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REAL ESTATE INVESTMENT TRUSTS:
A reit choice for the Economy
Authored By:
Kaushik Rajan
IIM Indore Batch of 2008
Mail : p06rajank@iimidr.ac.in
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 ones
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).
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BALANCE SHEET(ASSETS) |
Year 1 |
Year 5 |
Year 10 |
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REAL ESTATE( GROSS) |
1,000,000 |
1,000,000 |
1,000,000 |
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minus ACC. DEPRECIATION |
0 |
250,000 |
500,000 |
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|
1,000,000 |
750,000 |
500,000 |
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INCOME SHEET |
|
|
|
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REVENUES |
200,000 |
200,000 |
200,000 |
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EXPENSES |
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OPERATING |
100,000 |
100,000 |
100,000 |
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INTEREST |
40,000 |
40,000 |
40,000 |
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DEPRECIATION |
50,000 |
50,000 |
50,000 |
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NET INCOME |
10,000 |
10,000 |
10,000 |
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( REVENUES minus EXPENSES) |
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FFO |
60,000 |
60,000 |
60,000 |
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( NET INCOME plus DEPRECIATION) |
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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 REITs
(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.
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