Real Estate for Rookies

An Introduction to the Concept of Real Estate Investment Trusts (REITs)

Shibly Latiff, CFA

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Summary

Types of real estate investmentsFundamentals of REITsGlobal REIT performanceREITs in practiceWhat makes REITs a superior investment model?Is Sri Lanka ready for REITs? Some food for thought..

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Types of real estate investments

Direct investmentsIndirect investments

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Direct investments

Investors PropertyInvestRent

Ownership of direct real estate

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Indirect investments

PropertyCo

Investors

PropertyInvestRent/Disposals

DividendEquity

Ownership through tradable shares such as ordinary property companies or as REITs

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AffordabilityDiversification benefitHigh liquidityLow administration costManagement expertiseEconomies of scale

Advantages of indirect investments

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Equity

Equity REITs

REIT

Investors

PropertyInvestRent

Dividend

How do equity REITs work ?

= 90% tax profit

75% of Rev

75% in real estate

Tax exempt

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What is a REIT?

A company which owns income producing real estate or finance real estate, and pays out most of the income (generally 90% of taxable income) as dividends.

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At least 75% of total investment assets must be in real estate. At least 75% of gross income is derived from rents or mortgage interest. 90% of taxable income must be distributed annually.(i.e. profit + depreciation)Ownership: min 100 shareholders, 5 cannot hold more than 50%.Have shares that are fully transferable. Organized as a corporation, business trust, or similar association.Be managed by a Board of Directors or trustees.

Typical regulations

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REITs vs. investment in ordinary property companies

Lower risk – due to stringent regulationsTax efficientStable dividend

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Countries with REIT-like structures

US (started in 1960 – took off in the 1990s) Australia (started in 1971 – current form, 1985)Netherlands – 1969Canada – 1994Belgium – 1995Japan – 2000Singapore – 2002France – 2003Hong Kong – just started

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UKGermanyItalySpainS. KoreaMalaysiaTaiwanThailandPhilippinesIndia

Countries working to implement REIT legislation

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Countries that have passed or are considering REIT legislation

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US: REITS have outperformed all other indices

Source: NAREIT

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Performance of established countries

0%

5%

10%

15%

20%

25%

1 y 5 y 10 yData as at 30/6/2004

USAustraliaNetherlandsCanada

Source: Global Property Research

Double digit returns

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Performance of new entrants

0%5%

10%15%20%25%30%35%40%

1 y 2 yData as at 30/06/2004

Belgium

France

Singapore

NewZealand

Source: Global Property Research

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Risk vs. Return

Source: Ibboston Associates

Higher returns for little additional risk

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REITs in practice

Types of properties REITs invest in:OfficeApartmentsMallsShopping centersHotelsIndustrialsStorageHospitalsPrisonsGolf courses

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REITs in practice (Cont’d)

Company X:Started as a privately owned apartment rental company in 1977.Registered as a REIT and raised capital through an IPO in 1994.Continued to pay 90% of taxable income as dividend.Income was sufficient to pay dividend and meet routine capex.Expansion was done by raising debt/equity (but keeping leverage below 40%).

Profile of Company X

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REITs in practice (Cont’d)

Compounded annual growth rate 17%

Annual dividend yield 7%

Capital appreciation 10%

Performance break-up of Company X

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REITs in practice (Cont’d)

PV of net rents (rent - costs)

+

+

Change in market conditions (i.e. rent, occupancy)

Management expertise

From where is value generated?

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REITs in practice (Cont’d)

Annual rent income 10,000,000 Operating costs (3,000,000) Less routine maintenance capital expenditure (2,500,000)

4,500,000 Required rate 10%Value of the property 45,000,000

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Total return break-up of Co. X

Management expertise/Change

in market condition6%

Drop in required dividend yield

4%

Dividend7%

REITs in practice (Cont’d)

41%

24%

35%

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What makes REITs a superior investment model compared to an ordinary company?

Simple business model any investor could understand.Better earnings visibility reduces the possibility of over/under valuation.Since most of the surplus cash is paid out, there is better transparency.New investments require debt or equity, which means additional scrutiny of commercial viability.Limitation on share ownership reduces conflict of interest.Higher efficiency; companies can expand rapidly due to easy access to capital. This brings in economies of scale.

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Investors – An option to invest long term, medium level of risk.

Consumers – Better choice and service due to higher supply

Individuals: ApartmentsBusinesses: Office, Industrial, etc.

Government Higher efficiency means higher tax revenue in the long run.

Benefits of REITs

Is Sri Lanka ready for REITs?

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Basic requirements for REITs to function

InvestorsManagement expertiseDemand for rental properties

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Food for thought

Do we have the investors?Pension funds Individual saversForeign investors

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Food for thought (Cont’d)

Do we have the management expertise?

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Food for thought (Cont’d)

Is there demand for rental properties?Office?Apartments?Malls?Shopping centers?Hotels?Industrials?Storage?Hospitals?