Property Companies and REITs:Property Companies and REITs:Real Estate in the Public MarketsReal Estate in the Public Markets

Colin LizieriColin Lizieri

Market TypesMarket Types

Public Markets:Public Markets:- Generally single central market place- Regulated order processing systems- Price and deal transparency- Liquidity- Market makers / brokers role defined- Market makers limited impact on prices?

Private MarketsPrivate Markets- Generally no central market place- Highly restricted transparency and info.- Asymmetric information?- Market maker, broker role self-defined- Market makers may influence prices

Equity MarketsEquity Markets

Generally public marketsGenerally public markets Regular price, volume, performance dataRegular price, volume, performance data Brokers, market makers and ordersBrokers, market makers and orders For firms:For firms:

- Raise capital: initial public offering and seasoned offerings - Benchmark on market views of firm’s activity

For investorsFor investors- Income (dividends) plus capital growth- Liquidity and portfolio rebalancing- Ownership of (residual) asset base - Risk and volatility

Equity Market PricingEquity Market Pricing

Homogenous products, supply, demandHomogenous products, supply, demand Role of Players: Role of Players:

- brokers, analysts, informed investors and noise traders Pricing principles:Pricing principles:

- Investors want capital growth and income- Investors trade off risk against return- Pricing: Dividend discount model or Net Asset Value- Asset values and the Law of One Price- Risk return trade-off and Betas

Pricing in Public Markets - DDMPricing in Public Markets - DDM

Dividend Discount Model:Dividend Discount Model:- Price represents discounted value of future income stream:

P0 = D1/(1+r) + D2/(1+r)2 + D3/(1+r)3 + … Dn/(1+r)n + …

Assume that dividends grow at g% per annum, then

P0 = D1 / (r-g)

The dividend yield d = (r-g) = DThe dividend yield d = (r-g) = D11 / P / P00

We can observe the dividend yieldWe can observe the dividend yield If we know or can estimate g then we can find required return rIf we know or can estimate g then we can find required return r If we know or can estimate r, then we have market’s view of gIf we know or can estimate r, then we have market’s view of g

Pricing in Public Markets: NAVPricing in Public Markets: NAV

There are various claims on the value of the firm There are various claims on the value of the firm The equity holders stand behind:The equity holders stand behind:

- The debt holders- The government- Preference shareholders etc.

The equity holders own the “residual value of the company”The equity holders own the “residual value of the company” Take a property company with a simple structureTake a property company with a simple structure

- The assets are the real estate- There is debt to be paid- Property Values – Liabilities = Net Asset Value- NAV / Number of Shares = NAV per share- Shouldn’t that be the share price? If not, why not?

Real Estate in Public and Private MarketsReal Estate in Public and Private Markets

Real Estate in Private MarketsReal Estate in Private Markets- Direct ownership of portfolios- Investing in private real estate vehicles and funds- No central market place- Information asymmetry, transparency, illiquidity- High transaction costs, monitoring costs, management costs

Real Estate in Public MarketsReal Estate in Public Markets- Property companies and REITs- Exchange traded fund vehicles- Liquidity, price transparency, transaction costs- Volatility and correlation

But … Are Public Vehicles Real Estate Investments?But … Are Public Vehicles Real Estate Investments?

Property Companies vs. REITsProperty Companies vs. REITs

Property Companies:Property Companies:- Corporate Entities – Taxable- Management Control over Activity

o Gearing, non-core activities, disposal and acquisitiono Dividend policy and retained earnings

REITsREITs- Regulations on Activities and Structure

o Core real estate activityo Borrowing restrictions (?)o Distribution policyo Ownership rules

- Real Estate Income not taxed within the vehicle

Example: UK Property Companies to 2006Example: UK Property Companies to 2006

UK Property Companies:UK Property Companies:- Closed End Investment Vehicles- Taxable corporate entities- Distinguish between:

o Property Investment Companieso Property Developer-Trader Companies

- Often relatively low free-float- Often relatively high management holdings

Sector was shrinking with major players delisting or Sector was shrinking with major players delisting or restructuring, 1998-2004restructuring, 1998-2004

Growth potential with arrival of REITsGrowth potential with arrival of REITs

Real Estate in the UK Equity Market Real Estate in the UK Equity Market

As at December 2006As at December 2006- 43 UK Listed Companies, Market Cap £54.1bn- Represents just 2.86% of total market cap - Major firms:

1. Land Securities (34) £10.8bn

2. British Land (39) £8.9bn

3. Liberty International (66) £5.1bn

4. Hammerson (77) £4.5bn

5. Slough (87) £3.7bn

6. Brixton (160) £1.5bn Top Six = 64% market capo Helical Bar (353) £0.4bno Development Securities (441) £0.3bn

- A Reminder of Scale:o Royal Dutch Shell (1) £117.1bno BP (2) £110.8bno HSBC (3) £106.8bno Glaxo (4) £78.1bno Vodafone (5) £74.4bn

Performance 1988-2006Performance 1988-2006

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Equities

Bonds

Prop Co

   EquitiesEquities BondsBonds Prop CoProp Co

MeanMean 2.96%2.96% 2.15%2.15% 3.20%3.20%

CompoundCompound 2.68%2.68% 2.12%2.12% 2.70%2.70%

St DevSt Dev 7.48%7.48% 2.56%2.56% 10.02%10.02%

SkewSkew -0.626-0.626 -0.182-0.182 -0.378-0.378

But Are They Property Investments?But Are They Property Investments?

   EquitiesEquities BondsBonds Prop CoProp Co IPDIPD

MeanMean 2.96%2.96% 2.15%2.15% 3.20%3.20% 2.75%2.75%

CompoundCompound 2.68%2.68% 2.12%2.12% 2.70%2.70% 2.72%2.72%

St DevSt Dev 7.48%7.48% 2.56%2.56% 10.02%10.02% 2.27%2.27%

SkewSkew -0.626-0.626 -0.182-0.182 -0.378-0.378 0.1800.180

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Bonds

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IPD

But Are They Property Investments?But Are They Property Investments?

Stronger Correlation with Equity than Underlying Property?Stronger Correlation with Equity than Underlying Property?

   EquitiesEquities BondsBonds Prop CoProp Co IPDIPD

EquitiesEquities 1.0001.000         

BondsBonds 0.0510.051 1.0001.000      

Prop CoProp Co 0.6300.630 0.0180.018 1.0001.000   

IPDIPD 0.0580.058 -0.172-0.172 0.2270.227 1.0001.000

Is This Just a Measurement Issue?Is This Just a Measurement Issue?

Property Market Returns are Property Market Returns are ValuationValuation Based Based- May Lag Market Movements – Distorts Correlation- May Be “Smoothed” – Understates the Volatility

““Desmoothing” ProceduresDesmoothing” Procedures- Remove the Impact of Valuations in Data

Property Company Returns Property Company Returns - Are Affected by Gearing - Are Affected by Overall Market Movements and Noise

Desmoothing the IndexDesmoothing the Index

Should be no “memory” in the marketShould be no “memory” in the market However, valuers actually adjust their prior valuationHowever, valuers actually adjust their prior valuation Reported return is a blend of “true” and previous returnReported return is a blend of “true” and previous return RRvv

tt = = R Rvvt-1t-1 + (1- + (1-)R)Rtt

Therefore RTherefore Rtt = {R = {Rvvtt - - R Rvv

t-1t-1 } / (1- } / (1-) )

where where is the “smoothing parameter” is the “smoothing parameter”

   Prop CoProp Co IPDIPD DesmoothedDesmoothed

MeanMean 3.20%3.20% 2.75%2.75% 2.65%2.65%

CompoundCompound 2.70%2.70% 2.72%2.72% 2.53%2.53%

St DevSt Dev 10.02%10.02% 2.27%2.27% 5.06%5.06%

SkewSkew -0.378-0.378 0.1800.180 0.7240.724

Desmoothing in ActionDesmoothing in Action

-15.00%

-10.00%

-5.00%

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25.00%

IPD

Desmoothed

Lagging and CorrelationLagging and Correlation

Correlations:Correlations:Property Companies with:Property Companies with:

QuarterQuarter IPDIPD DesmoothedDesmoothed

00 0.2270.227 0.3260.326

11 0.4340.434 0.4920.492

22 0.5310.531 0.3590.359

33 0.4600.460 0.0680.068

44 0.4090.409 0.0930.093

Net Asset ValueNet Asset Value

Fixed Assets Properties 10,000,000Other 1,000,000

11,000,000Current Assets:

Trading Prop 2,000,000Debtors 600,000Cash 400,000

3,000,000

Less Creditors due < 1 Yr 2,000,000TOTAL CURRENT ASSETS 12,000,000

Less Creditors due > 1 Yr 3,000,000Book Value, Shareholders (+NAV) 9,000,0009,000,000

3,000,000 ordinary shares issuedNAV per share 300p

Discount to NAVDiscount to NAV

Discount / Premium to NAV = (P – NAV) / NAVDiscount / Premium to NAV = (P – NAV) / NAV

NAV = 300 Price = 225 so (225-300)/300 = -0.25 = NAV = 300 Price = 225 so (225-300)/300 = -0.25 = 25% discount 25% discount Why Might Property Companies Trade at a Discount?Why Might Property Companies Trade at a Discount?

- Tax - partic. Capital Gains Tax - liability - Uncertainty as to true NAV; - Minority holdings, control, agency issues- Liquidity and loss on forced sale- Risk: gearing and volatility; off balance sheet commitments- Noise traders- Pricing inefficiency?

In In long runlong run, Property Companies behave like underlying market, Property Companies behave like underlying market

Double TaxationDouble Taxation

Own Shares in Property Company or Own Real Estate?Own Shares in Property Company or Own Real Estate? Tax Position: Own the Real EstateTax Position: Own the Real Estate

- Receive rental income, deduct costs: tax liability- Trade property at profit, pay capital gains tax

Tax Position: Shares in Property CompanyTax Position: Shares in Property Company- Company rental income, less costs gives tax liability- Pays tax, distributes dividend to shareholder- Dividend taxable for shareholder- Company sells property, makes capital gain, pays tax- Investor sells shares, makes capital gain, pays tax

This Tax Leakage Leads to Demand for This Tax Leakage Leads to Demand for REITsREITs

Real Estate Investment Trusts Real Estate Investment Trusts

REITsREITs

Tax Efficient Real Estate VehiclesTax Efficient Real Estate Vehicles

n.b. some of these are offshore vehicles or pending final approvaln.b. some of these are offshore vehicles or pending final approval

US: REIT

Japan: J-REIT

Korea: K-REIT

Australia: LPTSouth Africa: PUT

Malaysia: REITSingapore: S-REIT

Italy: SIIQ

Netherlands: FBI

Belgium: SICAFIUK REIT

France: SIIC

Source: adapted from Emmott (2004), NAREIT (2005)

Germany: OEFs, GREIT

Canada: REIT

Brazil, FII

Russia: CEMF

Mexico: REIT-FI

US Real Estate Investment TrustsUS Real Estate Investment Trusts

Created in 1960s to allow smaller investors to participate in Created in 1960s to allow smaller investors to participate in property marketsproperty markets

Tax neutral vehicles provided meet qualification rules:Tax neutral vehicles provided meet qualification rules:- Shareholder base: minimum of 100 shareholders- Limited insider dominance: maximum of 50% shares held by

largest five shareholders- Asset test: at least 75% of total assets in real estate assets,

cash or government securities- no more than 25% of assets may be represented by securities

other than government securities- no more than 20% of assets within Taxable REIT Subsidiaries- Income test: at least 75% of gross income from rents of real

property, interest on mortgages, gains on sales of property and dividends from REITs

The Growth of REITsThe Growth of REITs

NAREIT Market Capitalisation

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ions Hybrid

Mortgage

Equity

REITs Listed: Growth and ConsolidationREITs Listed: Growth and Consolidation

NAREIT - REITs Listed

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The Growth of REITsThe Growth of REITs

From <$6bn 1990 to >$400bn end 2006From <$6bn 1990 to >$400bn end 2006 Based on series of liberalisation measuresBased on series of liberalisation measures

- Liberalisation in 1980s to solve real estate debt crisis- Early 1990s – creation of UPREIT structure- REIT Simplification Act, 1997- REIT Modernization Act, 1999

Key probably the UPREIT structureKey probably the UPREIT structure- Private investors can transfer assets into REIT- Investors get shares in return- Does not trigger capital gains tax event until shares sold- Allows orderly transfer into public markets

Some Myths and REITs:Some Myths and REITs:Diversification but not Real Estate?Diversification but not Real Estate?

-0.400

-0.200

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REITs with Equity REITs with Property

Sources: NAREIT, NCREIT, DataStream

REIT Performance in ContextREIT Performance in Context

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0.00%

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40.00%NAREIT(R)

NCREIF(R)

USEquity(R)

Source: NAREIT, NCREIF, Universty of Reading

  REITs Direct Equities

REITs 1.000    

Direct 0.058 1.000  

Equities 0.473 0.016 1.000

Some Myths and REITs:Some Myths and REITs:Discount to Net Asset ValueDiscount to Net Asset Value

Traded Property Companies trade at discount to NAVTraded Property Companies trade at discount to NAV Alleged that REITs do not (e.g. by EPRA)Alleged that REITs do not (e.g. by EPRA)

- SIICs had very low discounts to NAV post-conversion- But UK REITs now trade at sharp discount to NAV

But:But:- How much is a tax effect?- US REITs DO NOT publish NAV- Analysts estimate NAV from income- May use discount rates higher than market cap rates.

May thus be an overstating of the benefitsMay thus be an overstating of the benefits

REITs – Discount/Premium to NAVREITs – Discount/Premium to NAV

Source: Green Street Advisors, 2005Source: Green Street Advisors, 2005 Green Street estimate NAV from cashflow and cap rate figures.Green Street estimate NAV from cashflow and cap rate figures. REITs trade at times at substantial discounts to estimated NAVREITs trade at times at substantial discounts to estimated NAV However, they also trade at a premium at times.However, they also trade at a premium at times.

Some Myths and REITs:Some Myths and REITs:LiquidityLiquidity

REITs are supposed to remove illiquidity as a negative factor REITs are supposed to remove illiquidity as a negative factor damping investment damping investment

Listed vehicles are more liquid than private vehiclesListed vehicles are more liquid than private vehicles- Turnover: IPD 15%, Property Co. 61% (IPF Liquidity Report)- Tradable transparent public market- Low transaction costs, lower information costs

But … REITs may be But … REITs may be less less Liquid than Property CompaniesLiquid than Property Companies- Property Companies 61%- REITs 22%- LPTs 21%

(IPF Liquidity Report, data for 1993-2002)

Australian Listed Property TrustsAustralian Listed Property Trusts

A Tax-Transparent Trust Vehicle for Commercial Real EstateA Tax-Transparent Trust Vehicle for Commercial Real Estate LPTs take off in the 1990s, retail and institutional salesLPTs take off in the 1990s, retail and institutional sales Major market players (Lend Lease, AMP, ING, MacQuarie, Major market players (Lend Lease, AMP, ING, MacQuarie,

DeutscheBank)DeutscheBank) Come to dominate market: low cost of capital gives buying powerCome to dominate market: low cost of capital gives buying power Now expanding outside Australia Now expanding outside Australia

- Asian markets- USA- UK – e.g. Westfield, Lend Lease & UK shopping centres- Mainland Europe

LPT PerformanceLPT Performance

Australian Property and Equity Returns

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00% Direct Property

Listed Property Trusts

Equities

Source: PCA, University of Reading

  Direct LPTs Equities

Direct 1.000    

LPTs -0.221 1.000  

Equities -0.101 0.618 1.000

SIICsSIICs

Sociétés d’Investissements Immobiliers Cotées - French REIT Sociétés d’Investissements Immobiliers Cotées - French REIT Note legislative process and speed:Note legislative process and speed:

- Process begins 2001 with Industry working party- Opportunity with 2002 Presidential & General elections- Ministerial and political lobbying 2002- Placed in draft Finance Bill for 2003- Accounting and enabling legislation summer 2003- Passes into law end 2003- Many property companies transfer status early 2004- Further liberalisation 2004, 2006: UPREIT status?

SIICs - StructureSIICs - Structure

Primary objective:Primary objective:- Construction or acquisition of income-producing property; or- Ownership of shares in companies with that objective

Must be traded on French exchange, minimum cap. Must be traded on French exchange, minimum cap. €15million €15million Tax Exempt, provided:Tax Exempt, provided:

- Distribute 85% of net income to shareholders- Pay out 50% of cap gains within 2 years of realisation

Firms subject to an “exit” tax of 16.5% on unrealised capital Firms subject to an “exit” tax of 16.5% on unrealised capital gains, payable within four years of conversiongains, payable within four years of conversion

SIICs - DriversSIICs - Drivers

• Other competitor countries have REIT structures;Other competitor countries have REIT structures;

• Much property investment going “offshore”;Much property investment going “offshore”;

• Government needs cash – windfall Government needs cash – windfall €1.5 bn €1.5 bn ""exitexit"" tax; tax;

• Expectation of tax from secondary trading;Expectation of tax from secondary trading;

• Persistent discount to NAV for listed companiesPersistent discount to NAV for listed companies

• Concern about pensions in France:Concern about pensions in France:• Switch to private from public system• Need for diversified portfolio / access to asset class

• Capital issues:Capital issues:• Capital markets determine capital flows• Under Basel II, bank lending may be constrained

SIICs - DriversSIICs - Drivers

Other competitor countries have REIT structures;Other competitor countries have REIT structures; Much property investment going “offshore”;Much property investment going “offshore”; Government needs cash – windfall Government needs cash – windfall €1.5 bn "exit" tax;€1.5 bn "exit" tax; Expectation of tax from secondary trading;Expectation of tax from secondary trading; Persistent discount to NAV for listed companiesPersistent discount to NAV for listed companies Concern about pensions in France:Concern about pensions in France:

- Switch to private from public system- Need for diversified portfolio / access to asset class

Capital issues:Capital issues:- Capital markets determine capital flows- Under Basel II, bank lending may be constrained

SIICs: Developments and ProblemsSIICs: Developments and Problems

SIIC II: an attempt to increase market sizeSIIC II: an attempt to increase market size- UPREIT-like structure to permit inflow of assets- Relaxation of some of regulatory constraints

Corporate Float-Offs of Real Estate into SIICsCorporate Float-Offs of Real Estate into SIICs Tax and Ownership ProblemsTax and Ownership Problems

- Tax issues for non-French investors- Limited control and ownership constraints

Metrovacesa – GMetrovacesa – Gécina Dealécina Deal- Metrovacesa (Spanish firm) buys controlling interest in

French SIIC Gécina (€5.5bn deal, creating 2nd largest listed real estate fund in Europe)

- Borrows money in Spain to finance the acquisition- Pays no tax on dividend payments from Gécina - Interest payments offset against profits to reduce tax bill

The UK REITThe UK REIT

Industry has been seeking a REIT vehicle for many yearsIndustry has been seeking a REIT vehicle for many years Pressure on Government and Treasury for change:Pressure on Government and Treasury for change:

- External – SIICs etc.- Capital Flow Offshore- Pensions issues – poor performance of equities etc.- Clear appetite for real estate: buy-to-let- Urban Task Force / Barker Report

Pre-budget announcement and Treasury Consultation PaperPre-budget announcement and Treasury Consultation Paper Industry / interest group responseIndustry / interest group response Positive noises but delays and the election cyclePositive noises but delays and the election cycle

The UK REIT, January 2007The UK REIT, January 2007

Company and Listing RulesCompany and Listing Rules- Must be a closed ended company- Must be listed on main stock exchange (LSE not AIM)- Must have one class of (voting) shares- Must be resident in UK for tax purposes- Restrictions on large share-holdings (10% rule)

Activity RulesActivity Rules- Define a Tax Exempt Business (ring-fenced)- 75% of firm’s profit from real estate (rents)- 75% of firm’s assets = real estate- Must have three properties (not owner occupied)- Development activity OK for portfolio building (3 year rule)

The UK REIT, January 2007The UK REIT, January 2007

Other Constraints and RulesOther Constraints and Rules- Gearing rule: Profit/Finance Costs 1.25- Conversion charge 2% of GAV – may be phased

Tax and DistributionTax and Distribution- TEB not subject to corporation tax- 90% of profit must be distributed as Property Investment

Dividend (PID)- PID subject to withholding tax and treated as property income

for shareholders- Capital allowances set against income in profits calculation- Cannot offset losses inside/outside TEB

UK REITs – Market ReactionUK REITs – Market Reaction

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Slough

The UK REIT – Issues and ProblemsThe UK REIT – Issues and Problems

Establishing a Critical MassEstablishing a Critical Mass- Conversions of Property Companies- New entrants and listing requirements- The offshore industry and REITs

Specialist or Diversified Vehicles?Specialist or Diversified Vehicles?- Professional versus retail investors- Investor interests versus management interests

Returns and Market ExpectationsReturns and Market Expectations- REITs as an income vehicle- Property values, yields and distributions- Growth, retained earnings and distributions- The state of the market and investor confidence

The G-REIT … The G-REIT …

Must be public (German/EU) stock corporation, based in GermanyMust be public (German/EU) stock corporation, based in Germany Minimum free float of 25%, 10% shareholder maximumMinimum free float of 25%, 10% shareholder maximum 75% assets, 75% profits from real estate (residential restricted)75% assets, 75% profits from real estate (residential restricted) Must distribute 90% of distributable profitsMust distribute 90% of distributable profits Maximum 60% debt to asset valueMaximum 60% debt to asset value Restrictions on trading Restrictions on trading G-REIT exempt from corporation taxesG-REIT exempt from corporation taxes Investors fully taxable, withholding tax for non-domestic investorsInvestors fully taxable, withholding tax for non-domestic investors Retroactive to January 2007?Retroactive to January 2007?

Summing UpSumming Up

Listed Real Estate Offers Benefits:Listed Real Estate Offers Benefits:- Liquidity and Low Transaction Costs- Relatively Small Capital Requirement to Invest- Ability to Diversify Within and Across Countries

Listed Real Estate Has Disadvantages:Listed Real Estate Has Disadvantages:- High Volatility Compared to Underlying- Higher Correlation with Equity than Real Estate market- Part of This is Measurement Issue

REITs Offer Advantages over Property CompaniesREITs Offer Advantages over Property Companies- Elimination of Double Taxation- Reduction of Discount to NAV Problem- Linked to Real Estate Market in Long-Run- Linked to Equity Market in Short-Run