Western real estate advisors case study: REIT roll-up

Real Estate Issues, Dec 1997 by McMahan, John

Over the next three years, REITs would grow exponentially. The 1993 IPO calendar had focused on retail; 1994 saw the emergence of investor interest in multi-family and office/industrial; 1995 was the year of hotel IPOs; and 1996 was dominated by office/industrial (Exhibit 3). In 1995 and 1996, secondary offerings also became an important source in REIT equity financing, overshadowing IPO activity (Exhibit 4).

By the end of 1996, there were 302 REITs with a total market capitalization of $126 billion. Approximately two-thirds of these were equity REITs with a total market capitalization of $95 million (Exhibit 5).

Today, most successful REITs are fully-integrated operating companies rather than the passive conduits envisioned by Congress 37 years earlier. Most are focused by property type and by geographical area, although this is changing as larger, national firms come onto the scene. Retail and apartments are still the dominant property type, although office, industrial, and hotels have grown in importance in recent years. Economic scale is also important as larger REITs reduce their cost of capital and spread operating costs over a larger base.

Market Valuation: REIT earnings are usually measured in terms of funds from operations (FFO), which is net income (GAAP); plus depreciation and amortization; less gain (loss) on sale of investments. Stock prices are generally compared to FFO flows, much the same as price/earnings ratios for non-real estate stocks. More recently, many analysts have begun adjusting FFO for capital expenditures and the impact of floating rate debt. This is termed Adjusted Funds From Operations (AFFO).

REITs are also valued in terms of their premium or discount to Net Asset Value (NAV). Better performing REITs are generally rewarded by premium pricing, reflecting the market's perception of greater enterprise value which should result in enhanced future FFO growth.

Other factors that analysts and investors track are "payout ratios" (percent of distributable income that will be paid out as dividends); "total debt to total capitalization" (the market does not like leverage exceeding 40 percent); the proportion of floating debt in the capital structure; management compensation; and the alignment of management's interest with shareholders.

Recent Market Performance: 1996 turned out to be a good year for REITs with the average share price increasing 22.5 points, driving average total returns to over 35 percent. Office REITs produced the best investment performance, followed by industrial, hotel, apartments, and retail (Exhibit 6).

A large factor driving REIT investment performance was an increase in the price/FFO ratios, peaking in late 1996. Multiples declined after the first of the year and, as of June 30, 1997, averaged 12.4X 1997 FFO. The average dividend yield was 6.5 percent with an average total return of 15.7 percent over the prior 12 months. The average premium to NAV was 20.5 percent (Exhibit 7).

As indicated in Exhibit 7, office REITs traded at a premium of 26.0 percent over NAV in mid 1997, second only to industrial REITs (33.9 percent). The office price-to-earnings multiple of 13.3X was the highest in the industry. Office REITs also traded at a 7.3 percent premium to other equity REITs, reflecting the belief in the market that they would experience higher levels of future growth.3