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REAL ESTATE INVESTMENT TRUSTS: A ‘reit’ choice for the Economy

Authored By:

Kaushik Rajan

IIM Indore – Batch of 2008

Mumbai highrise.jpg A REIT or Real Estate Investment Trust is a security that invests in real estate directly, either through properties or mortgages, and like stocks it can be traded.
REITs receive special tax considerations and typically offer investors high yields as well as a highly liquid method of investing in real estate.

Presently, a REIT is a company that buys, develops, manages and sells real estate assets and allows participants to invest in a professionally managed portfolio of properties. Some REITs also are engaged in financing real estate.

THE HOW AND WHYS OF REIT INVESTING

A REIT is typically a real estate company that offers common shares to the public, with two unique features: its primary business is managing groups of income-producing properties and it must distribute most of its profits as dividends( in the US a REIT must distribute 90% of its annual taxable income to shareholders as dividends). Since REITs are required to distribute a large majority of their income, which may be taxable in the hands of the investors, they are a means of reducing or eliminating corporate income taxes.

Benefits to an investor

Investing in REITs is a liquid, dividend-paying means of participating in the real estate market .REITs are total return investments that typically provide high dividends plus the potential for moderate, long-term capital appreciation. Long-term total returns of REIT stocks are likely to be lesser than that of high-growth stocks and somewhat more than the returns of bonds.

· Dividends

One of the most attractive features of investing in REITs is that REITs must pay a large percent of their taxable income to shareholders in the form of dividends each year. Dividend growth rates for REIT shares have outpaced inflation over the last decade. The REIT industry's dividend yields are significantly higher than other equities on average and produce a steady stream of income through all market conditions.

· Diversification

REITs are also attractive additions to investment portfolios because there is a relatively low correlation between REIT and publicly traded real estate stock returns and the returns of other market sectors. Thus, including REITs in one’s investment program helps build a diversified portfolio.

Over the last 30 years the correlation of REIT returns to the returns of other stocks and bonds has declined significantly. REITs provide a way to realize the economic benefits of real estate obtain stable, consistent income and long-term growth while increasing portfolio diversification beyond what other common stocks and fixed income securities can offer by themselves.

Types

REITs are classified in the following categories:

Equity REITs own and operate income-producing real estate.
Mortgage REITs lend money directly to real estate owners and their operators, or indirectly through acquisition of loans or mortgage-backed securities.
Hybrid REITs are companies that both own properties and make loans to owners and operators.

Most REITs focus on the 'hard asset' business of real estate operations. These are called equity REITs. Equity REITs tend to specialize in owning certain types building such as apartments, regional malls, office buildings or lodging facilities. Some are diversified and some are specialized, for example a REIT that owns golf courses.

Mortgage REITs comprise fewer than 10% of REITs. Mortgage REITs are finance companies that use several hedging instruments to manage their interest rate exposure.
A handful of hybrid REITs run both real estate operations and transact in mortgage loans.

So What Kind of Asset Is a REIT Stock?

REITs are dividend-paying stocks that focus on real estate. If you seek income, you would consider them along with high-yield bond funds and dividend paying stocks. Stable dividends combine with price volatility to create a total return which is often promising, but volatile nonetheless.

Analyzing REITs

As dividend-paying stocks, REITs are analyzed much like other stocks. But there are some large differences due to the accounting treatment of property. Consider a simplified example. Say a REIT buys a building for Rs.1 million. Accounting requires that our REIT charge depreciation against the asset. Let's assume that we spread the depreciation over 20 years in a straight-line. Each year we will deduct Rs.50, 000 in depreciation expense (Rs. 50,000 per year x 20 years = Rs. 1 million).

BALANCE SHEET(ASSETS)	Year 1	Year 5	Year 10

REAL ESTATE( GROSS)	1,000,000	1,000,000	1,000,000
minus ACC. DEPRECIATION	0	250,000	500,000
	1,000,000	750,000	500,000

INCOME SHEET

REVENUES	200,000	200,000	200,000

EXPENSES
OPERATING	100,000	100,000	100,000
INTEREST	40,000	40,000	40,000
DEPRECIATION	50,000	50,000	50,000

NET INCOME	10,000	10,000	10,000
( REVENUES minus EXPENSES)

FFO	60,000	60,000	60,000
( NET INCOME plus DEPRECIATION)

Let's look at the simplified balance sheet and income statement above. In year 10, the balance sheet carries the value of the building at Rs.500, 000 (the book value Our income statement deducts Rs.190,000 of expenses from Rs.200,000 in revenues, but Rs.50,000 of the expense is a depreciation charge.

But the REIT doesn't actually spend this money in year 10; depreciation is a 'non-cash charge'. Therefore, we add back the depreciation charge to net income in order to produce funds from operations (FFO). The idea is that depreciation unfairly reduces our net income because our building probably didn't lose half its value over the last 10 years. FFO fixes this presumed distortion by excluding the depreciation charge and a few other adjustments too.

It is important to note FFO gets closer to cash flow than net income, but it does not capture cash flow. Counting capital expenditures gives a figure known as adjusted FFO, but there is no universal consensus regarding its calculation.

Our hypothetical balance sheet can help us understand the other common REIT metric: net asset value (NAV). NAV attempts to replace book value of property with a better estimate of market value. Calculating NAV requires a somewhat subject appraisal of the REIT's holdings. In the above example, we see the building generates Rs.100, 000 in operating income (Rs.200, 000 in revenues minus Rs.100, 000 in operating expenses). One method would be to 'capitalize' the operating income based on a market rate. If we think the market's present cap rate for this type of building is 8%, then our estimate of the building's value becomes Rs.1,250,000 (Rs.100,000 in operating income / 8% cap rate = Rs.1,250,000). This market value estimate replaces the book value of the building.

Assets minus debt equals equity, where the 'net' in NAV means net of debt. The final step is to divide NAV into common shares to get NAV per share, which is an estimate of intrinsic value. In theory, the quoted share price should not stray too far from the NAV per share.

Other Considerations

When picking stocksone sometimes hears of top-down versus bottom-up analysis. Top-down starts with an economic perspective and bets on themes or sectors (for example, an aging demographic may favor drug companies). Bottom-up focuses on thefundamentals of specific companies. REIT stocks clearly require both top-down and bottom-up analysis.

From a top-down perspective, REITs can be affected by anything that impacts the supply of and demand for property. Population and job growth tend to be favorable for all REIT types. Interest rates are, in brief, a mixed bag. A rise in interest rates usually signifies an improving economy, which is good for REITs as people are spending and businesses are renting more space. Rising interest rates tend to be good for apartment REITs as people prefer to remain renters rather than purchase new homes. On the other hand, REITs can often take advantage of lower interest rates by reducing their interest expense and thereby increasing their profitability.

Capital market conditions are also important, namely the institutional demand for REIT equities. In the short run, this demand can overwhelm fundamentals.

At the individual REIT level, one wants to see strong prospects for growth in revenue, such as rental income and related service income, and FFO. You want to see if the REIT has a unique strategy for improving occupancy and raising its rents.

REITS ACROSS THE WORLD

REITs were created by the US Congress in 1960 and played a limited role in real estate investment for more than 30 years. Since 1992, however, the REIT marketplace has grown dramatically.

The US has currently upwards of 200 publicly traded REITs, their assets included a combined $500 billion, and approximately two-thirds of them were trading on national stock exchange. Other REIT’s (approximately 800 in number) are publicly-registered but non-exchange traded or private companies. American REITs operate commercial properties in nearly every major metropolitan area across the country and in several international locations.

Australian REITs (Listed Property Trusts) were first listed on the Australian Stock Exchange in the early 1970s and have grown in number since then.

Canadian REITs were established in 1993. They are required to be configured as trusts and are not taxed if they distribute their net taxable income to shareholders.

Germany is also planning to introduce German REITs (short G-REITs) in order to create a new type of real estate investment vehicle. Government fears that failing to introduce REITs in Germany would result in a significant loss of investment capital to other countries. Nonetheless there still is resistance to these plans, especially by the social democratic party.

Japan is one of a handful of countries in Asia with REIT legislation (other countries/markets include Hong Kong, Singapore, Malaysia, Taiwan and Korea), which permitted their establishment in December 2001. J-REIT securities are traded on the Tokyo Stock Exchange, and most participants are Japanese conglomerates and foreign investment banks.

In the United Kingdom, the legislation laying out the rules for REITs was enacted in the Finance Act 2006 and came into effect in January 2007 British REITS have to distribute 95% of their income. They must be a close-ended investment trust and be UK resident and publicly listed on a stock exchange recognized by the Financial Services Authority.

REITS IN INDIA

From the point of view of real estate investment, a large country with enormous investment potential like India, interest is heightened. India's combined commercial and residential real estate market is valued to be around 2 percent of the country's GDP and 2 percent of total stock market capitalization. The real estate market is growing at a rate of 30 percent per year, a growth that has caused real estate majors from across the world to focus on India. However, while the real estate market is booming, REITs are currently non-existent in India.

Real Estate Investment in India

The factors which are favorable to investment in real estate in India are:

• Current macro economic background is extremely attractive

• Broadening industrial and commercial growth beyond IT and BPO

• Large demand foreseeable in commercial, residential and hospitality sectors. Retail sector might be slightly erratic.

• FDI has opened up and is evolving

• Gradual evolution of secondary market, longer leases and financing sophistication should be increasingly evident

In the present scenario, focus would be on following types of investments:

• Commercial : Offices and Parks

• Hospitality : Hotels, Leisure and Healthcare

• Retail : Large Malls

• Industrial

• Mixed use development sites : Including Residential

Several groups are actively working to improve the real estate investment options and establish a REIT industry in India.

The Associated Chambers of Commerce and Industry of India (ASSOCHAM) has proposed to create REITs to ensure that India's property markets are suitably expanded with proper regulation. The Securities and Exchange Board of India (SEBI) Advisory Committee on Mutual Funds has considered the subject of mutual funds launching specialized real estate products (REMFs) on the lines of German open-end funds.

The SEBI guidelines will enable retail investors to participate in the real estate market via real estate-dedicated mutual funds. The new guidelines will enable mutual funds to invest in the real estate sector and thereby will also allow small investors to own property.

The Association of Mutual Funds of India (AMFI) has constituted a committee for an in-depth study of relevant legal and operational aspects. At present, 38 companies have been licensed to operate as mutual funds in India, including well-known international names like Alliance Capital, Deutsche Bank, Merrill Lynch, Fidelity, HSBC, Morgan Stanley, Quantum and ING. These firms have already floated more than 500 funds and could be in line to offer a real estate fund.

A Citigroup Research report on real estate investment trust (REIT) strategy has identified over $15 billion of capital raised by opportunity funds targeted at India. In March 2005, the Union Government allowed FDI in real-estate development sector under automatic approval route for large projects

Impact of REITs in India

With the infusion of large amounts of foreign capital into India in recent times and with the growing popularity in owning global real estate assets, a viable listed real estate market would garner a sizable portion of that increasing foreign capital.

Currently, the bulk of the mutual fund assets are invested in income-oriented options, including debt and money market instruments. For a blossoming mutual fund industry, an investment option that combines both reliable income and strong growth, like a REIT, would be a favorable.

All of these ready sources of capital are important to the eventual success of a new REIT industry. Real estate developers presently have limited means of financing, few developers have tapped capital markets for fund raising, and there is too much dependence on debt.

The introduction of REITs in India would provide a further boost to the real estate industry. This would result in increased rental housing generation and also raise cheaper funds for this sector. The high growth rate of household savings is a source to be tapped.

REITs would also provide an opportunity for small investors to access commercial property returns (currently 9-10%) that are now unavailable without significant capital outlays. This would also be a tool for diversification of investor portfolios.

India's GDP is currently around $630 billion and is growing at an average rate of 7 percent to 8 percent. There are numerous sources of capital that would welcome a REIT investment option. The establishment of a REIT industry would provide a much-needed capital infusion to the Indian real estate market.