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2019 Curriculum CFA Program Level II Alternative Investments

Publicly Traded Real Estate Securities

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Introduction

This reading provides an overview of the publicly traded real estate securities, focusing on equity real estate investment trusts (REITs) and their valuation.

Real estate investments may play several roles in a portfolio. Investment in commercial real estate property—also called income-producing, rental, or investment property—may be either in the form of direct ownership investment or indirect investment by means of equity securities. They can provide an above-average current yield compared with other equity investments and may provide a degree of protection against inflation, especially when rental rates are inflation-indexed, rise periodically by predetermined amounts, or are easily adjusted. Real estate investment can be an effective means of diversification in many investment portfolios.

REITs are the most widely held type of real estate equity security. The valuation of REITs is similar in some respects to the valuation of other kinds of equity securities, but also takes into account unique aspects of real estate and sometimes uses specialized measures. This reading introduces and describes REIT valuation.

The reading is organized as follows: Section 2 provides an overview of publicly traded real estate securities. Section 3 describes publicly traded equity REITs in detail, including their structure, investment characteristics, and analysis and due diligence considerations. Section 4 presents real estate operating companies (REOCs). Sections 5, 6, and 7 present net asset value, relative valuation, and discounted cash flow valuation for REIT shares, respectively. After a mini case study in Section 8, Section 9 summarizes the reading.

Learning Outcomes

The candidate should be able to:

  1. describe types of publicly traded real estate securities;
  2. explain advantages and disadvantages of investing in real estate through publicly traded securities;
  3. explain economic value determinants, investment characteristics, principal risks, and due diligence considerations for real estate investment trust (REIT) shares;
  4. describe types of REITs;
  5. justify the use of net asset value per share (NAVPS) in REIT valuation and estimate NAVPS based on forecasted cash net operating income;
  6. describe the use of funds from operations (FFO) and adjusted funds from operations (AFFO) in REIT valuation;
  7. compare the net asset value, relative value (price-to-FFO and price-to-AFFO), and discounted cash flow approaches to REIT valuation;
  8. calculate the value of a REIT share using net asset value, price-toFFO and price-to-AFFO, and discounted cash flow approaches.

Summary

This reading has presented publicly traded real estate securities, including their structure, economic drivers, investment characteristics, and valuation. Among the important points made by the reading are the following:

  • The principal types of publicly traded real estate securities available globally are real estate investment trusts, real estate operating companies, and residential and commercial mortgage-backed securities.
  • Publicly traded equity real estate securities offer investors participation in the returns from investment real estate with the advantages of superior liquidity in small and large amounts; greater potential for diversification by property, geography, and property type; access to a superior quality and range of properties; the benefit of management services; limited liability; the ability to use shares as tax-advantaged currency in making acquisitions; protection accorded by corporate governance, disclosure, and other securities regulations; and, in the case of REITs, exemption from income taxation within the REIT if prescribed requirements are met.
  • Disadvantages include the costs of maintaining a publicly traded corporate structure, pricing determined by the stock market and returns that can be volatile, potential for structural conflicts of interest, and tax differences compared with direct ownership of property that can be disadvantageous under some circumstances.
  • Compared with other publicly traded shares, REITs 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 exemption but have less operating flexibility to invest in a broad range of real estate activities as well as 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. They 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.
  • Analysts make adjustments to the historic 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 companies’ assets and liabilities ranking prior to shareholders’ equity, all valued at market values instead of accounting book values.
  • REITs and REOCs are valued using a net asset value per share, price-to-FFO, price-to-AFFO, price-to-NAV, or a discounted cash flow approach, or combinations of these approaches. Three important factors influencing the P/FFO and P/AFFO of REITs and REOCs are expectations for growth in FFO/AFFO, risks associated with the underlying real estate, and risks associated with companies’ capital structure and access to capital. The P/NAV approach to valuation can be used as either an absolute basis of valuation or a relative valuation approach. NAV reflects, however, the estimated value of a REIT’s assets to a private market buyer, which may or may not be the same as the value that public equity investors ascribe to the business; this fact is one of the reasons for the wide historical premium/discount range at which REITs trade relative to NAV estimates.
  • REITs and REOCs generally return a significant portion of their income to their investors 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. Most typically, investors utilize two- or three-step dividend discount models with near-term, intermediate-term, and/or long-term growth assumptions. In discounted cash flow models, investors will often use intermediate-term cash flow projections and a terminal value based on historical cash flow multiples.

2 CE

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