Analyzing REIT Performance

REITs are differentFrom Industrial Corporations

Session Seven

Consideration in REIT Management Strategy

There are four ways in which REIT can grow income and increase cash flow from operation, so as to pay dividends and increase dividends in the future

Growth Strategies Growing income from existing properties Growing income through acquisitions Growing income through development Financial Engineering

Considerations in REIT Management Strategy

Financial Strategy REITs must distribute most of its income (at least 90% of

earnings in the case of US) to beneficial shareholders REITs have limited opportunities to retain earnings to

finance future growth opportunities To pursue growth opportunities REITs issue additional

stocks Some REITs (e.g. US REITs) have no need for corporate

income tax shield, so perhaps they should prefer equity to debt

Yet REITs use significant amount of debt to finance growth opportunities

Are REITs Growth Stocks or Income Stocks?

Fundamental Growth Opportunities Investors often think of stocks as either growth stocks or income stocks In the former case most of the total return is expected to come in the

form of capital appreciation rather than dividend The latter stocks are purchased based largely based on dividend yield For the most part REITs are income stocks in the long run, for four

fundamental reasons: REITs dividend policy is pretty much set by regulation, since it must pay all

or substantially most of its income to shareholders More importantly, stabilized operational commercial properties are, by their

very nature, income-oriented assets, not growth-oriented-assets Most REIT regulations restrict or discourage “merchant building” Most REITs have limited development rights

Factors that Influence REIT Growth

Individual REITs may experience extended periods of substantial growth in share price for several reasons

Economies of Scale Large REITs presumably have some advantage over smaller

ones Regional shopping centers may be able to engage in multiple

transactions with national tenants (e.g. General Growth Properties)

Economies of Vertical Integration REITs can grow their revenues by integrating vertically (1)

ownership, (2) development, and (3) management Example: Healthcare Realty Trust; Camden Property Trust

(multifamily REIT)

Factors that Influence REIT Growth

Economies of Scope Sometimes services are cheaper when provided by a single

entity rather than many entities Some REITs provide telephone service, e-mail, security

system and environmental control Quality of Management

Managerial skill is of course important for REIT performance Access to Capital

Bigger and successful REITs have better access to capital than others -- better able to pursue growth opportunities

In general the only major type of real estate asset that offers long-run sustainable growth stock characteristics is raw land or other development rights

A Unique Market Environment: Parallel Asset Markets

A unique feature that distinguishes REITs from most other non-real estate firms that trade in the stock market is the dual market situation in which two parallel markets exist for trading real estate

The key point to stress here is that the stock market valuation of property (indirect market), and the private market valuation (direct market) are not always the same

In general, the REIT market (indirect market) tends to lead the private market

When the two markets disagree, REITs can undertake positive NPV investments either by buying or selling in the private market

When the stock market values property more highly than private property market, REITs can grow merely by buying properties, and thus become growth stocks, at least temporarily

Net Asset Value and REITs Growth Opportunities The stock market perception and valuation of REIT

growth opportunities, and relative valuation differential between private and public market can be assessed by looking at Net Asset Value (NAV)

The REITs NAV per share is then compared with the REIT’s price per share

Roughly speaking, Exhibit 1 shows that US REITs share values tended to trade below their NAVs during mid 1980s to very early 1990s.

However for most of the 1990s REITs traded above their NAVs

In general REIT share prices tend to lead private market valuation

Exhibit 1End of Year Public vs Private Asset Mkt Commercial R.E. Values:

(Indexes set to have Equal Avg Values 1974-98)

1.0

1.2

1.4

1.6

1.8

2.0

2.2

74 76 78 80 82 84 86 88 90 92 94 96 98 2000

NAREIT (Unlevered) NCREIF (Unsmoothed)

REIT Valuation and Initial Public Offering (IPO) REIT’s P/E ratio has three determinants:

(1) REIT’s plowback ratio which is largely fixed (2) REIT’s return on book equity (3) REIT’s discount rate, which includes the risk-free rate and risk

premium The Dividend Growth Model

To see how these three determinants come into play, consider a REIT with dividend per share of D for the time period t to t+1

The market interest rate (discount rate) that relates the stream of future dividends to the REIT asset price P at time t is the constant k

Then the present value of REIT equity is determined as follows:

)1(....

)1()1( 22

11

kD

kD

kDP

The Dividend Growth Model

Assuming the REIT’s dividend grows at a constant rate g, in perpetuity, the previous equation simplifies into

Note that to use this constant growth model, k must be greater than g

Also in this model investors must expect both dividends and stock price to grow at the same rate g.

Expected capital appreciation lowers k - g and thereby increasing the REIT stock price

Subsequent growth in REIT assets due to reinvestment of profit will generate growth in future dividends which will be reflected in today’ price

gkD

gg

kg

kDP

)1()1(...

)1()1(

)1(1

21

REIT Valuation The long-run average growth rate for the REIT

dividend, g, reflects two considerations Growth in existing property cash flow (or same-store growth) Ability of REIT to effectively implement growth opportunities

These two factors are fundamentally affected by management abilities

The average equity cost of capital or the market’s required rate of return, k, is shaped by the market’s perception of the firm’s expected cash flow and share price

As a practical matter the market required total return can be stated as follows g

PDIVk 1

Valuation of REIT Now lets interpret the P/E ratio equation from

previous slide First, if the REIT is growing rapidly in earnings (e.g

has a high r), it is likely to have higher stock price Second, for any given return on equity, r, and

retention ratio, b, a lower k will result in a lower required rate of return, and thus a higher stock price

Third, the P/E ratio has a numerator and denominator

So is the P/E ratio high because of the numerator or because of the denominator

REIT Valuation: An Example

REIT1 -- 15% return on equity and 30% retention ratio; REIT2 -- 12.5% return on equity, which we will assume equals the market required rate of return, k, and its b = 30% Dividend growth rate (REIT1) = r x b = .15x.30 =

4.5% P/E ratio (REIT1) = (1-b)/(k – br) = (1 - .30)/(.125

-.045) = 8.75 Dividend growth rate (REIT2) = r x b = .125 x .30 =

3.75% P/E ratio (REIT2) = (1 – b)/(k – br) = (1 - .30)/(.125

- .0375) = 8.00

Measuring REIT Performance

An important issue in REIT investment analysis is how best to measure performance

Four Measures of REIT Performance (1) Net Income (NI) or GAAP Earnings – not the

best measure largely due to depreciation allowance

(2) Funds From Operations (FFO)– closer to economic truth, but ignores capital improvements

(3) Funds Available for Distribution (FAD) – cash flow available to share holders if there is no change in working capital or no new debt

(4) Free Cash Flow (FCF) – this is REIT’s true operating cash flow

Earnings Measure for Industrial Corporations

The official GAAP accounting-based Net Income for industrial firms is calculated as follows:Revenue- Operating expenses= Earnings before interest, taxes, and depreciation (EBITDA)- Depreciation and amortization= Earnings before interest and taxes (EBIT)- Interest= Earnings before taxes (EBT)- Taxes= Net Income

- This Net Income is the official measure of earnings for the typical industrial corporation used as input to calculate Earnings Per Share (EPS)

Earnings Measures for REITs

REIT taxable earnings which is essentially the official GAAP EBT (or EBIT – interest) is not well suited for determining REITs earnings:

Depreciation expenses are a particularly large portion of REIT expense

Unlike industrial firms the depreciation of real property by REITs is often not matched by actual loss of value of the property over time

As a results other measures are used to track the earnings of REITs by security analysts, such as Funds From Operation (FFO), Funds Available for Distribution (FAD) and Free Cash Flow (FCF) to equity

Calculating REIT GAAP Net Income

Real Estate Revenue Minus: Real Estate Expense Minus: Deprecation and Amortization of Real

Estate = Income from Real Estate Plus: other Income Minus: General and Administrative Expenses = Net Income per GAAP

Calculating FFO and FAD Net Income per GAAP Minus: Gains from Sale of Real Estate = Adjusted Net Income Plus: Depreciation and Amortization of Real

Estate* = Funds From Operation (FFO) Plus: Rent Adjustments* Minus Capital improvements* = Funds Available for Distribution (FAD)

Calculating Free Cash Flow Funds Available for Distribution (FAD) Minus: Real Estate Acquisitions* -- new investments Minus: Changes in Working Capital* Minus: Principal Payments* Plus: New Debt Issue* --- effects on REITs cash flow Plus: Gain on Sale of Real Estate* Plus: New Equity Issue (SEO)* = Free Cash Flow to Equity

Alternative Method of Calculating FFO and FAD

Potential Gross IncomeMinus: Vacancy and Bad Debt allowances= Effective Gross IncomeMinus: Operating expenses= Net Operating Income of the REITPlus: Gains (or losses) from sales of propertyPlus Debt Restructuring and Equity Restructuring= Net Income of the REITMinus Debt Service= Free Cash Flow of REITMinus: Gains (or losses) from sales of property Minus Debt and Equity Restructuring= Funds From Operations (FFO) of the REIT

REIT Performance Evaluation: A Case Study of Washington Real Estate Investment Trust (WRIT)

Washington Real Estate Investment Trust (WRIT) -- diversified REIT WRIT owns and operates 10 retail centers, 23 office buildings, 9 apartment and

15 industrial properties, all in the Washington-Baltimore metropolitan region. WRIT prefers to hold local assets rather than distant ones for which it has a relative information disadvantage. It considers markets to be local if they are within a two-hour drive time radius of its Rockville, Maryland headquarters. WRIT investment strategy according President and CEO Edmund B. Cronin, Jr., “is to acquire and manage real estate investments in markets we know well and protect our assets from single property-type value fluctuations through diversified holdings”. WRIT looks for property investments to produce a return on invested capital (ROIC) of 10-15%. WRIT hopes to achieve these returns by targeting strategically-located properties in the Washington-Baltimore metropolitan region with value-added potential as well as stabilized properties that offer future upside growth potential. To this end, WRIT looks for well located properties, particularly those that they find to be poorly managed and needing new mechanical systems, cosmetics and so on, permitting them to reposition the property in its market place, raise rents and reduce operating costs. The CEO further comments, “WRIT acquires assets at an attractive price relative to replacement cost, and putting these assets to new higher-valued uses than anyone had formerly perceived”. WRIT typically seeks investment that vary in size between $5 and $25 million. WRIT is unique in that it is one of the only five publicly traded US REITs that is A-rated by S&P and BAA-1 by Moody’s.

Exhibit 2: Washington Real Estate Investment Trust Consolidated Statements of Income, 1999-2000 2002 1999 Real Estate Revenue ($000) $134,732 $1118,975 Minus: Real Estate Expenses ($000) 38,316 35,281 Depreciation and Amortization of Real Estate Assets 22,723 19,590 Income from Real Estate ($000) 73,693 64,104 Plus: Other Income ($000) 943 732 Minus: Interest Expense ($000) 25,531 22,271 General and Administrative Expenses ($000) 7,533 6,173 Plus: Gain on Sale of Real Estate ($000) 3,567 7,909 Net Income per GAAP Financial Statement ($000) $45,139 44,301 Earnings Per Share (EPS) $1.26 $1.23

REIT Performance Evaluation

Net Income (Earnings) Net Income per share increased from $1.23 to

$1.26, a 2.4% annual increase The net income is, on average, about 34% to 37%

of real estate revenues Net income is after depreciation, and therefore

not a good measure of how much cash flow a REIT generates or consumes

One way to fix this problem is to estimate the firm’s funds from operation (FFO), as defined by National Association of Real Estate investment Trusts (NAREIT)

This procedure is shown in Exhibit 3

Exhibit 3: Washington Real Estate Investment Trust Annual Funds Analysis, 1999 - 2000 2000 1999 Net Income per GAAP Financial Statements ($000) $45,139 $44,301 Minus: Gain on Sale of Real Estate ($000) 3,567 7,909 Equals: Adjusted Net Income 41,572 36,392 Plus: Depreciation and Amortization of Real Estate Assets 22,723 19,590 Equals: Funds From Operation, FFO ($000) 64,295 55,982 Minus: Capital Improvement ($000) (16,535) (18,721) Plus: Rent Adjustment ($000) 1,265 4,605 Equals: Funds Available for Distribution, FAD ($000) $49,025 41,866 Funds From Operation per share $1.79 $1.57 Funds Available for Distribution per share $1.36 $1.17

REIT Performance Evaluation

Funds From Operation (FFO) and Funds Available for Distribution (FAD)

WRIT’s FFO is about 126% to 142% its net income This compares to a ratio of about 154 to 155% of adjusted

net income This latter calculation implies that depreciation adds about

(1.55-1.00)/1.55 = 35% to REITs FFO However there are two problems here

FFO does not account for capital expenditures and amortization of principal

FFO does not quite accurately reflect real estate revenues because accountants straight-line rents

The solution is to calculate funds available for distribution (FAD) For WRIT FAD is about 76% of FFO

REIT Performance Evaluation

Problems with FAD Does not take account of the following:

Capital spending on new investments Changes in REIT’s operating working capital Cash inflows due new debt (or new equity)

The latter reduces the firm’s cash flow to equity, which reduces the REITs stock value

Free Cash Flow (FCF) to equity It is easy to correct these problems by calculating the firms

free cash flow to equity (FCF), which is shown in Exhibit 5 FFC per share is about $1.27 in 2000 This equates to about 71% of FFO and 93% of FAD

Exhibit 4: Washington Real Estate Investment Trust Free Cash Flow to Equity, 1999-2000 2000 1999 Funds Available for Distribution ($000) $49,025 $41,866 Minus: Real Estate Acquisitions ($000) (25,581) (53,197) Minus: Change in Working Capital ($000) (34,668) (13,738) Minus: Principal Payments ($000) (778) (504) Plus: New Debt Issued ($000) 55,000 58,720 Plus: Gain on Sale of Real Estate ($000) 3,567 7,909 Plus: New Equity Issued ($000) 100 496 Equals: Free Cash Flow (FCF) to Equity ($000) $45,665 $41,462 Free Cash Flow to Equity per share $1.27 $1.16 Ratio of Free Cash Flow to FFO 0.71 0.74 Ratio of Free Cash Flow to FAD 0.93 0.99

Evaluation of REIT Financial Health

Exhibit 5 shows the analysis of REIT financial health Debt/Total Assets

The ratio of long-term debt outstanding to total capitalization is about 35% to 42% -- conservative debt policy by US standards

REITs typically use long term debt proceeds to repay advances on lines of credit, finance acquisitions and capital improvement

Interest Coverage Interest coverage is the amount of earnings available to pay

interest expense It provides a sense of how far operating profits could fall before

the company would experience difficulty servicing its debts WRIT’s interest coverage in 2000 was 3.4:1, which is extremely

safe

Exhibit 5: Washington Real Estate Investment Trust (WRIT) Balance Sheet, 1999-2000 2000 1999 Assets: Gross Real Estate Assets ($000) $698,513 $661,870 Less: Accumulated Depreciation (100,906) (83,574) Net Real Estate Assets ($000) 597,607 578,296 Cash ($000) $6,426 $4,716 Accounts Receivable ($000) 8,427 6,572 Prepaid Expenses and other Assets 19,587 18,896 Total Assets ($000) 632,047 608,480 Liabilities and Stockholders’ Equity Long-term Debt ($000) $265,000 $210,000 Mortgage Notes Payable ($000) 86,260 87,038 Accounts Payable ($000) 13,048 44,421 Other Current Liabilities 7,525 8,310 Total Equity ($000) 260,214 258,711 Total Liabilities and Equity ($000) 632,047 608,480 Long-Term Liabilities/Total Assets 41.9% 34.5% Short-Term Liabilities/Total Debt 5.5% 15.1% Properties/Total Assets 94.6% 95.0%

Evaluation of Financial Health of REITs

Profitability In 2000 WRIT’s Net Income = $45M, Total Assets = $632M, and

Shareholder Equity = $260M Thus, ROA = 7.1%; ROE = 17.3%

Dividend Payout Policy In 2000 WRIT’s paid out about 95% of net income in dividends,

or $1.2 per share, which meets the 90% payout ratio for US REITs

In practice many US REITs pay more than their earnings in dividends – HOW?

Dividend Yield In 2000 the P/E ratio or earnings multiple for WRIT was 20x This suggest a price per share of $25.2 based on 2000 EPS of

$1.26 Hence dividend yield = 4.8% (1.2/25.2)

Do You Believe in Magic? The FFO Magic !!!

How is it possible for REITs to pay more than their earnings in dividends?

The answer lies in FFO, which is calculated by adding back depreciation and amortization to net income

For WRIT in 2000 EPS = $1.26, while FFO per share = $1.79 WRIT could pay 90% of FFO or $1.61 per share in dividends,

which is 128% of earnings per share In this case the investor needs only report $1.26 for federal

income tax purposes The difference between the dividends paid ($1.61) and EPS

($1.26) or $0.35 is considered recovery of capital (ROC) The ROC of $0.35 serves to reduce the cost basis of the share

acquired by the REIT investor This tax treatment allows the REIT investor to receive part of

the dividend ($0.35) “tax free” until the stock is sold