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.

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

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

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

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

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

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

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

Privately Owned Commercial RE

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

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

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

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

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

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

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?

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

Choosing Optimal Form of Ownership

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.

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

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

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

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

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)

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

Sources of Commercial Real Estate Debt  

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

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

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

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?

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

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)

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

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

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

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

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?

A Closer Look at REITs

Security Offerings by REITs Large surge in capital raising in 97-98 and 04-05; capital raised by REITs is primarily used to acquire properties

In What Do REITs Invest?

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

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

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

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

A Typical UPREIT Structure 17-45

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

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

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

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

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

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

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

REIT Investment Performance

End of Chapter 17