© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 1 CHAPTER TWENTY-ONE REAL ESTATE INVESTMENT TRUSTS (REITS)

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 2 Chapter Objectives Qualifying requirements of the REIT Advantages of the REIT Classifications FFO Accounting and financial issues The REIT as an investment vehicle

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 3 Real Estate Investment Trusts (REITs) Primary Advantages: –REITs are not subject to double taxation –limited liability to shareholders –REITs allow investors liquidity and diversification Primary Disadvantages: –income is portfolio income –tax losses do not pass through to the shareholders –REITs must meet substantial operating restrictions

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 4 A Closer Look at Real Estate Investment Trusts (REIT) A (REIT) is a corporate form of ownership engaged in real estate investment, but with no taxation at the corporate level. Basic operations –REITs invest primarily in real property and mortgages.

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 5 Asset Requirements At least 75 percent of the value of a REITs assets must consist of real estate assets, cash, and government securities Not more than 5 percent of the value of the assets may consist of the securities of any one issuer if the securities are not includable under the 75 percent test A REIT may not hold more than 10 percent of the outstanding voting securities of any one issuer if those securities are not includable under the 75 percent test Not more than 20 percent of its assets can consist of stocks in taxable REIT subsidiaries

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 6 Income Requirements At least 95 percent of the entity’s gross income must be derived from dividends, interest, rents, or gains from the sale of certain assets At least 75 percent of gross income must be derived from rents, interest obligations secured by mortgages, gains from the sale of certain assets, or income attributable to investments in other REITs Not more than 30 percent of the entity’s gross income can be derived from sale of disposition of stock or securities held for less than 6 months or real property held for less than 4 years other than property involuntarily converted or foreclosed on Distributions to shareholders must equal or exceed the sum of 90 percent of REIT taxable income

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 7 Stock and Ownership Requirements Be taxable as a corporation Be managed by a board of directors or trustees Have shares that are fully transferable Shares in a REIT must be transferable and must be held by a minimum of 100 persons No more than 50 percent of REIT shares may be held by five or fewer individuals during the last half of a taxable year

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 8 REIT Types REITs can be classified by their assets –Equity REITs, Mortgage REITs, and Hybrid REITs pre-1990: “diversification plays” post-1990: “management plays”

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 9 Equity Trusts Industrial/ office Retail Residential Diversified Lodging/ resorts Health care Self storage Specialty

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 10 FFO-Funds From Operations REIT Income Statement REIT Cash Flow Rent$100 -operating expenses 40 Net operating income 60 -depreciation Net income Cash flow EPS$2---- FFO per share-----$6

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 11 REIT Expansion and Growth Growing income from existing properties Growing income through acquisitions Growing income through development Financial engineering

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 12 Accounting and Financial Issues TI’s and free rent Leasing commissions Use of SL rents Management income Mortgage debt Ground leases Renewal options and rent growth Leased space vs. occupied space Retail rents

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 13 REIT Valuation Discounted Cash Flow used by REITs to evaluate properties Net Asset Value (NAV) v. Total Stock Market Capitalization Price/Income ratio Funds from Operations (FFO)

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 14 REAL ESTATE CAPITAL Public Real Estate: –Real estate held by public corporations –Public REITs Private Real Estate: –Individuals, Partnerships, Private REITs, Limited partnerships, S corporations, or Limited liability companies –Pension funds, Commingled funds, Joint ventures, and other institutional investors