Analyzing REIT Performance

REITs are different

From 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 1
End of Year Public vs Private Asset Mkt Com m ercial R.E. Values:
(Indexes set to have Equal Avg Values 1974-98)
2.2

2.0

1.8

1.6

1.4

1.2

1.0
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:

D1 D2 D
P   .... 
(1  k )1 (1  k ) 2 (1  k ) 
 The Dividend Growth Model
 Assuming the REIT’s dividend grows at a constant rate g, in perpetuity,
the previous equation simplifies into

 1 (1  g ) (1  g )   D
P  D   ...  

 (1  k ) (1  k ) (1  g )  k  g
1 2

 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
 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
DIV1
k g
P
 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 Income

Minus: Vacancy and Bad Debt allowances
= Effective Gross Income
Minus: Operating expenses
= Net Operating Income of the REIT
Plus: Gains (or losses) from sales of property
Plus Debt Restructuring and Equity Restructuring
= Net Income of the REIT
Minus Debt Service
= Free Cash Flow of REIT
Minus: 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