Investments in Real Estate Through Publicly Traded Securities

Publicly Traded Real Estate Investments

Publicly traded real estate securities appeal to small investors seeking to gain exposure to professionally managed real estate. Just like mutual funds, REITs were tax advantaged under the tax codes of major developed markets and became a popular vehicle for investors to gain exposure to real estate asset class.

Publicly traded real estate securities can take several forms: real estate investment trusts (REITs), real estate operating companies (REOCs), and residential or commercial mortgage backed securities (MBS).

We can categorize publicly traded real estate securities into two broad groups: equity and debt.

Equity

Publicly traded real estate equity securities represent ownership stakes in properties.

Equity REITs and REOCs fall into this category.

Equity REITs (real estate investment trusts). REITs are tax advantaged companies (trusts) that are for the most part exempt from corporate income tax. Equity REITs are actively managed, own income producing real estate, and seek to profit by growing cash flows, improving existing properties, and purchasing additional properties.

REITs often specialize in a particular kind of property, while still diversifying holdings by geography and other factors.

To be tax advantaged, REITs are generally required to distribute more than 90% of their taxable income to their shareholders.

REOCs (real estate operating companies). REOCs are not tax advantaged; rather, they are ordinary (i.e., taxable) corporations that own real estate. A business will form as a REOC if it is ineligible to organize as a REIT.

For example, the firm may intend to develop and sell real estate rather than generating cash from rental payments, or the firm may be based in a country that does not allow tax advantaged REITs.

Debt

MBS (mortgage backed securities) and mortgage REITs fall into this category.

Residential or commercial mortgage backed securities (MBS). Residential or commercial mortgage backed securities are publicly traded asset backed securitized debt obligations that receive cash flows from an underlying pool of mortgage loans. These loans may be for commercial properties (in the case of CMBS) or on residential properties (in the case of RMBS).

Real estate debt securities represent a far larger aggregate market value than do publicly traded real estate equity securities.

Mortgage REITs. Mortgage REITs invest primarily in mortgages, mortgage securities, or loans that are secured by real estate.

REIT Structures

Most REITs are structured as corporations or trusts and are tax efficient conduits. In most countries, REITs are required to distribute 90% to 100% of their taxable income as dividends to be exempt from taxation. Additionally, REITs have other requirements, such as a minimum 75% investment in real estate and deriving at least 75% of their income from rental or mortgage interest.

Ownership rules vary by jurisdiction but tend to disallow family owned trusts from qualifying as REITs. In the U.S., REITs should have more than 100 owners, and no fewer than five owners can own more than 50% of the REIT shares (5/50 rule).

Advantages

Investments in REITs offer a number of advantages compared with direct investments in physical real estate:

Superior liquidity. Investors in publicly traded real estate securities enjoy far greater liquidity than do investors in physical real estate, because REIT shares trade daily on a stock exchange. The low liquidity of a direct real estate investment stems from the relatively high value of an individual real estate property and the unique nature of each property.

Transparency. Information about current and historical prices and volume is readily available.

Exemption from taxation. As long as certain requirements are met, REITs enjoy favorable taxation, because a major part of REIT distributions is treated as a return of capital and is thus not taxable.

Predictable earnings. The earnings of REITs tend to be relatively consistent over time, because REITs’ rental income is fixed by contracts, unlike the income of companies in other industries.

Access to premium properties. Some prestigious properties, such as high profile shopping malls or other prominent or landmark buildings, are difficult to invest in directly. Shares in REITs that have invested in these properties represent one way to take an ownership stake in these assets.

Active professional management. While a direct investment in properties requires a degree of real estate investment expertise and property management skill, REIT and REOC investments do not. REITs and REOCs employ professional management to control expenses, to maximize rents and occupancy rates, and sometimes to acquire additional properties.

Greater potential for diversification. Because of the high cost of a single property, it is difficult to achieve adequate diversification through direct investments in real estate. Through REITs, however, an investor can diversify across property type and geographical location.

Disadvantages

Most of the disadvantages for REITs as an investment center around the tax code requirement that a REIT distribute most of its earnings as dividends, limiting retained earnings as a means of growth.

Limited potential for income growth. REITs’ high rates of income payout limit REITs’ ability to generate future growth through reinvestment. This limits future income growth and may dampen the share price of REITs.

A REIT may be forced to issue equity at a disadvantageous price to finance its growth, as availability of retained earnings is limited.

Lack of flexibility. The rules that qualify REITs for favorable taxation also have a downside: REITs are restricted in their investment choices. These limits may prevent REITs from being as profitable as they might otherwise be.

Lower diversification benefit relative to direct investment in real estate. REITs tend to have a higher correlation with equities compared to direct real estate investments. So even though REITs allow superior diversification amongst property holdings, it offers poorer diversification overall inside an investment portfolio.

The net asset value per share (NAVPS) is the (per share) amount by which assets exceed liabilities, using current market values rather than accounting book values.

NAVPS is generally considered the most appropriate measure of the fundamental value of REITs. If the market price of a REIT varies from NAVPS, the premium (or discount) reflects an investor’s view of the management capabilities, leverage, and governance. REITs with high leverage and trading at a discount to NAVPS may find it difficult to refinance their maturing debt.

NAVPS is superior to book value per share (BVPS) because BVPS relies on the depreciated historical cost of a REIT’s asset.

Estimating NAVPS Based on Forecasted Cash Net Operating Income

In the absence of a reliable appraisal, analysts will estimate the value of operating real estate holdings of a REIT by capitalizing the REIT’s cash net operating income (NOI). This process first requires the calculation of a market required rate of return, known as the capitalization rate (“cap rate”), based on the prices of comparable recent transactions that have taken place in the market.

NOI is the amount of income remaining after subtracting vacancy and collection losses and operating expenses (e.g., insurance, property taxes, utilities, maintenance, and repairs) from potential gross income. NOI is calculated before subtracting financing costs, depreciation, general and administrative expenses, and income taxes.

Note that in calculating cash NOI, we subtract non cash rent. Non cash rent is the difference between the average rent over the term of a lease contract (i.e., straight line rent) versus the amount of cash rent actually received in a period. Further, in forecasting NOI for the next year, two adjustments are made to the current period NOI: (1) the impact of acquisitions (if any) for the current year, which are not fully reflected in the current period’s NOI, and (2) application of a growth rate.

In the following example, we show how to calculate NAVPS. First, estimated first year NOI is capitalized using a market cap rate. Next, we add the value of other tangible assets and subtract the value of REIT’s liabilities to find total net asset value.

Net asset value divided by the number of outstanding shares gives us NAVPS.

Generally, deferred financing expenses, deferred tax assets, and goodwill are excluded from total assets so as to only include “hard economic assets.” Similarly, debt and other liabilities are adjusted to their market values if the difference relative to book value is significant.

Analysts calculate and use two measures: FFO and AFFO.

1. Funds from operations (FFO). FFO adjusts reported earnings and is a popular measure of the continuing operating income of a REIT or REOC. FFO is calculated as follows:

Depreciation is added back under the premise that accounting depreciation often exceeds economic depreciation for real estate. Gains from sales of property are excluded because these are not considered to be part of continuing income.

2. Adjusted funds from operations (AFFO). AFFO is an extension of FFO that is intended to be a more useful representation of current economic income. AFFO is also known as cash available for distribution (CAD) or funds available for distribution (FAD).

The calculation of AFFO generally involves beginning with FFO and then subtracting non cash rent and maintenance type capital expenditures and leasing costs (such as improvement allowances to tenants or capital expenditures for maintenance).

Non cash rent often arises due to straight lining of rent: non cash rent is the amount by which the average contractual rent over a lease period exceeds the rent actually paid. A lease calling for increasing rental rates over the lease term will have significant non cash rent early in the lease term. Capital expenditures related to maintenance, as well as expenses related to leasing the space in properties, are subtracted from FFO because they represent costs that must be expended in order to maintain the value of the properties.

AFFO is considered a better measure of economic income than FFO because AFFO considers the capital expenditures that are required to sustain the property’s economic income. AFFO also provides a better indicator for the sustainability of the REIT’s dividend paying capacity. However, FFO is more frequently cited in practice, because AFFO relies more on estimates and is considered more subjective.

Comparison of Different Methods

Net asset value per share: The net asset value method of valuation can be used either to generate an absolute valuation or as part of a relative valuation approach. Note, however, that net asset value is an indication of a REIT’s assets to a buyer in the private market, which can be quite different from the value public market investors would attach to the REIT. For this reason, there have historically been significant differences (i.e., premiums or discounts) between NAV estimates and the prices at which REITs actually trade.

Advantages of Price Multiples

The advantages of price multiples are as follows:

1. Multiples P/FFO and P/AFFO are globally accepted in evaluating shares.

2. Multiples allow comparisons with other investment alternatives.

3. FFO estimates are widely available from reputed data providers such as Bloomberg.

4. Multiples are evaluated in conjunction with other factors such as growth rates to allow for reconciliation of differences in multiples between different REITs.

5. Because leverage is not explicitly accounted for in FFO and AFFO, analysts need to adjust for leverage differences in relative value analysis.

Drawbacks of Multiples

The drawbacks of price multiples are as follows:

1. Multiples do not capture the value of non income producing real assets (e.g., land held for development, vacant buildings).

2. FFO does not capture the impact of recurring capex type maintenance expenditures needed to maintain the earning power of properties.

3. One time gains and accounting charges distort FFO and AFFO and make comparisons between companies difficult.

Discounted cash flow approach: Dividend discount and discounted cash flow models of valuation are appropriate for use with REITs and REOCs, because these two investment structures typically pay dividends and thereby return a high proportion of their income to investors. DDM and DCF are used in private real estate in the same way that they are used to value stocks in general. For dividend discount models, an analyst will typically develop near term, medium term, and long term growth forecasts and then use these values as the basis for two or three stage dividend discount models.

To build a discounted cash flow model, analysts will generally create intermediate term cash flow projections plus a terminal value that is developed using historical cash flow multiples.

We have already identified the advantages and drawbacks of investing in REITs versus private investment (i.e., direct investment) in real estate. We summarize them here.

Advantages of private investment relative to publicly traded real estate securities

1. Direct exposure to the real estate class.

2. Returns dictated by property performance.

3. Tax benefits (accelerated depreciation, timing option for capital gains).

4. Inflation hedge.

5. Illiquidity premium.

6. Control and ability to pursue diverse strategies.

7. Lower correlation with other asset classes (superior diversification).

Drawbacks of private investments relative to publicly traded securities

1. Illiquidity.

2. High fees and expenses.

3. High minimum investment.

4. Low transparency.

5. Fewer regulatory protections for investors.

6. Appraisals lag actual market values.

7. Higher returns derived from the use of leverage, but increases risk.

Advantages of investing in publicly traded securities

1. Tracks real estate asset class fundamentals over the long term.

2. High liquidity.

3. Professional management.

4. Inflation hedge.

5. Tax efficiency (for REITs).

6. Access to a (diversified) pool of assets.

7. Access to special sectors (e.g., data centers).

8. Low minimum investment.

9. Low entry/exit costs.

10. Regulatory protection for investors.

11. High transparency.

12. Limited liability.

Drawbacks of investing in publicly traded securities

1. Higher volatility.

2. Higher correlation with stocks (compared to the correlation of stocks with private real estate).

3. Dividends are taxed at high current income tax rates.

4. Poor governance/agency conflict.

5. Equity markets penalize high leverage.

6. Market prices differ from NAV.

7. REIT structure limits possible activities.

8. Compliance costs may be prohibitive for smaller companies.