CHAPTER TWENTY ONE: REAL ESTATE INVESTMENT TRUSTS (REITs)

GROWTH BEGINNING IN 1992

* A national __REAL ESTATE CREDIT CRUNCH__ existed due to very limited real estate capital sources. In 1992 a tax deferred structure was created by the Internal Revenue Code called a _UMBRELLA PARTNERSHIP REIT___ (UPREIT) which produced a massive amount of capital investment in the following years. An UPREIT is a REIT that owns a controlling interest in a _OPERATING PARTNERSHIP_ that owns the real estate as opposed to the traditional structure where the REIT directly owned the real estate. * It was created so that real estate developers and owners could transfer their properties to the REIT form of ownership. (GIVES THE OWNERS GREATER LIQUIDITY, AVOIDS IMMEDIATE CAPITAL GAINS) * Since the transfer is an exchange of one partnership interest for another, it's not a _TAXABLE EVENT__. * The "modern" REIT structure featuring active management and tax deferred exchanges of assets was attractive to owners and investors, and led to a massive growth in REIT market capitalization. * The market capitalization of U.S. REITs declined almost 50% from 2005-2009 due to the sub-prime mortgage crisis and "credit crunch" when many were unable to refinance __CORPORATE__ or property-level debt. However, they have recovered strongly from $200 million market capitalization in 2009 to over $1 trillion as of January 2018. * The vast majority of REITs today active manage their portfolios in order to grow their cash flow and portfolios.

REIT EXPANSION AND GROWTH

* Because of the 90% earnings distribution rule, REITs have limited ability to retain enough earnings to acquire additional real estate assets. * Most REITs must plan for expansion by reserving the right to _ISSUE STOCK_ in the future. * Concern among investors and analysts is that __DILUTION__ of future share prices and earnings could result from the additional stock offerings. * The use of the funds from an additional stock offering has to be analyzed to determine if they will generate a future cash flow sufficient to offset the dilution.

INCOME GROWTH STRATEGIES 5) Growing Income through Financial Engineering

* Includes the ability to use __LEVERAGED__ (debt), obtain favorable rates, terms and sources of capital. These can influence the long-term cost of capital for the REIT. * For example, using short-term, variable rate loans to acquire properties instead of higher longer-term fixed rates. The use of the lower rate loans increases funds from operations which in turn can increase the REIT valuation.

INCOME GROWTH STRATEGIES 3) Growing Income through Development

* May result in higher _RISK__ than the first two options, but it can be mitigated, i.e focusing on _CUSTOM BUILD TO SUIT__ development with resulting long-term leases with quality tenants rather than riskier __SPECULATIVE__ development. * As acquisition opportunities decline, more REITs turn to development.

EQUITY REITs

* Most REITs specialize by _PROPERTY TYPE__, __LOCATION_ or both. * The term _SPECIALIZATION__ implies a concentration of effort to obtain a comparative or competitive advantage. The extent to which a REIT specializes impacts the degree of risk to the investor.

REITs

* REITs are companies with shareholders that own and in many cases manage income producing properties in the case of _EQUITY_ REITs or engage in financing real estate investments in the case of _MORTGAGE__REITs. * Although REITs have been in existence since the 1930s, as of 1960, REITs can elect to qualify as a _PASS-THROUGH__ entity to avoid double taxation by distributing most of their taxable earnings as well as any capital gains from the sale of their properties. * The investment appeal of equity REITs includes 1) the opportunity of smaller investors to invest is a diversified portfolio of properties professionally managed and 2) own shares of that trade on public exchanges thus providing more liquidity than if a property was owned outright. * Investments of a REIT must be approved by a board of trustees who are accountable to the shareholders.

INCOME GROWTH STRATEGIES 2) Growing Income through Acquisitions

* The most common acquisition method is by swapping shares of the REIT for interests in properties which has the advantage of _MINIMAL CASH REQUIREMENT OF THE REIT_. * REIT shareholders can benefit because the swaps are often done at favorable (higher than market) capitalization rates, with the owners of the acquired properties willing to accept a discount for their properties in exchange for _LIQUIDITY__. * Another benefit is that the acquired company may have expertise or capacities the REIT does not possess. The result is a larger portfolio for the REIT and a set of skills/capacity it did not have before the transaction.

TYPES OF REITs

* The two main types of REITs are _EQUITY__ (~80%) and _MORTGAGE__ REITs (~20%).

VALUEING REITs AS INVESTMENTS

* The valuation of a REIT involves estimating the value of 1) A PORTFOLIO OF PROPERTIES IN DIFFERENT LOCATIONS 2)THE REIT MANAGEMENT 3)ANY GOODWILL ESTABLISHED BY THE REIT (REPUTATION)

INCOME GROWTH STRATEGIES 4) Growing Income through Provision of Services

* This type of income varies significantly among REITs and come from related and unrelated third parties. * Examples would be property management, engineering or leasing services.

* The National Association of Real Estate Investment Trusts (NEREIT) divides equity REITs into the following nine categories:

1) _INDUSTRIAL OFFICE__. Some analysts further segregate the REITs by office, warehouse, office/warehouse or by location, i.e. _CENTRAL BUSINESS DISTRICT__ vs _SUBURBAN__. 2).RETAIL__ further segregated into those that own regional malls, neighborhood strip centers or free-standing properties. 3) _RESIDENTIAL_ further segregated into apartment complexes and manufactured home parks. 4) _DIVERSIFIED__ by owning a variety of property types or single property types not categorized, i.e. single-family rental properties, prisons, funeral homes, etc. 5) _LODGING/RESORTS_ including, hotels, motels, time shares and resorts. 6) _HEALTHCARE__ including hospitals, senior housing, hospice properties, etc. 7) _SELF-STORAGE_ 8) _TIMBER__. Owning and leasing timber land. 9) _INFRASTRUCTURE__ including railroads, electric and gas transmission lines, cell towers, etc

* REITs can also be finite-life or non-finite life.

Finite-life REITs are not traded publicly, and have a goal of liquidating all assets and distributing all proceeds to investors by a certain date. MARKET CONDITIONS may force those REITs to extend their termination date.

THE LARGEST CATEGORIES OF REITs CURRENTLY ARE

THE INDUSTRIAL/OFFICE AND RETAIL

LEGAL REQUIREMENTS

To qualify as a REIT for tax purposes, among numerous requirements, it must 1) have at least 75% of its assets in real estate, cash and government securities. 2) earn at least 95% of its gross income from __DIVIDENDS___, __INTEREST__, _RENTS__ or gains from the sale of certain assets. 3) distribute at least _90%__ of its taxable income to shareholders. 4) be managed by a board of directors or trustees. 5) have a minimum of _10%__ shareholders. * The shares of a REIT also must be fully transferable. * As of the 1986 Tax Act, REITs are now allowed to manage and maintain their own properties, collect rents, etc. which before had to be performed by a subcontractor. The result of the Tax Act is that 1) REIT managers can _INTERNALIZED__ those functions and create VERTICALLY INTEGRATED__ operating companies. 2) the REITs became more attractive to developers which have become the dominate sponsors of REITs. 3) As of September 2017, there were 191 U.S. REITs trading on the NYSE.

INCOME GROWTH STRATEGIES 1) Growing Income from Existing Properties:

a) Increasing _OCCUPANCY__ of existing space owned. b) Increasing _RENTS__ of existing space owned if permitted by the market c) _REDEVELOPMENT__ or remodeling of existing space owned to attract higher end tenants and higher end rents. d) Altering the market segment focus (__REBRANDING__), i.e. shifting the focus of an owned mall to one of clothing/fashion from home repair/home furniture. This strategy will require the expense of finding new tenants. e) Reducing expenses and changing policies, i.e. eliminating a no pets policy at an owned apartment complex to attract more tenants.