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Investments in Real Estate through Publicly Traded Securities

2024 Curriculum CFA Program Level II Alternative Investments

Introduction

Historically real estate investing was reserved for the wealthy and institutions. REITs were initially conceived of as a way for small investors to gain exposure to a professionally managed, diversified real estate portfolio. REITs were viewed as a type of (closed-end) mutual fund and income passthrough vehicle through which the portfolio manager would acquire attractively valued properties, occasionally sell fully valued properties, and distribute property earnings to the trust’s investors. Legislation was passed in the United States in 1960 to authorize REITs, and the Netherlands followed suit in 1969. The US model and other types of tax-advantaged real estate investment vehicles have been adopted worldwide. The S&P 500 Index added REITs as a separate GICS sector in 2016.

As of October 2020, more than 35 countries have REITs or REIT-like structures, more are considering adopting similar vehicles, and REITs are held by individuals and institutions alike.

Learning Outcomes

The member should be able to:
  • discuss types of publicly traded real estate securities
  • justify the use of net asset value per share (NAVPS) in valuation of publicly traded real estate securities and estimate NAVPS based on forecasted cash net operating income
  • describe the use of funds from operations (FFO) and adjusted funds from operations (AFFO) in REIT valuation
  • calculate and interpret the value of a REIT share using the net asset value, relative value (price-to-FFO and price-to-AFFO), and discounted cash flow approaches
  • explain advantages and disadvantages of investing in real estate through publicly traded securities compared to private vehicles

Summary

  • The principal types of publicly traded real estate securities include real estate investment trusts (REITs), real estate operating companies (REOCs), and residential and commercial mortgage-backed securities (RMBS and CMBS). 
  • Compared with other publicly traded shares, REITs typically offer higher-than-average yields and greater stability of income and returns. They are amenable to a net asset value approach to valuation because of the existence of active private markets for their real estate assets. 
  • Compared with REOCs, REITs offer higher yields and income tax exemptions but have less operating flexibility to invest in a broad range of real estate activities and less potential for growth from reinvesting their operating cash flows because of their high income-to-payout ratios. 
  • In assessing the investment merits of REITs, investors analyze the effects of trends in general economic activity, retail sales, job creation, population growth, and new supply and demand for specific types of space. Investors also pay particular attention to occupancies, leasing activity, rental rates, remaining lease terms, in-place rents compared with market rents, costs to maintain space and re-lease space, tenants’ financial health and tenant concentration in the portfolio, financial leverage, debt maturities and costs, and the quality of management and governance. 
  • Analysts make adjustments to the historical cost-based financial statements of REITs and REOCs to obtain better measures of current income and net worth. The three principal figures they calculate and use are (1) funds from operations or accounting net earnings, excluding depreciation, deferred tax charges, and gains or losses on sales of property and debt restructuring; (2) adjusted funds from operations, or funds from operations adjusted to remove straight-line rent and to provide for maintenance-type capital expenditures and leasing costs, including leasing agents’ commissions and tenants’ improvement allowances; and (3) net asset value or the difference between a real estate company’s asset and liability ranking prior to shareholders’ equity, all valued at market values instead of accounting book values. 
  • REITs and some REOCs generally return a significant portion of their income to their investors as required by law and, as a result, tend to pay high dividends. Thus, dividend discount or discounted cash flow models for valuation are also applicable. These valuation approaches are applied in the same manner as they are for shares in other industries. Usually, investors use two- or three-step dividend discount models with near-term, intermediate-term, and/or long-term growth assumptions. In discounted cash flow models, investors often use intermediate-term cash flow projections and a terminal value based on historical cash flow multiples.

1.5 PL Credit

If you are a CFA Institute member don’t forget to record Professional Learning (PL) credit from reading this article.