Topic 7: Real Estate Investment Trust

(Brueggeman Chapter 21)

We are going to cover…
 What is a REIT?
 The evolution of REITs in the US and Asia
 Types of REITs
 REIT regulation
 External vs internal managed models
 Agency issues in REIT
 REIT valuation
Webinar on REIT by Bursa Malaysia
 https://bursaacademy.bursamarketplace.com/en/article/equities/propertyinvestment-via-
reits
 https://bursaacademy.bursamarketplace.com/en/article/equities/reits-101
 https://bursaacademy.bursamarketplace.com/en/article/equities/introduction-to-reits
What is a REIT?

 Investment vehicles (trusts) that owns, operates, acquires and

manages income producing real estate.
 Does not pay corporate taxes.
 First introduced in the US in 1960s, and Australia in 1970s.
 More recently in Europe in 1990s and Asia in 2000s.
 What is a REIT?
Property
developers/owners

Divest real estate assets REIT shares/cash

proceeds

Pay rental for use of space

Dividend payout
REIT
Corporations with
RE needs Investors
Outsource RE service (retail/institutions)
Invest in REIT shares
IGB REIT IPO
 Property value = RM4.6 billion (Mid Valley Megamall + The Garden Mall)
 Financed by
 RM837.5 million (RM1.25 x 670m IPO shares)
 RM3,413 million (RM1.25 x 2,730m shares retained by the sponsors)
 RM1,205 million (syndicated loans)
A sidenote on listed business trust in Malaysia…
Why invest in REIT?
 Invest funds in a diversified portfolio of real estate under
professional management.
 More liquidity, transparency and less risky as compare to direct
property investment.
 High yield investment with decent capital gain.
 Regular income stream.
REITs vs physical properties
 Initial investment
 Liquidity
 Transaction costs
 Taxes (stamp duty)
 Rental yield
 Leverage
Impact of corporate tax transparency
(exemption)
REIT Non-REIT Non-REIT
(M’sia) (US)
Operating income 100 100 100
Corporate tax 0 25 40
After-tax income 100 75 60
Dividend tax 10 0 9
Cash to 90 75 51
shareholders
Major REIT market size as of June 2021

No of
Country REIT Mkt Cap (S$ Bil) % of stock mkt REITs
USA 1,492 3% 225
Japan 158 2% 62
Australia 105 6% 53
France 55 2% 32
Canada 72 3% 37

Singapore 82 12% 42
UK 92 3% 36

Hong Kong 29 0.4% 10

Malaysia 9 2% 17

Source: REITAS
 The evolution of US REITs’ market capitalization
15

EXHIBIT 23-3 Size of U.S. Equity REIT Sector, 1985–2011

Source: Based on data from the National Association of Real Estate Investment Trusts (NAREIT).
© 2014 OnCourse Learning. All Rights Reserved.
Factors contributed to emergence of new REIT
era in 1990s.
 Tax Reform Act of 1986
 Managerial flexibility – REITs are allowed to be internally managed
 Elimination of RELP & MLP’s tax loss carryforward benefits
 Invention of Umbrella REIT (UPREITs)
 Property owners can postpone capital gain tax payment
 Receive operating units (OP) for selling properties to REITs
 OP unitholders are entitled for dividend
 OP units are not shareholders
 Look through provision
 Pension/investment funds are not counted as single investors.
 Overcome the 5/50 ownership rule.
Umbrella Partnership REIT (UPREIT) created in 1992 in the
US

A REIT that owns a controlling interest in a limited partnership that owns

the real estate: Rationale: Property owners could defer their capital gain
tax payment.
 US REIT Market Cap during 1971-2018
US REIT Market 1971-2018
1200 250

1000
200

800
Market Cap (USD billion)

150

600 Number of REIT

Market Cap (USD billion)

100

400

50
200

0 0
7 1 7 3 7 5 7 7 7 9 8 1 8 3 8 5 8 7 8 9 9 1 9 3 9 5 97 99 01 03 0 5 0 7 0 9 11 1 3 1 5 1 7
19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20

Axis Title
Converted REITs in Europe

Wong (2021)
78% of the listed UK REITs are converted from existing listed
property companies

Wong (2021)
Wong (2021)
 The growth of REIT in East Asia

Aggregate number of Asian REIT IPOs by year (2001-2020)

Wong (2021)
Driving forces for REIT growth in Asia (Ooi et
al. 2006)
 Supply factors
 The need for divestment (exit strategy) of non-core RE owned by corporations, private equity
funds, government, and banks saddled with NPLs (Japan & South Korea).
 New source of funding for RE companies (dispose RE to a REIT for cash) besides bank loans.
 Demand factors
 Portfolio diversification and high dividend yield of REIT shares.
 Historically low interest regime.
 High saving rate & growing aging population in Asia.
Brief history of Malaysia REIT sector
 First Asian country to offer property trust in 1989 (Arab-Malaysian First Property
Trust in Aug 1989, First Malaysia Property Trust in Nov 1989, Amanah Harta
Tanah PNB in Dec 1990 and Maybank Property Trust Fund One in Mar 1997).
 However, property trust sector was not popular among institutional investors due
to the absence of tax transparency.
 Moreover, the sponsors are required to be the subsidiaries of financial institutions.
This made many non-financial companies especially the property developers with
ample “reitable” properties from disposing their properties to a property trust.
Brief history of Malaysia REIT sector
 It was the introduction of new guidelines to property trust in February 2005 that
saw the property trusts sector gained its momentum in Malaysia.
 In line the changes, property trusts were rebranded as REIT in Malaysia.
 Among the key changes to the REIT guidelines include the granting of tax
exempted status to REIT if they are distributing up to 90% of their taxable
income as dividends, the increased of borrowing limit from 10% to 35% of
REIT’s total asset value.
 Importantly, the new guidelines uplifted the requirement that sponsors have to be
a subsidiary of financial institution.
Types of REITs
 Equity REITs – acquire property interest (own property)
 Industrial/office
 Retail
 Residential
 Diversified
 Lodging/resorts
 Health care
 Self-storage (https://www.extraspaceasia.com.my/)
 Timber
 Infrastructure

 Mortgage REITs – purchase mortgage obligations (creditors)

M-REITs market capitalization by property
focus as of August 2021

Wong (2021)
M-REITs’ portfolio of properties
Guidelines for Islamic REITs in Malaysia
 The Shariah non-compliant rental income of an Islamic REIT cannot exceed 20% the
REIT’s total revenue.
 Non-compliant activities include conventional financial transactions (banking, insurance,
investment) and non-halal related activities (gambling, liquor, pork, tobacco, food, and
beverage).
 Islamic REITs are given 11 years from the day they first obtained Islamic REIT status to
reduce the percentage of the Shariah non-compliant revenue from 20% to 5%.
 There exist clear guidelines for the conversion from conventional to Islamic REIT.
MREIT Profile @ 27 April 2019

More than 50% of the M-REITs are sponsored by public

listed companies. Implication?
Malaysian REIT data @ 3 Oct 2019

Source: https://mreit.fifthperson.com/
 Industrial vs Retail REIT performance

Axis REIT (Industrial) CMMT REIT (retail)

 Industrial vs Retail REIT performance

Atrium REIT (Industrial) Sunway REIT (retail)

Office REIT performance
US REIT performance by property sector @ 31
August 2020
US REITs’ share prices rebounded in 2021

https://www.reit.com/
REIT regulations
 Listed REITs are subjected to REIT regulations on top of existing securities laws imposed
on public listed companies.
 Since the REIT model is originated from the US, most of the REIT regulations
implemented in other regimes are heavily adapted using the US’s mould (e.g., 75% real
estate, 90 distribution policy, corporate tax exemptions).
 These regulations are generally meant to ensure REITs remain a passive entity that
provides its shareholders’ stable rental revenue.
 The restrictions in the guidelines also serve to level playing field between REITs and other
listed property companies since REITs enjoy corporate tax exemption benefits that listed
property companies do not.
 US REIT legal requirements
 Pass-through entity: Don’t have to pay corporate taxes if they
pass the following tests
 Asset test: 75% in RE, cash & government securities
 Income test: 75% of the income from passive income such
as rents & mortgage interest
 Ownership test (US only): five-or-fewer rule. No five or
fewer individuals may own >50% of REIT shares
 Distribution test: 90% of taxable income as dividend
Prohibited Transactions (to ensure REITs do not turn into
property trading/development companies).

 REITs must own properties for at least 2 years prior to sale.

 Cost of capital improvements to the property during that period
cannot exceed 30% of the sales price (no merchant building)
 REIT cannot (1) have sold >7 properties; (2) have sold properties >
10% of total asset value in any taxable year.
 Properties must have been held for the production of rental income
for at least 2 years.
 Malaysian REITs legal requirements
 Pass-through entity: No corporate taxes subject to the
following tests
 Asset test: 75% in real estate that generates recurrent rental
income at all times.
 Distribution test: 90% of taxable income as dividend
 Property development activities: ≤15% of total assets
 Borrowing limit: ≤50% of total assets
 Externally managed by an asset management company
that usually wholly owned by the sponsor
REIT’s management structure
 REITs in western countries (including Australia) are established as public listed companies.
These REITs are mostly internally managed by their in-house managers.
 REITs in Asia on the other hand are established under a trust deed. REITs in Asia are
mostly externally managed where a separate asset management company is appointed to
manage the REIT.
 In fact, US REITs were externally managed prior to 1986 where the property management
functions (leasing, financing, manage & operate properties) were performed by an
independent contractor (advisor).
Watch Webinar “NUS IREUS Panel Discussion SREITS 24 September 2021” on
Youtube on Internal Vs External asset management model.
Asian REITs’ externally managed structure

46
CapitaLand Investment (sponsor)’s listed funds business
Source: EY (2017) “Internal vs. external
management
Structures"
Source: EY (2017) “Internal vs. external
management
Structures"
Agency costs: conflict of interest

 Remuneration structure of externally managed REITs

 External managers’ base fee structure incentivise REIT managers to
enlarge assets under their management with purpose to increase their
fee based income.
 Transaction bias in UPREITs:
 Due to tax-based conflict (different cost basis for LP investors vs
public stock investors).
 Real estate interests outside the REIT:
 Do REIT managers have other real estate interests that compete with
the REIT’s properties or for the managers’ time & energy (other
properties not in the REIT, other interests such as brokerage or
management firms)?
Agency costs: conflict of interest

 Related (interested) party transactions

 Do REIT managers have incentives to have the REIT engage in
“Sweatheart” deals with brokerage, management, development firms
in which they have interests?
REIT IPOs with stronger commitment from sponsors did not
experience lower cost of going public (underpricing).
Importance of FFO
(Funds from Operations)
 Funds from Operations (FFO).
 A cashflow per share measure.

FFO =
Net income + Depreciation-Gains on
sale of property-Gains on revaluation
REIT expansion and growth
 REITs are financially constrained entity due to their 90% payout
requirement.
 REITs rely heavily on external financing rather than retained
earnings to finance growth.
 Issuance of shares to finance acquisition that will cause dilution of
future earnings is offset by increase in cash flow from acquisition.
 REITs typically adopt a bridge financing strategy for asset
acquisition, i.e. use of bank lines of credit (revolving credit) as
interim source of fund for acquisition and later refinance this debt
with long-term bond.
Five strategies to grow REIT’s income
 Growing income from existing properties.
 Growing income through acquisitions.
 Growing income through development.
 Growing income through provision of services.
 Financial engineering.
Growing income from existing properties
 Increasing occupancy or renting more space
 Expansion on permitted/approved vacant land
 Altering market segment: retenanting focus
 Asset enhancement initiatives: facilities improvement to space
reconfiguration
 Raising rents
 Redevelopment: make space more appealing to prospective tenants
AEI works on The Link REIT’s T Town Mall
(Hong Kong)
Before After
Growing income through acquisitions
 Through the following two methods
 Purchase properties with cash.
 Swap of shares in the REIT or operating partnership
 REITs tend to acquire properties when their share prices are traded
above net asset value (NAV).
 An NAV premium typically means a firm can generate a return on new
investment that exceeds its cost of capital.
 Issue equity to finance acquisition when their stocks are overvalued with
respect to NAV.
Sunway REIT’s post IPO property acquisitions

Ian Tai (2021)

Growing income through acquisitions
 REITs strive to achieve positive spread (yield accretive) acquisition by acquiring property
that carries higher yield than REITs’ existing portfolio yield.

Ooi, Ong & Neo (2011)

Growing income through development

 Higher risk than redevelopment or acquisition due to construction

delays, cost overruns, and lease-up problems.
 REITs may shift to property development as acquisition
opportunities decline.
 Some REITs may have in-house development expertise while others
that do not can develop a relationship with an existing developer
and act as the take-out on its construction projects.
 In Malaysia, development activities are capped at 15% of total
assets.
Sunway REIT for example allocated a RM353 million development cost for the
expansion of Sunway Carnival Shopping Mall. The expansion will see the
increase in net lease area of the mall to increase by 41.7% to 840,000 sq ft. by
year 2021. This expansion project is expcted to take 2-3 years to complete.
The evolution of US REITs’ property development activities during
1992-2018

Wong & Ooi (2021)

Development activity of REITs vis-à-vis property investment
companies and homebuilders in the US

Wong & Ooi (2021)

Growing income through provision of services

 REITs may derive non-rental income by provision of services to related and unrelated third
parties.
 These services include property management, development, licensing agreements, or
provision of other real estate services to related or unrelated third parties through a taxable
REIT subsidiary (only in the US).
 Example #1: A REIT that owns an apartment building uses a taxable REIT subsidiary to
provide non-customary housekeeping services to tenants of REIT’s building.
 Example #2: A REIT that has previously provided telecommunications services through an
independent contractor because it was not certain whether the services are customary
services may provide these services through its taxable REIT subsidiary.
Growing income through financial engineering

 Uses of accounting treatment and leverage to magnify the funds

from operations (FFO).
 Accounting treatment: capitalized instead of expensed of recurring
expenses can artificially inflate FFO.
 REIT can also use leverage to magnify FFO in the short-term
because shot-term variable rate loan is cheaper than long-term fixed
rate debt.
 REIT can also artificially inflate its distribution yield by having the
IPO sponsor to provide temporary income support in the form of
rental guarantee.
Important issues in accounting and financial
disclosure: equity REITs
 Tenant Improvements and Free Rent: Effects on FFO.
 Leasing Commissions and Related costs.
 Use of Straight-Line Rents.
 FFO and Income from Managing Other Properties.
 Types of mortgage debt and other obligations.
 Existence of Ground leases.
 Lease Renewal Options and REIT Rent Growth.
 Occupancy Numbers: Leased Space or Occupied Space.
 Retail REITs and Sales per Square Foot.
 Additional Costs of Being a Public Company.
Valuing REITs as Investments

 Gordon Dividend Discount Model.

 Income (FFO) Multiple.
 Net Asset Value.
Valuation of Midwestern America Property
Trust
 Gordon Dividend Discount Model
 V = D1/(K-g)
 V = $4.2/(0.105-0.05) = $76.36 per share
 Income (FFO) Multiple
 V = peer FFO multiple x FFO per share
 = 14 x $5.72 = $80.08 per share
 Net Asset Value
 =NAV = (NOI/r – total liability)/total share outstanding
 =(40m/0.0875 - $82m)/5m
 =$75.03 per share
Homework
 Q3 page 731
 a: $10, $100
 b: $50
 c: $60