1. Sources of Commercial Debt and Equity Capital
Chapter 17
Sources of Commercial Debt and Equity Capital
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

2. How Large is U.S. Commercial Real Estate Market?
Investible commercial real estate excludes real estate owned by non-real estate companies and smaller properties such as duplexes and fourplexes

3. Value of U.S. Commercial RE?
Direct vs. securitized investments?
RE owned by non-RE corporations?
How leveraged is commercial real estate?

4. Sources of Commercial RE Equity Capital
Investors hold ownership positions through either direct private investment or real estate securities
Direct private investment:
Investors purchase & hold title to the properties
With RE securities, capital is:
pooled from multiple investors
invested in a separate ownership entity which, in turn, purchases & holds title to the RE

5. Public vs Private Markets
Public markets:
Securities are bought & sold on a centralized public exchange, such as NYSE
Relatively liquid
Lower transaction costs
Market value of a security is continuously revealed by the selling price of perfect substitutes

6. Public vs Private Markets
Characterized by individually negotiated transactions
Relatively illiquid
High transaction costs
Market value of a security not necessarily revealed by the selling price of often imperfect substitutes

7. Public Equity Markets Primarily RE Investment Trusts (REITs)
REITs can be described as mutual funds for investing in RE
Diversification benefits
Liquidity
Types of REITs?
Equity REITs
Mortgage REITs
Hybrid REITs

8. More on REITs
REITs not taxed at corporate level if they satisfy a set of restrictive conditions on an ongoing basis including:
At least 100 shareholders
75% of assets must be RE, cash, or government securities
75% of gross income must come from RE assets
90% of REIT taxable income must be paid out in dividends each year
Taxed to some extent if > 90% but < 100% of taxable income is distributed

9. Privately Owned Commercial RE

10. Institutional Investors in Private Equity Markets?
Pension funds
Important participant in commercial RE equity markets
Commingled RE funds
Life insurance companies
Long-term liabilities a good match for long-term, illiquid, private RE investments
More active as RE lenders than as investors

11. Institutional Investors in Private Equity Markets?
Others:
Foreign investors
Commercial banks
Savings associations

12. Privately Owned Commercial RE
88% ($1,918/$2,184) of private commercial equity is owned by “non-institutional” investors
Who are these folks?

13. Non-Institutional Investors in Private Equity Markets?
Individuals & families
RE syndications that form:
Limited partnerships (LPs)
Limited liability companies (LLCs)
S corporations
Syndication is a pooling of private equity capital

14. Advantages of Pooling Equity
Allows investors to purchase an interest in larger properties
Diversification of portfolio
Economies of scale in acquisitions, management and disposition
Access to cheaper debt capital
Expertise of management team hired by syndicator/organizer

15. Disadvantages of Pooling Equity
Often must relinquish management control to active manager(s)
Must compensate syndicator/manager(s) with fees, salary and/or a disproportionate share of equity ownership
➨ lower returns on equity, all else equal

16. Forms of Ownership for Pooled Equity Investments in Real Estate
C corporation
S corporation
General partnership
Limited partnership
Limited liability company
Tenancy-in-common
What about REITs?

17. What Drives Choice of Ownership Form?
Federal income tax rules
Desire of investors for limited liability
Management control issues
Ability to access debt & additional equity capital
Ability of investors to dispose of their interests
First two probably most important

18. Choosing Optimal Form of Ownership

19. Notes to Exhibit 17-4
The general partner(s) is subject to unlimited liability.
Co-tenants are jointly and severaly liable for all debts of the TIC. This potential liability may be avoided if investors use bankruptcy remote, special purpose entities to invest in the TIC.
Corporate structures and LLCs allow ownership interests to be freely transferred; however, the actual liquidity of corporate or LLC investments depends on the size of the entity and, in the case of corporate shares, whether the shares are traded on a major exchange.
A special allocation occurs when an entity’s cash flows and/or taxable income are not distributed to investors in proportion to each investor’s ownership interest in the entity.

20. What Ownership Structure is Typically Chosen by Noninstitutional Investors?
C-corporation & GP structures seldom chosen
S-corporations are popular with some sole proprietors/families
However, LLCs & LPs are the dominant ownership structures
Emergence (& recent decline) of TIC structures, designed primarily to help investors avoid capital gain taxes, is an important trend

21. More on Limited Liability Companies
IRS gave partnership tax status in 1998, then all 50 states had to enact LLC laws
NOT a corporation, partnership, or sole proprietorship
IS a blend of some of best characteristics of corporations, partnerships, and sole proprietorship.
➨ a “super pass through entity”
IS a separate legal entity (like a corporation), but is treated as a partnership for tax purposes

22. More on Limited Liability Companies
To create, “members” file articles of organization with state
Members should have an “operating agreement” that explains operation & management of business
Relative to LPs…LLCs permit all owners to participate in management & have limited liability

23. Tenancy-in-Common (TIC) Investments
Co-ownership by two or more investors
Investors possess undivided interests in property
Investors receive separate deed…considered direct owners
Investors share “pro rata” in CFs, tax liabilities, and price appreciation
≤ 35 investors

24. Tenancy-in-Common (TIC) Investments
Co-owners must unanimously approve:
hiring of manager
sale of property
all leases
all mortgage liens
(voting implies a partnership)
For all other actions, co-owners may agree to be bound by a vote of more than 50% of co-owners
Unanimous approval creates significant problems (see Industry Issues 17-2)

25. Why Incur the Brain Damage of a TIC?
In a tax-deferred exchange, real property can’t be exchanged for a LP or LLC interest!
However, under a revenue procedure released in March of 2002 by the IRS, taxpayers can exchange an interest in real property for a TIC investment
Caused a “TIC” industry to be created overnight to facilitate tax-deferred exchanges

26. Sources of Commercial Real Estate Debt

27. Sources of Commercial Real Estate Debt
71% of outstanding commercial debt ($2.5 trillion) is privately held by individual & institutional investors such as:
Commercial banks
Savings associations
Life insurance companies
Government sponsored enterprises (GSE)
Mostly Freddie and Fannie
State & local governments

28. Sources of Commercial Real Estate Debt
29% of outstanding commercial debt ($1 trillion) is publicly traded
GSE backed commercial mortgage-backed securities (CMBSs)
Non-government backed CMBS
Investment grade unsecured debt of large REITs

29. Mortgage Originators vs. Long-Term Holders
Many long-term holders purchase commercial mortgages in the secondary mortgage market
Who originates the mortgages purchased by life insurers, foreign investors, pension funds, and CMBS issuers?
Other long-term holders—primarily banks
Mortgage banking/brokerage companies

30. A Closer Look at Syndications
A syndication is a group of people who pool funds to invest in real estate.
Not a separate form of ownership.
RE syndicates are usually organized as limited partnerships or limited liability companies
Syndicator is general partner (GP) in LP or managing member in LLC
How are LPs & LLCs taxed?
Why are LPs & LLCs the dominate forms of ownership?

31. Advantages of Syndication (either through a LP or LLC)
Provides passive investors with benefits of real estate ownership
Professional management of properties
Freedom from personal liability beyond equity investment

32. Roles of the Syndicator/Organizer
Organization Phase
Develop concept
Organize the legal entity
Draft offering memorandum
Market the ownership interests
Acquire the real estate (or purchase option)

33. Roles of the Syndicator/Organizer
Operation Phase
Manage the syndication
Send out tax information
Manage the property?
Raise additional debt or equity capital if necessary

34. Roles of the Syndicator/Organizer
Disposition Phase
Prepare the property for sale
Market the property
Send out final tax information
Dissolve the syndication

35. Economics of Equity RE Syndication
Need to understand how ownership of units in a LP or LLC that owns property differs from direct ownership
Main analytical job is dividing up CFs & tax liabilities to determine equity dividend rates, NPV's, & IRR's for different investors

36. Economics of Equity RE Syndication
Partnership agreement (LPs) or operating agreement (LLCs) must specify how:
initial equity requirements will be funded
future cash assessments will be funded
annual operating CFs will be distributed
annual taxable income & losses will be distributed
CF & tax liability from future sale will be distributed
  NOTE: Difficult to construct a "generic“ spreadsheet

37. How are Costs & Benefits Allocated Among Syndicator & Investors?
Pro-rata basis:
Usually passive investors share in CFs & taxable income in proportion to equity investment
“Special" allocations, however, are allowed in LPs & LLCs…as long as they have “substantial economic effect”
What are “preferred” returns?

38. A Closer Look at REITs

39. Security Offerings by REITs
Large surge in capital raising in and 04-05; capital raised by REITs is primarily used to acquire properties

40. In What Do REITs Invest?

41. What is an “UPREIT”?
Section 1031 of IRC allows “like-kind” tax-deferred exchanges, which REITs routinely use to acquire properties from other REITs
However…
Most U.S commercial RE is held in private markets by LPs or LLCs
REITs can’t acquire LP or LLC interests from property owners in exchange for cash or stock (or even RE)
Would violate like-kind requirement

42. UPREITs, continued
In November 1992, a new form of REIT emerged to facilitate tax-deferred exchanges
Taubman Centers completed IPO with an “UPREIT” structure
“Umbrella partnership REIT" ("UPREIT") structure proved popular in attracting capital
Since Taubman, more than 75% of new REITs have taken this form

43. How Does UPREIT Structure Work?
In typical UPREIT, partners in an existing partnerships & a newly-formed REIT become partners in a new LP termed the “operating partnership” (OP)
Owners transferring LP interests into OP receive units in OP w/o triggering a taxable sale
If they received REIT stock or cash it would trigger a taxable gain

44. How Does UPREIT Structure Work?
Recipients of OP units receive distributions from OP
These “dividends” are equal to dividends paid to REIT shareholders
REIT is general partner & majority owner of OP Units

45. A Typical UPREIT Structure
17-45

46. Measuring REIT Income: Funds From Operations (FFO)
Cash flow, expressed as “Funds from Operations” (FFO), is often used instead of accounting net income to measure current performance
FFO is a supplemental measure of a REIT's operating performance

47. Funds From Operations (FFO)
Net (accounting) income (excluding gains/losses from sales of property)
+ Depreciation (real property)
+ Amortization of leasing expenses
+ Amortization of tenant improvements
- Gaines/losses from infrequent & unusual events

48. Funds From Operations (FFO)
FFO is different from GAAP net income because commercial RE maintains value to a much greater extent than may other assets
Thus, economic depreciation < tax depreciation
Securities usually analysts judge REIT performance according to FFO growth
Price / FFO multiples reflect underlying RE value, management quality, and growth potential

49. How Are REIT Stocks Valued?
To determine share values, typical analyses involves one or more of the following criteria:
Management quality;
Current prevailing dividend yield
Anticipated total return from the stock
Capital Sources
Because REITs are obligated to distribute 90% of taxable income, they usually require external funding sources

50. How Are Total Returns Estimated?
Investors attempt to forecast dividends REIT will pay out over time.
This projected dividend stream is converted into a present value
In practice, however, long-term dividend projections are difficult to develop

51. Net Asset Value
A commonly used valuation approach centers around concept of net asset value (NAV)
NAV is equal to estimated total market value of a REIT’s underlying assets, less all liabilities including mortgages

52. How is NAV Used to Make Decisions?
If total stock market capitalization > its NAV, REIT is said to be selling for a “premium” to NAV
A stock price in excess of per-share NAV may indicate a REIT is overpriced relative to value of assets currently in the portfolio
Conversely, REITs selling at “discounts” to NAV may signal buying opportunities for investors

53. REIT Investment Performance

54. End of Chapter 17