Sources of Commercial Debt and Equity Capital. How Large is U.S. Commercial Real Estate Market?

Transcription

1 El Paso, TX Chapter 17 Sources of Commercial Debt and Equity Capital McGraw-Hill/Irwin Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved. How Large is U.S. Commercial Real Estate Market? Note: Investible commercial real estate excludes real estate owned by non-real estate companies and by federal, state, and local governments. (> 10 trillion for non public)

2 How Large is U.S. CRE Market? Exhibit 17-1 (Year-end 2015) 2015Q4: $35.7 Trillion 2015Q4: $22.0 Trillion 2015Q4: $ Q4: $ Q4: $ Q4: $3.7 Source: Data from Flow of Funds Accounts of the United States Federal Reserve, March 10, 2016, various tables, Estimate of investible CRE is from CBRE Global Investors (ww.cbreglobalinvestors.com). CRE owned by non-re companies & by federal, state, & local governments. Note: $8.8 trillion of investible CRE excludes CRE owned by non-re companies and by federal, state, and local governments 17-3 Value of U.S. Commercial RE? Direct vs. securitized investments? RE owned by non-re corporations? (e.g. HEB) How leveraged is commercial real estate? (3583/6000 = 60% LTV)

3 Value of U.S. Commercial RE? Direct vs. securitized investments? How leveraged is commercial real estate? 3247/6500 = 50% Value of U.S. CRE? Exhibit 17-2 Direct vs. securitized investments? How leveraged is commercial RE? CLTV=3974/8800 = 43% Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

4 Value of other real estate According to our textbook... USAA, HEB, and the real estate held for business throughout the US is estimated to be in excess of 12.5 trillion dollars Government held real estate estimated at 11 trillion Compare to investable CRE at 8.8 trillion. The value of owner occupied housing was estimated at 22 trillion This give RE a sum of 54.4 trillion For comparison stock market equity is 36 trillion Sources of Commercial RE Equity Capital Investors hold ownership positions through either direct private investment or real estate securities Direct private investment: Investors purchase & hold title to the properties With RE securities, capital is: pooled from multiple investors invested in a separate ownership entity which, in turn, purchases & holds title to the RE

5 Public vs Private Markets Public markets: Securities are bought & sold on a centralized public exchange, such as NYSE Relatively liquid Lower transaction costs Market value of a security is continuously revealed by the selling price of perfect substitutes 17-9 Public vs Private Markets Private markets: Characterized by individually negotiated transactions Relatively illiquid High transaction costs Market value of a security not necessarily revealed by the selling price of often imperfect substitutes

6 Advantages of Pooling Equity Allows investors to purchase an interest in larger properties Diversification of portfolio Economies of scale in acquisitions, management and disposition Access to cheaper debt capital Expertise of management team hired by syndicator/organizer May be TAX ADVANTAGES Disadvantages of Pooling Equity Often must relinquish management control to active manager(s) Must compensate syndicator/manager(s) with fees, salary and/or a disproportionate share of equity ownership (incentivize performance) lower returns on equity, all else equal

7 What Drives Choice of Ownership Form? 1. Federal income tax issues/rules 2. Desire of investors for limited liability 3. Management control issues 4. Ability to access debt & additional equity capital 5. Ability to share risk with other investors Including special allocations 6. Ability of investors to dispose of their interests Multiple Levels of Organizations Multiple levels of ownership are commonly at work in CRE investments Ex., office building owned by a limited liability company (LLC) whose two members, in turn, are a LLC and a publicly-traded REIT

8 Economics of Equity RE Syndication Partnership agreement (LPs) or operating agreement (LLCs) must specify how: initial equity requirements will be funded future cash assessments will be funded annual operating CFs will be distributed annual taxable income & losses will be distributed CF & tax liability from future sale will be distributed NOTE: Difficult to construct a "generic spreadsheet How are Costs & Benefits Allocated Among Syndicator & Investors? Pro-rata basis: (or pari-passu ) Usually passive investors share in CFs & taxable income in proportion to equity investment Special" allocations, however, are allowed in LPs & LLCs as long as they have substantial economic effect What are preferred returns and promotes (or carried interest)?

9 Errors on Online Quiz 6. Limited Partnership has both limited and unlimited liability partners Forms of Ownership for Pooled Equity Investments Due to large size of typical RE investments, investors almost always pool their equity capital General partnership Limited partnership C corporation S corporation Limited liability company Tenancy-in-common REIT

10 General Partnership Treated as conduit for tax purposes investors avoid double taxation All partners can make operating decisions: How much leverage; when to sell, etc. No separation between ownership & control; lessens potential conflicts of interest Share of cash flow & taxable income determined by partnership agreement special allocations permitted General Partnership-Disadvantages General partners liable for all debts Contractual debts, debts arising from legal actions, wrongful acts committed by other partners So personal assets are subject to claim s of the partnership s creditors Result? Fairly uncommon & those that are created have few partners

11 Limited Partnership Creates two types of partners: general & limited GP who organizes venture is usually a knowledgeable builder, broker, or investor Same flowthrough tax treatment as general partnership Limited liability for LPs; unlimited for GP But GP may be a corporation or LLC Limited Partnership-Disadvantages LPs give up control of management & policy making A principal-agent relationship is created with its attendant problems

12 C Corporations Legal & taxable entity separate from shareholders Therefore potential double taxation All shareholders have limited liability Separation of ownership & control which creates agency problems Many non-real estate C corporations own real estate, but not a desirable structure for investing in RE S Corporations Same limited liability for shareholders as C corporations Although a separate legal entity, it is not a separate taxable entity S corporations pay no income taxes, and taxable income is passed through to its stockholders who become liable for the tax Must not have more than 75 shareholders All cash flow and taxable income must be allocated to each shareholder in proportion to his/her ownership of the corporation i.e., special allocations are not allowed Used in some cases by individuals and families to own real estate

13 Limited Liability Companies NOT a corporation, partnership, or sole proprietorship IS a blend of some of best characteristics of corporations, partnerships, & sole proprietorship a super pass through entity IS a separate legal entity (like a corporation), but is treated as a partnership for tax purposes Limited Liability Companies Relative to LPs, LLCs permit all owners to participate in management & have limited liability Managing member creates operating agreement that explains operation & management of entity

14 Tenancy in Common (TIC) TICs-one of the oldest forms of direct co-ownership Essentially, fee simple interest with multiple owners: Investors receive separate deed are direct owners Investors may hold different ownership percentages, otherwise interests are indistinguishable i.e., investors share pro rata in CFs, tax consequences, & appreciation 35 investors Tenancy in Common (TIC) Generally considered bad form for investing in RE joint & several liability Yet after 2002, TICs gained significant popularity with private investors Capital invested in TIC structures increased over 700% Volume of TIC equity raised dropped significantly after 2008 What is/was going on?

15 Why the Increased Use ? In a tax-deferred exchange, real property can t be exchanged for a LP or LLC interest But under a 2002 revenue ruling, taxpayers can exchange an interest in real property for a TIC investment Is considered real estate for real estate Result? TIC industry was created No limit on number of exchanges Have 45 days to identify exchange property close within 6 months Disadvantages of TICs Sponsor fees may consume 15-25% of equity raised Evidence that TICs overpaid for properties Joint & several liability Co-owners must unanimously approve: hiring of manager; sale of property; all leases; all mortgage liens For other actions, co-owners may agree to be bound by majority vote

16 Optimal Ownership Form? C-corporation & GP structures seldom chosen S-corporations popular with some sole proprietors/families However, LLCs & LPs are dominant ownership structures Private RE funds are typically set up as LPs Small, local investments marketed to accredited, but noninstitutional investors typically set up as LLCs Accredited Investor In the United States, for an individual to be considered an accredited investor, they must have a net worth of at least one million US dollars, not including the value of their primary residence or have income at least $200,000 each year for the last two years (or $300,000 together with their spouse if married) and have the expectation to make the same amount this year. From Wikipedia

17 Ultimate Equity Investors Investors can hold ownership (equity) positions directly or through intermediaries ex. LLCs, LPs, REITs But most investors can t invest directly For well capitalized investors, choice of direct vs. indirect involves trade-offs between: control access to managerial expertise liquidity & risk sharing Direct Investment Gives individual & institutional investors complete control: who leases it, who manages it, how much debt financing is used, when it is sold But investor must supply the expertise Liquidity of direct investments reflects the liquidity of the underlying property market i.e., there is no liquidity!

18 Direct Investment As size of investor's portfolio increases, the economics of direct ownership make more sense; i.e., easier to retain in-house experts or hire consultants diversify risk create liquidity across assets classes (stocks, bonds, etc.) Direct Investment Direct ownership also prevalent at smaller end of investor spectrum Single-family rental homes, duplexes and fourplexes Owner-occupied office buildings Lack of diversification vs. local market knowledge?

19 Value of U.S. CRE Equity Exhibit 17-3 Source: Data from CBRE Global Investors, ACLI Fact Book 2016, Flow of Funds Accounts of the United States Federal Reserve, March 10, 2016, Real Capital Analytics; National Council of RE Investment Fiduciaries; National Association of Real Estate Investment Trusts Institutional Investors in Private Equity Markets Pension funds Long-term liabilities well suited to LT RE investments Direct purchases as well as acquisitions through funds

20 Institutional Investors in Private Equity Markets Life insurance companies Long-term liabilities a good match for long-term, illiquid, private RE investments More active as CRE lenders than as equity investors U.S. CRE: A Favorite among Foreign Investors Several recent high profile foreign investments China Life Insurance Co. recently purchased a $1.65 billion Manhattan office tower But real story lies in growth of foreign investment in small-tomedium sized U.S. CRE properties Marketplace (peer-to-peer) lending gives foreign investors opportunity to participate as lenders in U.S. CRE Matching borrowers & lenders through online platforms Borrowers able to gain access to funds quickly & typically at lower interest rates than banks

21 Other Institutional Investors Hedge funds, endowment funds, real estate private equity funds Institutional vs. Non-Institutional Equity Investors $1.8 trillion (48%) of $3.7 trillion in private equity held by institutional investors Remaining $1.9 trillion (52%) held by (mostly) high net worth investors Who are these investors & how do they invest? Exhibit 17-3 (partial)

22 Investors in Private RE Equity Markets (non-institutional) High net worth individuals & families that invest indirectly in JVs/LLCs organized by others directly (although they form LLCs, etc.) None-institutional investors in private equity funds The great investor masses that invest in private local RE syndications that form LLCs Country club money Maybe $50-100K investments (per member) Common for LLC to own one building Is crowdfunding next? Exhibit 17-3 (partial) Copyright 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education Time Trend

23 Investment Through Intermediaries: Other Private Market Investment Vehicles Separate accounts Large investment management company will buy, hold, and dispose of properties on behalf of investors (mostly pension funds) Each investor s properties are treated independently Allows investors to access expertise of manager in exchange for fees Limited liquidity Does little to help investor diversify portfolio Conflicts of interest due to loss of full control Investment Through Intermediaries: Other Private Market Investment Vehicles Commingled RE funds (CREFs) Offered by many banks, life companies, investment banks, RE advisory firms Typically organized as LPs Targeted to pension funds that do not have in-house expertise Fund managers pool contributions from multiple pension funds to purchase multiple properties

24 Investment Through Intermediaries: Other Private Market Investment Vehicles Commingled RE funds (CREFs), continued Closed-end or open-end In 2011, $75.6 billion in assets in open-end RE funds; 18 managers were offering open-end funds Fee structure front-end fees for acquiring properties % of assets under management (AUM) back-end fees performance fees Investment Through Intermediaries: Other Private Market Investment Vehicles Private equity funds Did not really exist prior to early 1990s Mostly finite life (typically 7-10 years) Although manager can typically extend life a year or two Typically include some degree of side-by-side investment by fund manager/sponsor Sponsor invests as both GP and LP (say 5% as GP with another 5% as LP) Aligns manager s incentives & returns with investors

25 Investment Through Intermediaries: Other Private Market Investment Vehicles Private equity funds-continued LPs earn a preferred return (e.g., 8%) before GP earns bulk of its expected fees/return Once LPs IRR exceeds threshold, GP receives a disproportionate share of remaining cash distributions called carried interest (Also called promote ) Disproportionate relative to what? 20% is a typical carried interest which is more than a pro rata share Carried Interest or Promote Example $100 is invested in CRE. The Sponsor (GP)puts in $5 and the other investors $95 There is a 10% pref and 20% carried interest (promote) The CRE earns $18, that is 18%. The first $10 are paid out pari-passu, Latin for equal footing The sponsor receives $0.5 and the LP investors $9.5 For the remaining $8, the sponsor gets 20%, or $1.6, and the investors get $6.4. Return to sponsor: $2.1 for a $5 investment = 42% Return to investors: $15.9 for a $95 investment = 16.7% Typically much more complicated than this

26 Investment Through Intermediaries: Other Private Market Investment Vehicles Private equity funds-continued Besides the promote, there are additional sources of GP compensation that vary from fund to fund including: management fees (as a fraction of AUM or funds committed) leasing commissions acquisition fees, and disposition fees Fund managers often offer funds in a series due to their finite life (Fund I, Fund II, Fund III, etc.) Important role for reputation in the market to raise funds CRE Investment Strategies Core: Low risk by investing in large Class A properties in the major markets. Value Add: Identifies opportunities for capital gains possibly through better occupancy, or major upgrades to improve rents Opportunistic: Likely one-off investments where a large potential for upside, though at a much greater risk. One-off: An investment that is not generally part of the overall investment strategy but offers the potential for a high return; thus, it is chosen

27 Real Estate Investment Trusts The majority of commercial RE is owned in private markets (3.7 trillion), While, $1.1 trillion (about 25% of total equity) is owned & traded in public markets mostly REITs REITs can be described as mutual funds for investing in RE Diversification benefits Liquidity

28 Real Estate Investment Trusts REITs not taxed at corporate level if they satisfy a set of restrictive conditions on an ongoing basis including: At least 100 shareholders 75% of assets must be RE, cash, or government securities 75% of gross income must come from RE assets 90% of REIT taxable income must be paid out in dividends each year Taxed to some extent if > 90% but < 100% of taxable income is distributed Sources of CRE Debt Exhibit 17-4 Source: Data from Flow of Funds Accounts of the United States Federal Reserve, March 10, 2016, various tables,

29 Sources of CRE Debt 75% of outstanding commercial mortgage debt (or $2.96 trillion) is privately held by individuals & institutional investors: Commercial banks Savings associations Life insurance companies Freddie & Fannie (multi) State & local governments Commercial Banks are Major Providers of permanent CRE Mortgages Commercial banks hold in portfolio 46% ($1.84 trillion/$3.973 trillion) of existing CRE debt 62% of private CRE debt

30 Sources of CRE Debt 24% ($1.0 trillion) is publicly traded GSE-backed commercial mortgage-backed securities (CMBSs)-all multifamily Non-government backed ( private label ) CMBS Investment grade unsecured debt of large REITs CMBS originations about $100 billion $100 billion in 2014 & 2015 about $67 billion in Development & Construction Lending Can be extremely risky Developer will fail to complete the project in a timely manner or fail to complete it at all Builders may experience cost overruns, poor weather, strikes, structural or design problems, or difficulties with subcontractors Builder may simply be a bad manager Failure to pass various building code inspections may delay ability of tenants to occupy building (and pay rent)

31 Development & Construction Lending All of these risks are assumed by construction lender Thus, construction lenders must have specialized skills in monitoring and controlling the construction process Because risks are significant and much different than risks of long-term lending, the capital sources for development & construction loans differ significantly from permanent financing Construction loan market is dominated by commercial banks Real Estate Investment Trust

32 A Closer Look at REITs Measures of importance of REITs include equity and debt offerings and stock market capitalization Security Offerings by REITs Exhibit 17-6 Large surge in capital raising in 97-98, 04-06, and ; capital raised by REITs is primarily used to acquire properties

33 Types of Listed REITs, Continued REITs distinguish themselves by their focus/specialization geographically (by region, state, or metro area) and/or by property type (retail, industrial, office, apartments, etc.) What does stock market tend to reward/punish? REIT Cafe: REIT Industry: as of March 31, REITs in FTSE NAREIT All REIT Index 186 equity REITs 38 mortgage REITs 50 public, non-listed REITs Listed REITs own 112,375 properties ( $1.8 trillion in value) Listed REITs own 15,691 properties ($92 billion) in FL ( FTSE is an independent company owned by The Financial Times and the London Stock Exchange. Its sole business is the creation and management of indices and associated data services

34 In What Do REITs Invest? Exhibit 17-7 Core REITs invest in retail, apartment, office, & industrial properties But many non-core REITs exist Types of REITs In addition to listed (publicly-traded) REITs, there are 2 additional REIT forms: Private REITs Public, non-listed REITs (PNLRs)

35 Private REITs Privately issued & narrowly held Not publicly registered or listed on a stock exchange Private placement sold to accredited investors Because data are limited to IRS filings, private REIT counts & info are difficult to obtain NAREIT estimates 800 private REITs Public Non-Listed REITs (PNLRs) Publicly registered & publicly offered, but not listed on an exchange Marketed by brokers through financial advisors Minimum investment: $5-$10 thousand

36 Public Non-Listed REITs (PNLRs) Governed by regulatory environment that applies to all publicly registered securities Must issue a prospectus & file 10-K s, etc. with SEC Must follow FASB /GAAP; disclosure must conform to Sarbanes- Oxley These are NOT private placements But.they look & feel like closed-end private equity funds Measuring REIT Income: Funds From Operations (FFO) Cash flow, expressed as Funds from Operations (FFO), is often used instead of accounting net income to measure current performance FFO is a supplemental measure of a REIT's operating performance

37 Funds From Operations (FFO) FFO = Net (accounting) income (excluding gains/losses from sales of property) + Depreciation (real property) + Amortization of leasing expenses + Amortization of tenant improvements - Gaines/losses from infrequent & unusual events Funds From Operations (FFO) FFO is different from GAAP net income because commercial RE maintains value to a much greater extent than may other assets Thus, economic depreciation < tax depreciation Securities usually analysts judge REIT performance according to FFO growth Price / FFO multiples reflect underlying RE value, management quality, and growth potential

38 Dividends as a % of FFO REITs not as cash constrained as some think Net Asset Value A commonly used valuation approach centers around concept of net asset value (NAV) NAV is equal to estimated total market value of a REIT s underlying assets, less all liabilities including mortgages

39 How is NAV Used to Make Decisions? If total stock market capitalization > its NAV, REIT is said to be selling for a premium to NAV A stock price in excess of per-share NAV may indicate a REIT is overpriced relative to value of assets currently in the portfolio Conversely, REITs selling at discounts to NAV may signal buying opportunities for investors REIT Total Return Performance Exhibit 17-8 Equity REITs have performed well relative to both large cap & small cap stocks REITs also help to diversify portfolios that contain only stocks and bonds

40 REITs in S&P 500 In 2001, Standard & Poor s added Equity Office Properties (EOP) to S&P REITs now included (as of Oct. 2016) Indicates acceptance of REITs as a mainstream investment REIT Funds (as of Oct. 31, 2016) 72 actively managed open-end REIT mutual funds Fund that issues or redeems shares at NAV 16 closed-end funds investment co. that issues fixed # of shares with IPO After IPO, shares trade like regular stocks Price of shares = its market price, not fund's NAV 28 exchange traded funds 66 global funds

41 Global Real Estate Securities? Following lead of U.S., many countries have established REIT regimes during last 40+ years Same attributes that have driven growth of REITs in U.S. are fueling this growth Diversification Dividends Transparency Liquidity, and Performance Comprehensive index for the REIT & global listed property market is the FTSE EPRA/NAREIT Global Real Estate Index Series: Global Expansion of REIT Market-- Increasing Investment Opportunity

42 Kimco REIT Holdings Real Estate Investment Trusts (REITs) Primary Advantages: REITs are not subject to double taxation limited liability to shareholders REITs allow investors liquidity and diversification Primary Disadvantages: income to shareholders is portfolio income tax losses do not pass through to the shareholders REITs must meet substantial operating restrictions

43 REIT Investor Taxation Example - Unitholder Tax Calculation Jennifer decides to invest in an REIT that is currently trading at $20 per unit. The REIT has funds from operations of $2 per unit and distributes 90%, or $1.80, of this to the unitholders. However, $0.60 per unit of this dividend comes from depreciation and other expenses and is considered a nontaxable return of capital. Therefore, only $1.20 ($ $0.60) of this dividend comes from actual earnings. This amount will be taxable to Jennifer as ordinary income, with her cost basis reduced by $0.60 to $19.40 per unit. As stated previously, this reduction in basis will be taxed as either a longor short-term gain/loss when the units are sold. (From Real Estate Investment Trusts Equity Trusts Specializations Property Type Office, Retail, Residential, Healthcare, Hospitality, Industrial Trust Duration Most now infinite lives Investment Appeal Diversified Portfolio The REIT has diversity, plus its easy for investors to include additional REITs and other investments to achieve a broad portfolio Liquidity trades like other stocks

44 FFO In 1991, NAREIT adopted a definition of Funds From Operations (FFO) in order to promote a supplemental industry-wide standard measure of REIT operating performance that would not have certain drawbacks associated with net income under generally accepted accounting principles ( GAAP ). The definition was clarified in 1995, 1999 and The current definition follows: FUNDS FROM OPERATIONS means net income (computed in accordance with generally accepted accounting principles), excluding gains (or losses) from sales of property, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. Adjustments for unconsolidated partnerships and joint ventures will be calculated to reflect funds from operations on the same basis NAREIT goes on to say... Historical cost accounting for real estate assets implicitly assumes that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen or fallen with market conditions, many industry investors have considered presentations of operating results for real estate companies that use historical cost accounting to be insufficient by themselves. The term Funds From Operations was created to address this problem. It was intended to be a standard supplemental measure of REIT operating performance that excluded historical cost depreciation from or added it back to GAAP net income

45 Review: Funds from Operations (FFO) FFO is not GAAP but considered a useful tool for valuing and comparing REITs Considers uniqueness of REITs due to depreciation and the effect on income and cash flows from buying or selling properties FFO (Funds From Operations) Income Statement FFO calc Rent Operating Expenses Net Operating Income Depreciation 40 + Gains on sale of property 20 Net Income 40 Cash Flow 60 EPS (10 shares outstanding) 4 FFO per share

46 REIT Analysis further adjustments Cash Available for Distribution (CAD). CAD is a measure of the REIT's ability to generate cash and to distribute dividends to its shareholders. CAD is derived by subtracting nonrecurring expenditures. Adjusted Funds From Operations (AFFO). AFFO refers to a further adjustment by subtracting from Funds from Operations (FFO) both (1) normalized recurring expenditures that are capitalized by the REIT and then amortized (example paint every 3 years, carpet every 5 year), but which are necessary to maintain a REIT's properties and its revenue stream and (2) straight-lining of rents (straight-lining averages the tenant s rent payments over the life of the lease) REIT Expansion and Growth Low retained earnings 90% of net income distributed so retained earnings are not the engine for growth However, the depreciation can be reinvested so it acts like the retained earnings Follow on Stock Offering Concern for dilution of original stockholders Debt Financing Limited by capital markets

47 Mortgage REITs Does not own property; owns mortgage paper Started as a source of development capital not subject to banking regulations Rates tended to be higher than bank rates May have to borrow money from banks to provide to developers More recently were buyers of B paper of CMBS to get higher yields From Vanguard REIT 94 Specialized may include prisons, theaters, golf courses, cellular towers and timberland

48 From Vanguard REIT From Vanguard REIT

49 From Vanguard REIT From Vanguard REIT

50 From Simon Property 2014 Annual Report From Simon Property 2014 Annual Report

51 From Simon Property 2014 Annual Report From Simon Property 2014 Annual Report

52 From Simon Property 2014 Annual Report Simon Property Group Total dividends paid per common share Percent taxable as ordinary income Percent taxable as long-term capital gains Percent nontaxable as return of capital

53 End of Chapter 17 53