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Property Companies and REITs: Real Estate in the Public Markets

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Presentation on theme: "Property Companies and REITs: Real Estate in the Public Markets"— Presentation transcript:

1 Property Companies and REITs: Real Estate in the Public Markets
Colin Lizieri

2 Market Types Public Markets: Generally single central market place
Regulated order processing systems Price and deal transparency Liquidity Market makers / brokers role defined Market makers limited impact on prices? Private Markets Generally no central market place Highly restricted transparency and info. Asymmetric information? Market maker, broker role self-defined Market makers may influence prices

3 Equity Markets Generally public markets
Regular price, volume, performance data Brokers, market makers and orders For firms: Raise capital: initial public offering and seasoned offerings Benchmark on market views of firm’s activity For investors Income (dividends) plus capital growth Liquidity and portfolio rebalancing Ownership of (residual) asset base Risk and volatility

4 Equity Market Pricing Homogenous products, supply, demand
Role of Players: brokers, analysts, informed investors and noise traders Pricing principles: Investors want capital growth and income Investors trade off risk against return Pricing: Dividend discount model or Net Asset Value Asset values and the Law of One Price Risk return trade-off and Betas

5 Pricing in Public Markets - DDM
Dividend Discount Model: Price represents discounted value of future income stream: P0 = D1/(1+r) + D2/(1+r)2 + D3/(1+r)3 + … Dn/(1+r)n + … Assume that dividends grow at g% per annum, then P0 = D1 / (r-g) The dividend yield d = (r-g) = D1 / P0 We can observe the dividend yield If we know or can estimate g then we can find required return r If we know or can estimate r, then we have market’s view of g

6 Pricing in Public Markets: NAV
There are various claims on the value of the firm The equity holders stand behind: The debt holders The government Preference shareholders etc. The equity holders own the “residual value of the company” Take a property company with a simple structure The assets are the real estate There is debt to be paid Property Values – Liabilities = Net Asset Value NAV / Number of Shares = NAV per share Shouldn’t that be the share price? If not, why not?

7 Real Estate in Public and Private Markets
Real Estate in Private Markets Direct ownership of portfolios Investing in private real estate vehicles and funds No central market place Information asymmetry, transparency, illiquidity High transaction costs, monitoring costs, management costs Real Estate in Public Markets Property companies and REITs Exchange traded fund vehicles Liquidity, price transparency, transaction costs Volatility and correlation But … Are Public Vehicles Real Estate Investments?

8 Property Companies vs. REITs
Corporate Entities – Taxable Management Control over Activity Gearing, non-core activities, disposal and acquisition Dividend policy and retained earnings REITs Regulations on Activities and Structure Core real estate activity Borrowing restrictions (?) Distribution policy Ownership rules Real Estate Income not taxed within the vehicle

9 Example: UK Property Companies to 2006
Closed End Investment Vehicles Taxable corporate entities Distinguish between: Property Investment Companies Property Developer-Trader Companies Often relatively low free-float Often relatively high management holdings Sector was shrinking with major players delisting or restructuring, Growth potential with arrival of REITs

10 Real Estate in the UK Equity Market
As at December 2006 43 UK Listed Companies, Market Cap £54.1bn Represents just 2.86% of total market cap Major firms: Land Securities (34) £10.8bn British Land (39) £8.9bn Liberty International (66) £5.1bn Hammerson (77) £4.5bn Slough (87) £3.7bn Brixton (160) £1.5bn Top Six = 64% market cap Helical Bar (353) £0.4bn Development Securities (441) £0.3bn A Reminder of Scale: Royal Dutch Shell (1) £117.1bn BP (2) £110.8bn HSBC (3) £106.8bn Glaxo (4) £78.1bn Vodafone (5) £74.4bn

11 Performance 1988-2006 Equities Bonds Prop Co Mean 2.96% 2.15% 3.20%
Equities Bonds Prop Co Mean 2.96% 2.15% 3.20% Compound 2.68% 2.12% 2.70% St Dev 7.48% 2.56% 10.02% Skew -0.626 -0.182 -0.378

12 But Are They Property Investments?
Equities Bonds Prop Co IPD Mean 2.96% 2.15% 3.20% 2.75% Compound 2.68% 2.12% 2.70% 2.72% St Dev 7.48% 2.56% 10.02% 2.27% Skew -0.626 -0.182 -0.378 0.180

13 But Are They Property Investments?
Stronger Correlation with Equity than Underlying Property? Equities Bonds Prop Co IPD 1.000 0.051 0.630 0.018 0.058 -0.172 0.227

14 Is This Just a Measurement Issue?
Property Market Returns are Valuation Based May Lag Market Movements – Distorts Correlation May Be “Smoothed” – Understates the Volatility “Desmoothing” Procedures Remove the Impact of Valuations in Data Property Company Returns Are Affected by Gearing Are Affected by Overall Market Movements and Noise

15 Desmoothing the Index Should be no “memory” in the market
However, valuers actually adjust their prior valuation Reported return is a blend of “true” and previous return Rvt = a Rvt-1 + (1-a)Rt Therefore Rt = {Rvt - a Rvt-1 } / (1-a) where a is the “smoothing parameter” Prop Co IPD Desmoothed Mean 3.20% 2.75% 2.65% Compound 2.70% 2.72% 2.53% St Dev 10.02% 2.27% 5.06% Skew -0.378 0.180 0.724

16 Desmoothing in Action

17 Lagging and Correlation
Correlations: Property Companies with: Quarter IPD Desmoothed 0.227 0.326 1 0.434 0.492 2 0.531 0.359 3 0.460 0.068 4 0.409 0.093

18 Net Asset Value Fixed Assets Properties 10,000,000 Other 1,000,000
11,000,000 Current Assets: Trading Prop 2,000,000 Debtors ,000 Cash ,000 3,000,000 Less Creditors due < 1 Yr 2,000,000 TOTAL CURRENT ASSETS 12,000,000 Less Creditors due > 1 Yr 3,000,000 Book Value, Shareholders (+NAV) 9,000,000 3,000,000 ordinary shares issued NAV per share p

19 Discount to NAV Discount / Premium to NAV = (P – NAV) / NAV
NAV = 300 Price = 225 so ( )/300 = = 25% discount Why Might Property Companies Trade at a Discount? Tax - partic. Capital Gains Tax - liability Uncertainty as to true NAV; Minority holdings, control, agency issues Liquidity and loss on forced sale Risk: gearing and volatility; off balance sheet commitments Noise traders Pricing inefficiency? In long run, Property Companies behave like underlying market

20 Double Taxation Own Shares in Property Company or Own Real Estate?
Tax Position: Own the Real Estate Receive rental income, deduct costs: tax liability Trade property at profit, pay capital gains tax Tax Position: Shares in Property Company Company rental income, less costs gives tax liability Pays tax, distributes dividend to shareholder Dividend taxable for shareholder Company sells property, makes capital gain, pays tax Investor sells shares, makes capital gain, pays tax This Tax Leakage Leads to Demand for REITs

21 Real Estate Investment Trusts

22 Tax Efficient Real Estate Vehicles n. b
Tax Efficient Real Estate Vehicles n.b. some of these are offshore vehicles or pending final approval Russia: CEMF Netherlands: FBI Belgium: SICAFI Germany: OEFs, GREIT UK REIT Canada: REIT Japan: J-REIT France: SIIC Italy: SIIQ US: REIT Korea: K-REIT Mexico: REIT-FI Malaysia: REIT Singapore: S-REIT Brazil, FII South Africa: PUT Australia: LPT Source: adapted from Emmott (2004), NAREIT (2005)

23 US Real Estate Investment Trusts
Created in 1960s to allow smaller investors to participate in property markets Tax neutral vehicles provided meet qualification rules: Shareholder base: minimum of 100 shareholders Limited insider dominance: maximum of 50% shares held by largest five shareholders Asset test: at least 75% of total assets in real estate assets, cash or government securities no more than 25% of assets may be represented by securities other than government securities no more than 20% of assets within Taxable REIT Subsidiaries Income test: at least 75% of gross income from rents of real property, interest on mortgages, gains on sales of property and dividends from REITs

24 The Growth of REITs

25 REITs Listed: Growth and Consolidation

26 The Growth of REITs From <$6bn 1990 to >$400bn end 2006
Based on series of liberalisation measures Liberalisation in 1980s to solve real estate debt crisis Early 1990s – creation of UPREIT structure REIT Simplification Act, 1997 REIT Modernization Act, 1999 Key probably the UPREIT structure Private investors can transfer assets into REIT Investors get shares in return Does not trigger capital gains tax event until shares sold Allows orderly transfer into public markets

27 Some Myths and REITs: Diversification but not Real Estate?
Sources: NAREIT, NCREIT, DataStream

28 REIT Performance in Context
REITs Direct Equities 1.000 0.058 0.473 0.016

29 Some Myths and REITs: Discount to Net Asset Value
Traded Property Companies trade at discount to NAV Alleged that REITs do not (e.g. by EPRA) SIICs had very low discounts to NAV post-conversion But UK REITs now trade at sharp discount to NAV But: How much is a tax effect? US REITs DO NOT publish NAV Analysts estimate NAV from income May use discount rates higher than market cap rates. May thus be an overstating of the benefits

30 REITs – Discount/Premium to NAV
Source: Green Street Advisors, 2005 Green Street estimate NAV from cashflow and cap rate figures. REITs trade at times at substantial discounts to estimated NAV However, they also trade at a premium at times.

31 Some Myths and REITs: Liquidity
REITs are supposed to remove illiquidity as a negative factor damping investment Listed vehicles are more liquid than private vehicles Turnover: IPD 15%, Property Co. 61% (IPF Liquidity Report) Tradable transparent public market Low transaction costs, lower information costs But … REITs may be less Liquid than Property Companies Property Companies 61% REITs 22% LPTs 21% (IPF Liquidity Report, data for )

32 Australian Listed Property Trusts
A Tax-Transparent Trust Vehicle for Commercial Real Estate LPTs take off in the 1990s, retail and institutional sales Major market players (Lend Lease, AMP, ING, MacQuarie, DeutscheBank) Come to dominate market: low cost of capital gives buying power Now expanding outside Australia Asian markets USA UK – e.g. Westfield, Lend Lease & UK shopping centres Mainland Europe

33 LPT Performance Direct LPTs Equities 1.000 -0.221 -0.101 0.618

34 SIICs Sociétés d’Investissements Immobiliers Cotées - French REIT
Note legislative process and speed: Process begins 2001 with Industry working party Opportunity with 2002 Presidential & General elections Ministerial and political lobbying 2002 Placed in draft Finance Bill for 2003 Accounting and enabling legislation summer 2003 Passes into law end 2003 Many property companies transfer status early 2004 Further liberalisation 2004, 2006: UPREIT status?

35 SIICs - Structure Primary objective:
Construction or acquisition of income-producing property; or Ownership of shares in companies with that objective Must be traded on French exchange, minimum cap. €15million Tax Exempt, provided: Distribute 85% of net income to shareholders Pay out 50% of cap gains within 2 years of realisation Firms subject to an “exit” tax of 16.5% on unrealised capital gains, payable within four years of conversion

36 SIICs - Drivers Other competitor countries have REIT structures;
Much property investment going “offshore”; Government needs cash – windfall €1.5 bn "exit" tax; Expectation of tax from secondary trading; Persistent discount to NAV for listed companies Concern about pensions in France: Switch to private from public system Need for diversified portfolio / access to asset class Capital issues: Capital markets determine capital flows Under Basel II, bank lending may be constrained

37 SIICs - Drivers Other competitor countries have REIT structures;
Much property investment going “offshore”; Government needs cash – windfall €1.5 bn "exit" tax; Expectation of tax from secondary trading; Persistent discount to NAV for listed companies Concern about pensions in France: Switch to private from public system Need for diversified portfolio / access to asset class Capital issues: Capital markets determine capital flows Under Basel II, bank lending may be constrained

38 SIICs: Developments and Problems
SIIC II: an attempt to increase market size UPREIT-like structure to permit inflow of assets Relaxation of some of regulatory constraints Corporate Float-Offs of Real Estate into SIICs Tax and Ownership Problems Tax issues for non-French investors Limited control and ownership constraints Metrovacesa – Gécina Deal Metrovacesa (Spanish firm) buys controlling interest in French SIIC Gécina (€5.5bn deal, creating 2nd largest listed real estate fund in Europe) Borrows money in Spain to finance the acquisition Pays no tax on dividend payments from Gécina Interest payments offset against profits to reduce tax bill

39 The UK REIT Industry has been seeking a REIT vehicle for many years
Pressure on Government and Treasury for change: External – SIICs etc. Capital Flow Offshore Pensions issues – poor performance of equities etc. Clear appetite for real estate: buy-to-let Urban Task Force / Barker Report Pre-budget announcement and Treasury Consultation Paper Industry / interest group response Positive noises but delays and the election cycle

40 The UK REIT, January 2007 Company and Listing Rules
Must be a closed ended company Must be listed on main stock exchange (LSE not AIM) Must have one class of (voting) shares Must be resident in UK for tax purposes Restrictions on large share-holdings (10% rule) Activity Rules Define a Tax Exempt Business (ring-fenced) 75% of firm’s profit from real estate (rents) 75% of firm’s assets = real estate Must have three properties (not owner occupied) Development activity OK for portfolio building (3 year rule)

41 The UK REIT, January 2007 Other Constraints and Rules
Gearing rule: Profit/Finance Costs  1.25 Conversion charge 2% of GAV – may be phased Tax and Distribution TEB not subject to corporation tax 90% of profit must be distributed as Property Investment Dividend (PID) PID subject to withholding tax and treated as property income for shareholders Capital allowances set against income in profits calculation Cannot offset losses inside/outside TEB

42 UK REITs – Market Reaction

43 The UK REIT – Issues and Problems
Establishing a Critical Mass Conversions of Property Companies New entrants and listing requirements The offshore industry and REITs Specialist or Diversified Vehicles? Professional versus retail investors Investor interests versus management interests Returns and Market Expectations REITs as an income vehicle Property values, yields and distributions Growth, retained earnings and distributions The state of the market and investor confidence

44 The G-REIT … Must be public (German/EU) stock corporation, based in Germany Minimum free float of 25%, 10% shareholder maximum 75% assets, 75% profits from real estate (residential restricted) Must distribute 90% of distributable profits Maximum 60% debt to asset value Restrictions on trading G-REIT exempt from corporation taxes Investors fully taxable, withholding tax for non-domestic investors Retroactive to January 2007?

45 Summing Up Listed Real Estate Offers Benefits:
Liquidity and Low Transaction Costs Relatively Small Capital Requirement to Invest Ability to Diversify Within and Across Countries Listed Real Estate Has Disadvantages: High Volatility Compared to Underlying Higher Correlation with Equity than Real Estate market Part of This is Measurement Issue REITs Offer Advantages over Property Companies Elimination of Double Taxation Reduction of Discount to NAV Problem Linked to Real Estate Market in Long-Run Linked to Equity Market in Short-Run

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