1. 1 What is a Real Estate Investment Trust? A REIT is a: Publicly or privately held company that that owns real estate equity or real property debt Passes most of its earnings and capital gains onto shareholders Only retained earnings are taxed, PROVIDED REIT meets –Ownership requirements –Management requirements –Asset requirements –Income requirements –Distribution requirements Trade Association: National Association of Real Estate Investment Trusts (www.nareit.com)

2. 2 REITs

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4. 4 Requirements Ownership –5 or fewer entities may not own 50% or more of the outstanding shares (the “5/50 Test”) –No one shareholder owns more than 9.9% (pension funds excluded) –REIT shares must be transferable and held by at least 100 persons –Must be managed by a board of directors or trustees –Must be incorporated in one of the 50 states or DC as a taxable entity

5. 5 Requirements Management –REIT managers must be passive REIT trustees, directors or employees may not actively engage in managing or operating REIT properties (includes providing service and collecting rents from tenants). Managers may set policy: rental terms, choose tenants, sign leases, make decisions about properties. –REITs allowed to own 100% of a Taxable REIT Subsidiary (TRS). REIT Modernization Act of 1999 (effective 2001) TRS can provide services to REIT tenants and others (previously, this was not allowed). Debt and rental payments from TRS to REIT are limited to ensure that the TRS actually pays income taxes.

6. 6 Requirements Assets –75% of assets must be real estate, cash, and govt. securities other REIT shares are considered real estate assets, but not more than 20% of its assets can be stocks in taxable REIT subsidiaries –not more than 5% of assets can be stock in non-real estate corporations –may not have more than 10% of voting securities of any corporation other than another REIT, Taxable REIT Subsidiary (TRS) or subsidiary whose assets and income are owned by the REIT for federal income tax purposes

7. 7 Requirements Income –95% of gross income must be from dividends, interest, rents, or gains from sale of certain assets (real estate, cash, or govt securities). –The 95% rule includes income from dividends and non-real estate sources (e.g. bank deposit interest) –Implication: less than 5% of REIT income can come from service fees

8. 8 Requirements Income –No more than 30% of gross income can be derived from sale or disposition of any securities held less than 6 months sale or disposition of real estate held for less than 4 years, except those involving foreclosures. properties held for sale in the normal course of business (anti-dealer provision)

9. 9 Requirements Compliance –Company must make a REIT elective by filing IRS Form 1120-REIT. –Company must mail letters to shareholders of record requesting details of REIT benefits Source: http://www.investinreits.com/learn/formingareit.cfm

10. 10 Requirements Distributions –must distribute 90% of all taxable income to investors mandates fairly low retained earnings policy has important implications for financing growth –Note: prior to 2001, minimum distribution requirement was 95%.

11. 11 Tax Treatment Accelerated depreciation is allowed for determining taxable income 40 year asset life required for calculating income available for distribution to investors Shareholders dividends may exceed REITs taxable income (because of depreciation, amortization) REIT distributions –Dividends taxed as ordinary income –Return of capital reduces shareholder’s tax basis

12. 12 Tax Treatment REIT Management has Considerable Flexibility Tax treatment of leasing commissions Tax treatment of financing fees Tax treatment of tenant improvements Straight-line graduated lease payments That influence analysts’ performance evaluation.

13. 13 REITs

14. 14 REITs

15. 15 REITs

16. 16 REITs

17. 17 REITs

18. 18 Equity REITs

19. 19 Debt REITs

20. 20 Umbrella Partnership REIT UPREIT REIT formed by consolidating limited-partnerships Partnership interests known as Operating Partnership (OP) units REIT owns property indirectly through OP Partnerships allocated REIT shares based on appraised value of partnership property Property owners can swap RE investments for OP units using IRS tax deferred exchange rule 731 REIT issues shares to the public and purchases properties owned by the OP First UPREIT created by Taubman in 1992

21. 21 Taubman UPREIT

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23. 23 DownREIT Like an UPREIT, a DownREIT acquires property on a tax deferred basis by issuing partnership units DownREIT can own multiple partnerships –Can form partnerships with each acquisition –More flexible than an UPREIT DownREIT can own assets at both the REIT and OP levels

24. 24 REITs in Market Indexes

25. 25 REITs in Market Indexes

26. 26 REITs in Market Indexes

27. 27 REIT Valuation EPS v. FFO Earnings per share (EPS) is an accounting number –REIT must distribute at least 90% of EPS Funds from operations (FFO) is REIT cash flow (no depreciation/amortization) FFO means net income (computed in accordance with GAAP), excluding gains (or losses) from debt restructuring and sales of property, plus depreciation and amortization of assets uniquely significant to the real estate industry, and after adjustments for unconsolidated entities in which the REIT holds an interest. Adjustments for these entities are to be calculated to reflect FFO on the same basis. Moreover, NAREIT believes that items classified by GAAP as extraordinary or unusual are not meant to either increase or decrease reported FFO.

28. 28 REIT Valuation How to Calculate FFO Revenues –Operating expenses –Depreciation & amortization –Interest expense –General & Administrative expense = NET INCOME (GAAP) Net Income –Profit from real estate sales + Depreciation & amortization = FFO

29. 29 REIT Valuation How to Calculate FFO

30. 30 REIT Valuation Key Parts (D&A) Legitimate add-backs real property depreciation amortization of capitalized leasing expenses amortization of tenant allowances and improvements Add-backs not allowed amortization of deferred financing costs depreciation of computer software depreciation of company office improvements

31. 31 REIT Valuation Adjusted FFO FFO minus: –Recurring capital expenditures (e.g. painting, carpets, etc.) –Amortization of tenant improvements –Amortization of leasing commissions –Adjustment for rent straight-lining = Adjusted FFO (AFFO)

32. 32 REIT Valuation Impact on FFO Depending upon management’s strategy with respect to capitalizing or expensing items, calculated FFO and percentage of payout of net income can vary widely Kimco Realty (KIM) expenses everything they can -- reduces measured NOI -- increases amount they can retain (65% payout ratio - lowest in industry) Large group of about 10 has payout ratios over 95% -- capitalize aggressively -- raises FFO -- reduces what they can retain

33. 33 Financial Analysis

34. 34 Financial Analysis

35. 35 Financial Analysis

36. 36 Financial Analysis

37. 37 Financial Analysis

38. 38 Financial Analysis

39. 39 Financial Analysis

40. 40 Economies of Scale Minimum Efficient Firm Size Typical REIT IPO from 1993 –$100,000,000 firm with 50/50 debt-equity ratio, yielding 8% on equity –implies roughly $4,000,000 in income –even with relatively low payout ratio of 75% of earnings, can retain only $1,000,000

41. 41 Economies of Scale What will $1,000,000 buy? –for an apartment REIT, a good-sized garden apt. complex costs $20-$25 million, retaining the added $1,000,000 adds little flexibility with respect to acquiring properties for portfolio. –from broad capital market perspective, this firm probably should increase payout ratio (this is what happened in reality) shareholders received high dividend yield, firm had to repeatedly go to the capital markets to fund acquisitions

42. 42 Economies of Scale $10 billion REIT –same 50/50 debt-equity ratio and 8% yield on equity for a $10 billion REIT –implied income of about $400,000,000 –if firm chooses not to aggressively expense, it will have a relatively high payout ratio if that ratio is 95%, implies the firm can retain $20,000,000 that’s a good-sized garden apt complex, 1/5th of a large regional mall, or a couple of decent- sized warehouses or industrial sites.

43. 43 Economies of Scale $10 billion REIT –if firm chooses to aggressively expense items to reduce accounting earnings and lower its required payout under the REIT tax law, the situation is markedly different –assume its payout ratio falls to 75%: ratio implies retention of $100,000,000 which will buy a portfolio of any property type except regional malls and downtown office buildings

44. 44 REIT Advisors Prior to 1986, REITs –Passive investment vehicles –Day to day business decisions (property management and investment decisions) conducted by 3 rd party external advisors –Advisors frequently had conflicts of interest Were property owners trying to sell the REIT property Were advisors to other (competing) REITs 1986 Tax Reform Act –A REIT “may directly select, hire and compensate those independent contractors who will provide customary services that may be provided by a REIT in connection with the rental of property, rather than hiring an independent contractor to hire other independent contractors.” –Allowed REITs to be self-advised/self-managed.

45. 45 REIT Advisors

46. 46 REIT Growth 1.Grow income from existing properties –Raise rents –Reduce vacancy –Increase Operating Efficiency 2.Acquisitions –Purchase properties @ positive spreads between property yields and WACC –Swap shares in REITs to take advantage of tax provisions 3.New construction 4.Financial Engineering –Manipulate Funds from Operations –Leverage –Change payout ratio Most REITs finance expansion with additional stock offerings