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 securitiesDirect private investment:Investors purchase & hold title to the propertiesWith RE securities, capital is:pooled from multiple investorsinvested 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 NYSERelatively liquidLower transaction costsMarket value of a security is continuously revealed by the selling price of perfect substitutes
6 Public vs Private Markets Characterized by individually negotiated transactionsRelatively illiquidHigh transaction costsMarket 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 REDiversification benefitsLiquidityTypes of REITs?Equity REITsMortgage REITsHybrid REITs
8 More on REITsREITs not taxed at corporate level if they satisfy a set of restrictive conditions on an ongoing basis including:At least 100 shareholders75% of assets must be RE, cash, or government securities75% of gross income must come from RE assets90% of REIT taxable income must be paid out in dividends each yearTaxed to some extent if > 90% but < 100% of taxable income is distributed
10 Institutional Investors in Private Equity Markets? Pension fundsImportant participant in commercial RE equity marketsCommingled RE fundsLife insurance companiesLong-term liabilities a good match for long-term, illiquid, private RE investmentsMore active as RE lenders than as investors
12 Privately Owned Commercial RE 88% ($1,918/$2,184) of private commercial equity is owned by “non-institutional” investorsWho are these folks?
13 Non-Institutional Investors in Private Equity Markets? Individuals & familiesRE syndications that form:Limited partnerships (LPs)Limited liability companies (LLCs)S corporationsSyndication is a pooling of private equity capital
14 Advantages of Pooling Equity Allows investors to purchase an interest in larger propertiesDiversification of portfolioEconomies of scale in acquisitions, management and dispositionAccess to cheaper debt capitalExpertise 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 corporationS corporationGeneral partnershipLimited partnershipLimited liability companyTenancy-in-commonWhat about REITs?
17 What Drives Choice of Ownership Form? Federal income tax rulesDesire of investors for limited liabilityManagement control issuesAbility to access debt & additional equity capitalAbility of investors to dispose of their interestsFirst two probably most important
19 Notes to Exhibit 17-4The 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 chosenS-corporations are popular with some sole proprietors/familiesHowever, LLCs & LPs are the dominant ownership structuresEmergence (& 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 lawsNOT a corporation, partnership, or sole proprietorshipIS 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 stateMembers should have an “operating agreement” that explains operation & management of businessRelative 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 investorsInvestors possess undivided interests in propertyInvestors receive separate deed…considered direct ownersInvestors 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 managersale of propertyall leasesall 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-ownersUnanimous 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 investmentCaused a “TIC” industry to be created overnight to facilitate tax-deferred exchanges
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 banksSavings associationsLife insurance companiesGovernment sponsored enterprises (GSE)Mostly Freddie and FannieState & local governments
28 Sources of Commercial Real Estate Debt 29% of outstanding commercial debt ($1 trillion) is publicly tradedGSE backed commercial mortgage-backed securities (CMBSs)Non-government backed CMBSInvestment grade unsecured debt of large REITs
29 Mortgage Originators vs. Long-Term Holders Many long-term holders purchase commercial mortgages in the secondary mortgage marketWho originates the mortgages purchased by life insurers, foreign investors, pension funds, and CMBS issuers?Other long-term holders—primarily banksMortgage 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 companiesSyndicator is general partner (GP) in LP or managing member in LLCHow 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 ownershipProfessional management of propertiesFreedom from personal liability beyond equity investment
32 Roles of the Syndicator/Organizer Organization PhaseDevelop conceptOrganize the legal entityDraft offering memorandumMarket the ownership interestsAcquire the real estate (or purchase option)
33 Roles of the Syndicator/Organizer Operation PhaseManage the syndicationSend out tax informationManage the property?Raise additional debt or equity capital if necessary
34 Roles of the Syndicator/Organizer Disposition PhasePrepare the property for saleMarket the propertySend out final tax informationDissolve 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 ownershipMain 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 fundedfuture cash assessments will be fundedannual operating CFs will be distributedannual taxable income & losses will be distributedCF & 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?
41 What is an “UPREIT”?Section 1031 of IRC allows “like-kind” tax-deferred exchanges, which REITs routinely use to acquire properties from other REITsHowever…Most U.S commercial RE is held in private markets by LPs or LLCsREITs 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, continuedIn November 1992, a new form of REIT emerged to facilitate tax-deferred exchangesTaubman Centers completed IPO with an “UPREIT” structure“Umbrella partnership REIT" ("UPREIT") structure proved popular in attracting capitalSince 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 saleIf 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 OPThese “dividends” are equal to dividends paid to REIT shareholdersREIT is general partner & majority owner of OP Units
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 performanceFFO 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 assetsThus, economic depreciation < tax depreciationSecurities usually analysts judge REIT performance according to FFO growthPrice / 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 yieldAnticipated total return from the stockCapital SourcesBecause 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 valueIn practice, however, long-term dividend projections are difficult to develop
51 Net Asset ValueA 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 NAVA stock price in excess of per-share NAV may indicate a REIT is overpriced relative to value of assets currently in the portfolioConversely, REITs selling at “discounts” to NAV may signal buying opportunities for investors