Learning Module 3: Investments in Real Estate Through Publicly Traded Securities

Learning Module 3 Investments in Real Estate Through Publicly Traded Securities KNOWLEDGE CHECK Publicly Traded Real Estate Investments 1. Which of the following assets requires the most expertise in real estate on the part of the investor? A. A REOC share B. An equity REFT share CA direct investment in a single property Solution C is correct. Direct investment in a single property requires a high level of real estate expertise. Investment in publicly traded equity investments (in REITS or REOCs) requires much less expertise because investors benefit from having their property interests actively managed on their behalf by professional managers and from having their business interests overseen and guided by boards of directors, as in the case of all public corporations. 2. Which of the following has the most operating and financial flexibility? A. A REOC B. An equity REIT A direct investment in a single property Solution A is correct. REOCs are free to invest in any kind of real estate or related activity without limitation, This freedom gives management the opportunity to create more value in development activity and in trading real estate and to retain as much of their income as they believe is appropriate. A wider range of capital structures and degrees of financial leverage may be used in the process. In contrast to REOCs, REITs face restrictions on the amount of income and assets accounted for by activities other than collecting rent and interest payments. Direct investment is less liquid and divisible than REOC and REIT shares, which limits the operational flexibility of such investment. 3. Investors seeking broad diversification would invest in the securities of which of the following companies? A. A company that owns multi-family rental properties in Hong Kong SAR B. A company that owns large office properties in New York City, San Francisco, Los Angeles, and Chicago C. A company with a mix of office and retail properties in urban and suburban markets Solution C is correct. It should be clear that a company with a mix of assets office and retail-with exposure to urban and suburban markets offers the best diversification. A is incorrect because the company has only one type of asset, multi-family rentals, in one market, Hong Kong SAR. The systematic risk is high for that portfolio. B is incorrect because the company owns only one asset type, office properties, and the economic activity correlation may be high among urban cities with exposure to global trade and the financial sector. Alternatively, investors looking for property and market diversification might, instead of the solutions provided, consider investing in a few large companies that own different asset types in multiple cities or several pure-play companies, each of which concentrates on a single asset type in its given region, as long as the companies regions and product type do not overlap to a large extent. KNOWLEDGE CHECK Publicly Traded Real Estate Investments 1. Which of the following best represents an advantage of REITs over a direct investment in an income-producing property? A. Diversification of property holdings B. Operating flexibility C. Diversification of overall portfolio Solution A is correct. REITs provide diversification of property holdings. B is incor rect because REITs do face restrictions on the amount of income and assets accounted for by activities other than collecting rent and interest payments: these restrictions can prevent a REIT from maximizing its returns. Cis incorrect because as shares of REITs are publicly traded, their price is partly determined by stock market movements and market liquidity, reducing the diversification benefits to an overall portfolio as compared with private real estate. KNOWLEDGE CHECK Investment Objectives 1. Two real estate investors are each choosing from among the following investment types: a REOC, an equity REIT, or a direct investment in an income-producing property. Investor A's primary objective is liquidity, and Investor B's primary objective is maximum growth/capital gain potential. State and explain which real estate investment type best suits: 1. Investor A. 2. Investor B. Solution For Investor A, with a liquidity objective, REOC and REIT investments are most appropriate because REOCs and REITs are traded on stock exchanges and are more liquid. Direct investments in income-producing property are generally less liquid. For Investor B, with a maximum growth objective, REOCs and direct property investment are most appropriate because REOCs and direct investors are free to invest in any kind of real estate or related activity without limita- tion and to reinvest as much of their income as they believe is appropriate for their objectives. This freedom gives them the opportunity to create more value in development activity and in trading real estate. The constraints of REITs prevent them from retaining earnings to reinvest, so their growth opportunities are more limited. There are several caveats to note for each generalized solution. Shares of closely held listed companies with low market float that trade infrequently may not offer the desired liquidity. Management quality, corporate governance, balance-sheet capacity and leverage, attractive investment and reinvestment opportunities, and many other considerations matter greatly when it comes to selecting the vehicle and company that are best at delivering growth and value to shareholders. KNOWLEDGE CHECK Analyst Adjustments (1) 1. Which of the following to the best of a RETTS систент солен return to sheruholders? AFFO CNet income Solution Biscarrect. AFFO is calculated fnas FFQ by deducting non-cash rent, capi tal expenditures for maintenance, and leasing costs, A is incorrect because it does not accourt for non-cash rent, capital expen ditares for maintenance, and lessing costs. It is incorrect hecause it includes non-cash depreciation and amortization expense and does not account for non-cash rest, capital expendituren, and expitakzod leasing ensts, which are appropriate The REIT'S NAV per shace in closest to A $10.05 511.38 C $1642 Solution Bis orrect, NAVPS estimates wal estate values by capitalizing NOI. Valo ing $115 million of NOX with a capitalization rate of 7% yields a value for the properties of 51.642,457,000. After deducting 5506 million of debt at markat valu, NAV is $1,117,857,000 NAVPS equals NAV divided by 100 ml shans outstanding, ne 811.38. A is incorrect because it is the book value of the morts (not the net as sets) per shuce: $1.005 million divided by 100 million shares $10.05 per share. It does not take anto assunt the market value of the aswets and dom not deduct debt. Cis inenmec because it is the market value of the real estate that is. NOI capitalized at 7%, divided by 100 million shares $15GZRS 0000 100,000,000 $1642. This calculation excludes the liabilities of the entity. 1. All the equal estimated NAV per share will decrease with an increase in the A. capitalization rate Bestimated growth rats. Ceferes tas liabilities. Solution A in corret. The capitalization rate is used to calculate the estimated vaku of operating real estate because it is the NOI as a percentage of the value of operating real estate: NOL/Cxpitalization rate Estimated value. As the capitalization rate increases, the estimated value of operating real estate and thus NAV will decrease Bis incorrect because an increase in the estimated growth rate would in crease the estimated NOI and the estunated value of operating income. Ca incorrect because deferred liabilities are not counted as "hand" labiitties and am not subtracted from the NAV KNOWLEDGE CHECK Analyst Adjustments (II) 1. An increase in the capitalization rate will most likely decrease a REITE A enst of dobe estimated NOI Cestimated NAV Solution Cis correct. The capitalization rate is ased to estimate the market value of real estate, which is then used to calculate NAV. A is incorrect because a higher capitalization rate does not decrease the REIT's cost of debt. B is incorrect because the estimated NOI is hased on income growth, not the capitalization rate 2. An analyst gathers the following information for a REFT The REIT'S FFO per share is closest to A €3.93. €4.08 C1448 Solution B is correct. FFO AFFO Non-cash (straight-hae) rent - Becurring maintenance-type capital expenditures and leasing commissions - 3,320,000 -550,750+200,430 = 64,078.180. The number of shares outstanding 3,320,000/3.32 1,000,000. FFO per share 4,078,180/1,000,000 €4.08. A in incorrect because it adds depreciation to AFFO (3,320,000 611,900- €3,931,900, 3,951,900/1,000,000-€3.95 per sharel. C is incorrect because it also adds depreciation to AFFO+Non-cash (straight-line) rent + Recurring saintenance-type capital expenditures and leasing commissions. 3. Which of the following estimates is least likely to be compiled by firms that publish REIT aralysta estimates? A FFO BAFFO CNAV Solution B is correct. Firms that compile statistics and estimates of REITs tend not to gather AFFO estimates because of the absence of a universally accepted methodology for computing AFFO and inconsistent corporate reporting of actual AFFO figares. FFO is commonly trucked in the United States, and NAV is the standard measure in Europe and Asia. If the REITs have similar property portfolio values, interest expense, and corporate overhead, which REIT most likely has the higher price/FFO? A. REIT A B. REIT B C. They will have similar P/FFO because their ratios of price to NAV are almost identical. Solution A is correct. If both companies have similar portfolio values as indicated in the text and by the similar P/NAV, then the company with the lower capi- talization rate is more expensive, which results in lower FFO and hence a higher P/FFO. If each company were worth ¥100, then REIT A, which is valued at a 6% cap rate, would have ¥6 of NOI and REIT B would have ¥8 of NOI. Because interest expense and overhead are similar for both companies, REIT A would also have lower FFO and a correspondingly higher P/FFO multiple. B is incorrect because A has a lower capitalization rate, implying a lower FFO and hence a higher P/FFO if P/NAV for each company is similar, which is the case here. C is incorrect because it neglects the effect of the lower capitalization rate of REIT A.