income at the bottom: Revenue: Split into rental income (90%+) and miscellaneous revenue & fees. Expenses: Property-level operating expenses, property taxes, G&A, Depreciation, and Net Interest Expense.

7 Earnings / (Loss) from Equity Investments and Gain / (Loss) on Sale of Land two intermediate items; the first one refers to net income from any companies or ventures where the REIT owns less than 50%. Income from Continuing Operations: Revenue Expenses + Earnings / (Loss) from Equity Investments + Gain / (Loss) on Sale of Land. Discontinued Operations: Income from Discontinued Operations + Gain / (Loss) on Sale of Buildings and FF&E. This one s important for REITs. They always have discontinued operations since they re always selling off assets. Net Income: Income from Continuing Operations + Discontinued Operations. Note that there are no corporate income taxes due to the REIT requirements referenced above. Earnings / (Loss) from Noncontrolling Interests: This one goes beyond the scope of this crashcourse guide, but it refers to net income from companies that the REIT owns over 50% of, and which have already been embedded in the financials above. You must subtract these due to accounting rules. Net Income Attributable to Company: Net Income Earnings / (Loss) from Noncontrolling Interests. To get a real-world example of a REIT s financial statements, click here to see the historical statements of AvalonBay (a residential REIT). REIT Balance Sheet Unlike a traditional company s balance sheet, a REIT s balance sheet is split into Real Estate Assets and Other Assets on the Assets side. The other side is more traditional, with categories for Liabilities and Shareholders Equity. Here are the most common items on the Assets side in each category: Real Estate Assets: Land; Buildings and Improvements; Furniture, Fixtures & Equipment; Accumulated Depreciation; Construction in Progress; Land Held for Development; Real Estate Assets Held for Sale. Other Assets: Cash & Cash-Equivalents; Equity Interests; Capitalized Financing Fees; Accounts Receivable; Prepaid Expenses. The Accumulated Depreciation number tends to be massive, which creates problems for our valuation, as you ll see later on. Also, note how the Real Estate Assets are not separated into the categories you might expect Existing Properties, Developed Properties, Acquired Properties, etc. It would make our lives easier if they were, but REITs must follow GAAP / IFRS conventions for asset categories on their balance sheets. Equity + Liability: Liabilities: Debt (separated into many tranches); Accounts Payable; Accrued Expenses; Redeemable Noncontrolling Interests. Shareholders Equity: The same as usual. Noncontrolling Interests are extremely common here. Redeemable Noncontrolling Interests go beyond the scope of this tutorial, but refer to the REIT s option to repurchase part of the corporate partnership structure from investors.

8 REIT Cash Flow Statement The cash flow statement is very standard: start with net income, add back non-cash charges such as depreciation, amortization, and stock-based compensation, and then take into account changes in operating assets and liabilities to calculate cash flow from operations. Cash Flow from Investing for REITs refers to anything related to their Real Estate Assets: development, acquisitions, capital expenditures, and selling property, land, and so on. Cash Flow from Financing includes all the normal items: raising and paying off debt and preferred stock, issuing stock, buying back stock, and issuing dividends (huge for REITs). How Everything Flows Together 1. First, you project how the REIT will raise rents on its same-store properties (existing properties) from year to year; that comprises the bulk of the REIT s revenue. 2. Then, you project how much they spend on developing and acquiring new properties and assume a cap rate and margin for both of those to calculate the NOI and revenue. 3. Then, you estimate how many properties the REIT will dispose of and you assume a cap rate and NOI margin on those to calculate its income from discontinued operations. 4. Using the margin and revenue assumptions, you can back into the operating expenses and property taxes for each segment. 5. Add up the revenue and expenses for each different segment to start creating the income statement; the depreciation can be a simple assumption (gross building and FF&E value / useful life) and the interest expense flows in from the debt schedules. 6. Discontinued operations items flow in from the disposed properties segment. 7. Once you have the income statement, the balance sheet flows in mostly from the segmentlevel schedule and other items like AR and prepaid expenses can be a percentage of revenue or expenses. 8. Much of the cash flow statement flows in from the other statements, and the investing activities section comes from the segment-level schedule. To get a flavor for how some of this works, click here to view a free sample lesson on how to model dispositions and discontinued operations for AvalonBay. Important REIT Operating and Valuation Metrics Let s start with operating and valuation metrics that are not meaningful for REITs: P / E It includes Depreciation, a massive non-cash charge for REITs, so we don t use it. P / BV REITs have a huge amount of Accumulated Depreciation, so we don t use Book Value. All that Accumulated Depreciation is a contra-asset on the Assets side, so it pushes Shareholders Equity down artificially low. EBITDA and EBIT We actually want to take into account the interest expense for REITs, because it s a cash charge that does affect how much they can pay out in dividends. Revenue / Revenue Growth We care far more about a REIT s ability to pay dividends and how much cash flow it s generating than its top-line growth.

9 So rather than the metrics above, there are two new important metrics you need to know when analyzing REITs: Funds from Operations (FFO): Net Income + Depreciation & Amortization + Losses on Asset Sales Gains on Asset Sales Adjusted Funds from Operations (AFFO): FFO Maintenance CapEx + Other Adjustments With FFO, you are approximating how much the REIT can actually issue in dividends on a recurring basis from year to year. D&A is always non-cash and does not affect its dividend-issuing capacity, so you add it back; losses and gains are assumed to be non-recurring, so you also exclude those. The only issue with FFO is that you re not taking into account the CapEx required to maintain all your properties, which is why AFFO exists. Many analysts argue that AFFO better represents how much in potential dividends a REIT can issue on an ongoing basis, because they must maintain their properties no matter what else they do. Then there are a few other metrics to know: Calculate Net Operating Income (NOI) for the entire REIT by summing up the NOI of all its properties, and you can also calculate the REIT s Cap Rate by dividing its NOI by the gross real estate asset value on its balance sheet. Dividend Payout Ratios (Dividends / Net Income) are also important to track because a REIT must pay out at least 90% at all times to avoid corporate income taxes. Sometimes you also calculate Dividends / FFO or Dividends / AFFO and call those Payout Ratios, under the argument that FFO and AFFO are better metrics for how much in dividends a REIT can really issue. REIT Valuation Just as with other industries, the formula is the same here: So you still use public companies and precedent transactions, and you can even use a DCF to value a REIT if you want, however that s not common. For the public companies and precedent transactions, the key metrics are FFO and AFFO and the corresponding valuation multiples are Equity Value / FFO and Equity Value / AFFO (sometimes you see these calculated as Price Per Share / FFO Per Share and Price Per Share / AFFO Per Share). You usually screen for comparables and transactions based on gross real estate assets rather than metrics like revenue or EBITDA, and you may do another cut based on REIT sub-industry (residential, hotels, offices, etc.). There is usually a correlation between FFO and AFFO multiples and the Cap Rate of the REIT a lower Cap Rate means that the REIT s portfolio is worth more, which (theoretically) means that they should have higher valuation multiples, and vice versa. Sometimes you also calculate the FFO Yield (1 / FFO) and the AFFO Yield (1 / AFFO) and compare those to the Cap Rate of the REIT s entire portfolio to see whether the public markets are valuing it correctly.

10 The Net Asset Value (NAV) Model Remember the point above about Book Value not being a great metric for REITs due to their high Accumulated Depreciation balances? You can fix that and value a REIT using its balance sheet with the Net Asset Value (NAV) model, can also be used for oil and gas companies. 1. You look at the REIT s existing NOI by segment, and assign a Cap Rate to each segment to determine how much each one is worth. Sum up each segment s value to calculate how much the Gross Real Estate Assets of the REIT are worth. 2. Then, you value the rest of the REIT s assets (anything non-real-estate-related + anything real estate-related but non-income-generating, such as Construction in Progress) by assuming a slight premium or discount to their balance sheet values. You exclude Accumulated Depreciation completely. 3. Add up the total value of all their assets. 4. Now, assume a slight premium or discount (or nothing at all) for all the REIT s liabilities, and sum them up. 5. Subtract the modified liability value from the modified asset value to arrive at the Net Asset Value (NAV), which you can then divide by the share count to get NAV Per Share. As you can see, the mechanics of a NAV model are not difficult: you re just modifying balance sheet values and picking Cap Rates. The theory behind a NAV model is that private markets, for real estate, are often more efficient than the public markets; so the prevailing Cap Rates by property and geography can be more accurate than the public market valuation of a REIT. Picking up on the appropriate Cap Rates is difficult and time-consuming and you need knowledge of the local real estate markets, or access to brokers and developers in those markets, to do any of this. Assuming you can actually pick the Cap Rates and value everything else on the balance sheet properly, you can then compare the NAV Per Share to the REIT s current stock price to see whether it s trading at a discount, premium, or at about the right level. Replacement Cost Replacement Cost (Replacement Value), is another real estate-specific valuation methodology. Just like the NAV model, the idea is simple: you look at the gross area of your property and estimate how much it would cost to re-construct the entire property today, based on the Hard Costs, Soft Costs, Land Acquisition Costs, FF&E, and TIs per square foot or per square meter. 1. So let s say you add up all of those and it comes out to $ per square foot. But the asking price for the property is $ per square foot. 2. In that case, it would seem that the property is slightly overvalued since you could theoretically construct a new, identical property for less than the asking price. However, that logic doesn t exactly hold up in the real world because constructing a new property is risky and time-consuming, often runs over-budget and behind-schedule, and you can t build the new property in the same exact location; so there are no guarantees that it will be worth as much. So Replacement Cost is used as more of a sanity check than anything else. You use it to see whether the asking price of a property roughly makes sense rather than as a strict valuation methodology.

11 And while you can technically apply it to REITs as well, it s mostly used for individual properties due to the time-consuming nature of the analysis and the inability to get good estimates of the expense per square foot or per square meter in different regions. REIT Merger Models and LBO Models Just as with merger and LBO models in other industries, there s nothing mechanically different about either one for REITs: you still combine the 3 statements and allocate the purchase price in a merger model, and you still use a combination of debt and equity and then sell the company after 3-5 years in an LBO model. The differences relate to purchase methods and the viability of deals rather than the mechanics. With a merger model, for example, it s nearly impossible for a REIT to use much cash or debt. They have little cash due to the issue 90% of taxable income as dividends requirement and they tend to be highly leveraged already so 100% stock deals are extremely common. Just like normal companies, REITs are motivated to merge to reduce costs and earn more revenue, but often they are also geographically motivated: two competing REITs in one region, for example, might decide to join forces and gain more pricing power so they can raise rents and avoid competing with each other. And then there are a bunch of smaller differences: no corporate income taxes when calculating accretion / dilution, asset write-ups perhaps based on Cap Rates instead, and accretion / dilution of metrics such as FFO Per Share, AFFO Per Share, and Dividends Per Share in addition to the standard EPS. REIT LBO models are not terribly common in normal economic times because REITs are highly leveraged by nature; it s hard to realize a good return if the company already has a high debt load. They are still more common than oil & gas or commodities-related LBOs because rental income is a much more stable than revenue earned from volatile commodity prices. But in general, it s tough to realize a great IRR solely through financial engineering adding on additional debt unless the PE firm in question also has plans to improve the REIT s properties or operations in some way. You re Fired? That was quite long, but we ve actually just scratched the surface of real estate and REITs. And you may not be Donald Trump quite yet, but if you ve made it this far you re more than prepared to dominate your interviews and land offers in real estate investment banking groups, real estate PE, and even at that REIT you ve been eyeing. Remember the key real estate development terms outlined above, the most important REIT metrics, and the NAV model and you ll be ahead of 90% of the competition. Reference: 1. UBS, Global Investment Outlook EY Mergers and Inquisitions

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