RE Securities

Question 1

What is the main rationale for the emergence/popularity of REIT?

Answer 1

usually not feasible to get exposure to diversified prop for the significant capital required in direct re inv, hence popularity of lpt (listed prop trusts aka REITs) or trend toward unitisation/securitisation of re

Question 2

how does a trust differ from an incorporated vehicle?

Answer 2

unlike companies, a trust is not a separate legal entity, cannot sue or be sued and does not have the legal powers of a company/individual

Question 3

4 elements of a re trust?

Answer 3

• underlying re and assets/liabs of the trust
• beneficiaries
• manager/trustee (responsible for performance and compliance of the trust)
• custodian (separate to the manager)

Question 4

name the main types of re trusts?

Answer 4

• fixed
• discretionary
• unit trusts (in which case units are like shares in a company and the beneficiaries are unit holders)

Question 5

trust is externally managed. what are the 2 categories of management vehicles?

Answer 5

1. internally managed vehicles i.e. stapled trusts (property development-based management vehicles e.g. Westfield and GPT Group) combining the management coy and the trust but perceived to be prone to loss of arm’s length pricing and tendering;
2. mgmt vehicles NOT associated with prop developer but with financial institution

Question 6

REIT sector is now a major property inv alternative - what makes it attractive other than exposure to diversified prop invs at affordable price?

Answer 6

• stable distributions based on asset quality and transparent sources of income;
• investor confidence follows expertise of management (sector interest enhanced through niche specialisation in health, aged care, data centres and caravan parks, but fundamentally investors focus on the fundamental quality of their underlying prop/asset of the REIT holdings

Question 7

Name the 6 specific factors that determine the growth of REIT sector

Answer 7

• conversion of unlisted to listed prop trusts
• growing oppo to arbitrage the yld differential b/w physical props and listed REITs
• low interest rates
• institutional investors electing to gain exposure to prop via listed trusts (vs direct re inv )
• ability to access offshore re inv (tax efficient and currency efficient)
• emergence of listed re equity structures around the world and local/regional/global re equity indices

Question 8

Distinguishing characteristics of unlisted REITs (often aka prop syndicate) and listed REITs, what are the main differences?

Answer 8

• unitholder redemption process - listed REITs are closed-end (price is driven by mkt forces, capital of the trust is intact), whereas unlisted REITs are open-end structures (investor is paid out at a stated net asset backing determined by independent valuation).
• quality of the underlying assets in a syndicate (or unlisted trust) is generally lower than that of the listed RE sector, and the underlying assets generally trade at a higher cap rates and provide higher yld to unitholders (which usually appeal to retail investors and self-funded retirees) - trusts usually have interests in 90% of the largest shoppening centres and trophy offices/hotels/industrial estates in aus/major cities (which are rarely traded so investors can only access Rs of these RE via A-REITs); difficult to replicate quality of these assets through direct prop inv.

Question 9

Discuss 3 ways manager of an **unlisted trust** can satisfy unitholder’s redemption claim?

Answer 9

* dip into trust’s cash reserves
* increase trust borrowings
* transfer the units to new investor who’s willing to invest at the net asset backing

Question 10

What challenges do trust managers of unlisted trust face when meeting unitholders’ redemption claims?

Answer 10

simply put, under stressed market conditions, tst mgers may not be able to borrow, dip into cash reserves or sell to raise cash reserves whilst faced with a prop mkt downturn creating a flood of redemptions). also, increasing interest rates (banks unwilling to increase lending against property), dearth of transaction in the physical re mkt, limited cash reserves, reduced ability to sell prop -> collectiveluy lead to liquidy crisis for the unlisted trust managers faced with a flood of redemption claims. essentially, it was **the limited liquidity/limited value** to the broader range of investors (esp. institutional investors) that led to the demise of unlisted REIT sector in early 90s - mid 90s.

Question 11

What are the main characteristics of listed REITs?

Answer 11

• divisibility and liquidity - unitising the prop assets so that investors can access the Rs in proportion to their inv size constraints ; liquidity is facilitated by the orderly mkt provided by the ASX
• valuation - real time pricing made possible by monitoring actual stock trading on the ASX
• quality of prop - difficult to use direct prop inv to replicate the quality of underlying assets as REITs mostly interested in 90% of the largest shopping centres in aus and trophy offices/hotels/industrial RE in major cities which are rarely traded in the physical prop mkt.
• trans costs - mainly brokerage (0.1-1.5% of the unit price of A-REIT units ) and trans taxes, settlement of A-RET stocks typically within 3 working days (vs 1 month + settlement, 3-5.5% stamp duty + agency fee with physical re transactions)
• ASX listing rules - think disclosure stds and ratification requirements
• diversification - difficult to replicate these benefits via direct prop inv in terms of: a. numerical diversification - investor not dependent on the performance of any single prop in a particular country e.g. may have retail tenants across several countries ; b. geographic diversification - access many diff mkts in diff metropolitan, non-metropolitan, offshore; c. category diversification (diverse re assets : shopping centres, office buildings, industrial props , hotels, car parks; can invest in a trust that provides sector diversification ) locations
• mgmt - g exentive re inv mgmt skills of the mgmt team within a trust that add value to the investors. however, MER (management expense ratio) and manager/trust relationship can affect the Rs to unitholders hence should be examined carefully.

Question 12

In what ways does a trust structure differ from a coy?

Answer 12

• tax - a tst structure must be a passive investment vehicle to main its advantageous tax status. such provision constrains tst mgmt from entering the vehicle into speculative trading of re which are risky activities that might not align with the LT prop ownership inv objectives of the tst unitholders.
  * franking credits are not accessible to investors such as low income earners and offshore investors who’d prefer to receive income stream that has not been subject to taxation.
• debt - tsts have borrowing restrictions (usually up to 60% of asset val ) as per tst deeds, unlike coys. re tsts have historically been **conservatively geared** simply coz they typically pay out earnings hence have no way to accumulate funds to pay off principal debt.
• mgmt - mgmt of a tst and its assets CANNOT be internal func of the tst (a tst mgmr (external party) is contracted to ensure the activities of the tst are performed as per tst deed); whereas in a coy structure, mgmt is typically an internal func of the entity.

Question 13

why has it been argued that interests of tst mgmt and those of tst unitholders are non-aligned?

Answer 13

because tst mgmr is an external entity to the tst with his own objectives, and fees to him are not necessarily tied to the inv performance but typically size of the tst.

Question 14

What may give rise to conflicts b/w tst mgr and the tst?

Answer 14

• tst mgr may grow the size of the fund (and thus mgmt fee to tst mgr) via acquisitions /developments or
• tst mgr may fail to sell assets that have reached optimum R outlook just to maintain a large tst size (selfish reason)
• tst mgr may charge mgmt fees for services like development and construction, prop mgmt, leasing, acquisition due diligence, internal tst accounting and other admin

Question 15

How are conflicts b/w tst mgrs and tst unitholders usually mitigated?

Answer 15

* **disclosure requirements** (relating to all services/transactions between the mgr and the tst)
* **unitholders being able to vote a mgr out** by majority
* **formal unitholders approval** of major trans b/w mgmr and the tst
* have the big boys (significant boys and financial institutions) as the tst mgr, then their reputation is on the line.

Question 16

What’s the main feature and advantage of stapled securities?

Answer 16

A stabled security is designed for tax efficiency/avoid paying tax on passive prop invs so that stapled security holder maximises pre-tax income received.

investor given an equivalent number of shares in a coy and units in a tst. (shares and units are not separable i.e. must be bought and sold together)
tst holds LT passive prop inv (remains untaxed), while the coy carries on any trading/business activities (subject to tax)

Question 17

Discuss internally vs externally managed stapled structure vehicles.

Answer 17

• interally managed stapled structure (prop in the tst, mgmt in the coy) - passive prop invs are contained in the tst structure, tst mgmt and other operating business activities (development, prop mgmt, land trading etc) are contained an a coy structure ; this address (to some extent) the issue of alignment of interests between the investor and the vehicle manager, although this structure makes it difficult to remove mgmt and allows greater risks (to be taken by mgmt), also difficult to obtain tax authority approval
• externally managed stapled structure (prop in the coy, mgmt external) - allows investors to gain exposure to props that have a component of business operation. asset is typically a hotel (that would otherwise be contained in a trading trust subject to tax). hotel business is owned by the coy but it pays out virtually all its pre-tax earnings to the tst as a rent. and unitholders receive all this income from the tst vehicle. mgmt of the tst is carried out by an external entity.

Question 18

What are the 2 basic types of re trust vehicles confronting REIT investors ?

Answer 18

1. sector-specific trust - most welcome by institutional investors in recent years and now dominate the sector by number. exposure to a single RE sector (3 major REIT sectors: office, industrial, retail, development… ) via choosing sector-specific tsts, investors can choose a pf of tsts that best serve their needs and expectations at different points in time/ or **you can say the tst investor can determine RE sector allocation at varying points in the prop cycle.**
2. diversified RE trust - within a **single inv vehicle**, a diversified RE tst provides investors with **exposure to a mix of RE sectors (typically incl office, industrial and retail props)** if you invest in a single diversified RE tst, you are contracting out the prop type allocation decision to the tst manager of the diversified RE tst. the actual mix varies from tst to tst and is determined by the tst mger (who may have a passive or active inv style)

Question 18

What are the 2 basic types of re trust vehicles confronting REIT investors ?

Answer 18

1. sector-specific trust - most welcome by institutional investors in recent years and now dominate the sector by number. exposure to a single RE sector (3 major REIT sectors: office, industrial, retail, development… ) via choosing sector-specific tsts, investors can choose a pf of tsts that best serve their needs and expectations at different points in time/ or **you can say the tst investor can determine RE sector allocation at varying points in the prop cycle.**
2. diversified RE trust - within a **single inv vehicle**, a diversified RE tst provides investors with **exposure to a mix of RE sectors (typically incl office, industrial and retail props)** if you invest in a single diversified RE tst, you are contracting out the prop type allocation decision to the tst manager of the diversified RE tst. the actual mix varies from tst to tst and is determined by the tst mger (who may have a passive or active inv style)

Question 19

What are the fundamental differences between direct RE inv and listed REITs?

Answer 19

• basic legal right - unitholder (i.e. beneficiary) in A-REIT **does NOT own the prop**), but a unit in the vehicle that holds the props (where each prop asset is not separable) ;
• REIT unitholders have **limited say in inv policies of the tst** (hence essentially relying on the skills, inv process, integrity of the tst mgr) ;
• REIT unitholders can access **risk-return characteristics of RE mkt** in a more **digestible size and liquid form** (which direct inv in prop may not obtain) but the liquidity comes with approx 0.6 correl with eq mkts (higher than correl between eq mkts and physical prop mkt) . tst factors (non-re assets, debt, tst expenses/mgmt expenses, ST volatility of the eq mkt as its moderately strongly correlated with REIT mkt) affect the risk-return profile of the REIT vehicle. Note that mgmt has a significant influence over the risk-return profile of the tst, next to volatility of the eq mkt.
• LT Rs of the REITs however are determined by the performance of the underlying physical RE assets.

Question 20

Which factors are the main factors that influence valuation of listed REITs?

Answer 20

Risks and growth prospects of the listed REIT.

generally, certainty surrounding earnings or cash flows comes from income-producing assets with secure leases. mkt requires a higher dist yld if greater uncertainty surrounding CFs from the tst, or in the case of a stapled tst, lower PE to corporate earnings that have greater uncertainty.

Question 21

What is the formula for assessing the total R of the REIT (like total R of any other inv)?

Answer 21

Essentially, the earnings are either paid out as pre-taxed income to unitholders from the REIT tst or as corporate earnings from a stapled trust. Either way, uncertainty surrounding cash flows (from a tst) or earnings (from a coy structure in a stapled security structure) will be discounted by the equities mkt by requiring higher yld from tst or attaching lower PE ratio

~mkt’s assessement of risk and reward from the tst will be reflected in the dist yld of the listed REIT (and mkt will generally discount risk and reward certainty)~

Question 22

How is capital return on REIT measured?

Answer 22

capital return can be measured by the exp. g in the stated NTA or unit price as traded on the stock exchange (since investors would usually have to sell/liquidate their unitholdings via the securities exchange).

Question 23

How is income return on REIT measured?

Answer 23

income R is commonly measured by dist or precisely dist yld. because of the high income (equivalent to earnings) are typically paid out by the REIT (recall that an externally managed tst passively holds prop inv whilst virtually all income derived from the prop gets paid out as pre-tax earnings to unitholders)

Question 24

What is the formula for distribution yield?

Answer 24

Question 25

How do we compare various tsts’ dist ylds on a risk-adjusted basis?

Answer 25

compare the ylds that are paid but with regard to the security behind that yld and growth prospects

Question 26

What are the risk-return characteristics that affect the unit price and hence dist yld?

Answer 26

• prop fundamentals - pf quality, prop type, location, diversification, tenant quality, capex requirement, potential to add value via development etc.
• tax elements - tax deferred elements obv affect total Rs to unitholders
• corporate earnings - only applicable to stapled tst structure vehicles; stapled tst has corporate earnings from various sources incl. development, funds mgmt, and if paired with strong outlook, will be reflected in a higher PE than peers; if you value the overall security of a stapled tst, you ust derive values from assessing the passive tst assets and the corporate entity then combine these values
• debt - generally tsts with high debt = more risky, but again depending on interest rate environment and security of CFs from the tst prop(s). note that debt can actually be an attractive means of increasing Rs to unitholders
• non-prop assets/balance sheet strength - again we are talking liquid assets like cash or money market investments - these indicate strong balance sheet which enables tst to take oppo should re inv oppos (like corporate activity/takeovers of other REITs ) come along
• mgmt - ultimately responsible for setting the risk-return profile of the tst
• capital component should be treated separately in a dist yld evaluation - note that dist may sometimes incl. capital reserves (e.g. when there’s been capital dist because there’s been a realised gain from selling a prop contained in the tst) but this is obviously not considered maintainable income stream of the vehicle.
• size/liquidity - generally larger the better as it’s more liquid (assessed value means nothing if you can’t sell and make a realised gain i.e. there is thin-trading on the securities exchange!

Question 27

As part of the investment return valuation, how is income quality determined?

Answer 27

income quality is collectively determined by:

• quality of underlying re assets
• quality of tenants occupying the assets
• pf construction
• quality of the tst mgmt
• capital structure (debt/equity)
• MER (mgmt expense ratio)

info on these is generally avail from tst’s qrtrly, half yearly and annual result releases]. you can ofc also do some subjective analysis like analysing the quality of the tst mgmt by looking at historical trading and operating performance
(note for below: stapled tsts generate additional income from corporation

Question 28

What is a typical way to derive property trust income return or distribution yield from a net income statement?

Answer 28

Question 29

Discuss the 6 key determinants of property trust income.

Answer 29

1. geographic profile - if pf is geographically weighted towards growth mkts, then mkt is likely paying more for that, otherwise, discounts NPV

2 lease covenants, expiry and rent review profile - nature of covenants will be assessed by the mkt to discount risk and reward certainty e.g. pf of props without ratchet clause will be viewed as having a less valuable income stream (i.e. higher risk of rent reduction) rent review and lease expiry profile reasonably indicate how much tst income is at stake each yr e.g. in a strong mkt rent growth phase, mkt can expect rent review profile to indicate potential upside; if prop mkt is in decline, mkt likely rewards tst vehicles that structured rent increases inherent in their pfs .
* lease expiry profile - say a pf faces a large no. of lease expires in the ST then the pf faces risk of losing sitting tenants, possible protracted reletting campaign, lower rent, having to offer significant incentive to lease out to new tenant, substantial capex; mkt will especially perceive lease expiry as high risk when expiries coincide with a period of oversupply or when the underlying prop’s specifications limit it to a select number of potential occupiers.

3. tenant quality and numerical diversity - tenant quality or the tenant’s credit reating in other words (e.g. government tenants have lower risk than companies ) is critical to the security of income . a secure pf shouldn’t be reliant on a partcular tenant or industry (diversify)
4. finance capital structure mgr’s ability to structure capital requirements (debt/equity) - affects cost of capital (debt is cheaper than equity) hence R on tst
5. gearing and interest rate exposure tst vehicles can gear up and still trade at prem - this is coz investors may favour those tst vehicles that can acquire props that produce income Rs higher than interest cost associated with additional borrowings (investor’s expectation adjusts to the nature of the underlying prop invs, although generally significant gearing means higher risk, think aggressive gearing up to bust in 2008-2011, in the aftermath of the re credit crsis, REIT mgrs had to unwind gearing levels)
6. equity

Question 30

What are the 2 main ways to manage debt or interest rate exposure or uncertainty inherent with gearing in a REIT (debt management schemes) ?

Answer 30

• varied debt maturity profiles
• interest rate hedging

Question 31

What is MER and how is it normally calculated?

Answer 31

MER = mgmt expense ratio. Numerator incl. tst mgmt fees, trustee fees, listing fees, legal costs, printing and postal costs; denominator is tst’s total assets, net assets or income , if tst mgr is good enough, s/he would have minimise the diff between prop Rs (post funding cost) and Rs to unitholders.
* investor should assess MER by asking1. does the manager earn the mgmt fee? 2. what is the extent of the relationship b/w the mgr and the tst ?

Question 32

What are some of the minor factors that impact the return on prop trust?

Answer 32

• depreciation - not recognised by tsts, instead periodical reviews to mkt are used, that’s why investors should assess age and quality of prop pf and how these affect CFs , think capex for redevelopment/refurbishmen to remain competitive
• tax (and tax advantages) - recall tst passes tax benefit in the form of tax deferred elements (relating to plant and equipment deprec and building deprec, tax is only paid when unitholder disposes of units and is treated under CGT rather than income tax ), but stapled tsts pay tax on the corporate earnings with FCs avail to shareholders on that portion only,
• capital distribution - we are talking one-off payments (non maintainable) to investors because there’s been proceeds from sale of prop (i.e. realised CG) and dists enhanced
• size/liquidity - easier it is for investor to enter/exit the inv, better the value of the inv. size too small -> hard to exit inv; liquidity can be severely restricted if one party is commited LT holder of a substantial proportion of the units on issue. that’s why larger and/or more liquid vehicles generally attract more investors (larger vehicles also likely to trade at a prem to smaller less liquid ones)

Question 33

How does non-prop assets affect valuation process of an REIT?

Answer 33

usually refer to cash or other money mkt securities that are held to 1. support capex, operational expenses 2. in some cases, support dist to unitholders. any cash unused is usually parked away in liquid assets (cash, money mkt or whatever comes with limited capital risk) while mgr seeks suitable prop acquisition oppos. although some REITs (esp. stapled) may invest that cash in other securities. (e.g. strategic func like a retail exposure rather than quasi cash inv)

Question 34

What have been the key drivers of increasing corporate earnings from a stapled tst?

Answer 34

• increases in prop development
• management of funds for and on behalf of third parties

Question 35

How may the stated NTA (net tangible asset) be of use in valuation of REITs?

Answer 35

At best, it is a guide to value rather than a determinant of value.

usually used as a benchmark for assessing the value of a re inv tst. but there is STATED nta and realied mkt price in an actual transaction. the two can be vastly diff if re mkt is in rapid decline whilst the stated nta only represents the opinion of an independent valuer as to the value of prop at a point in time (being a historical representation of prop value)

Question 36

What are the main issues inherent in using stated NTA?

Answer 36

• each stated NTA is the opinion of an independent valuer and each valuer uses diff assumptions in calculations, and then the mkt has its own assessment of the value of the tst vehicle, considering each prop’s stated NTA.
• a re inv tst usually holds a pf of various types of props (think diversified tst), NTA doesn’t recognise that value of a group of props is greater than sum of each prop value because diversification benefits are ignored
• NTA doesn’t reflect non-prop items (tst mgmt fees, tst fees, listing fees, legal fees…) that affect Rs to unitholders
• NTA doesn’t reflect corporate earnings from the corporate component of a stapled tst (from prop development, mgmt of funds for and on behalf of 3rd parties)
• NTA /re valuation may be calculated once a year or once every 3 years, all depending on tst’s policy and how tst interprets the term ‘material change’ (material change warrants re-evaluation)
• NTA ignores gearing and CGT at the time of transaction. (yet we know how different cgt rules result in diff a/t gains, no good if ignoring CGT altogether)

Question 37

If we have many issues with stated NTA, why do we bother using it at all?

Answer 37

Stated NTA can still be used for
* making sure borrowing does not exceed limit as per tst deed (e.g. no more than 60% of NTA)
* provides some insight as to expected Rs in the event tst is would-up and cash is returned to unitholders (albeit it’s rare to see a listed REIT wound up)
* used for working out mgmt/tstee fees
* valuer is given information like lease and outgoings (info that is NOT avail to tst unitholders) to derive an INFORMED opinion as to the expected R and value of each prop, which then helps the investors gain an informed opinion about the prop inv

Question 38

What asset class is the listed REIT? How to categorise it? Debt, RE, or Equities?

Answer 38

it’s tricky coz it is like a hybrid - Rs hinge on prop assets, tst is listed on the ASX in the industrial company area, while tst’s yld embodies characteristics of fixed interest inv (esp. if tst holds a pf of props with secure income stream due to fixed LT leases and ratchet clauses)

However REIT sector should not be categorised as debt.

Question 39

What are the reasons why REIT sector should NOT be categorised as debt?

Answer 39

* yld(income stream), capital and maturity of the A-REIT are not fixed or certain (these are essential features of actual debt)
* unitholders equity ranks behind debt in the case of liquidiation
* listed REITs are usually priced at discount to the long bond for many reasons - better liquidity, easier access, tax benefits (building deprec allowances), hedge on inflation via retail exposure, prospects of capital growth, securely leased -> secure income stream -> income risk as low as bond’s income risk (closely mirrors), less sensitive than bonds to changes in interest rates because of expectations towards growth
* fully invested REIT actually retains the same broad characteristics of the underlying props (in many cases the only avenue for investors to gain exposure to institutional-grade commercial re)
* correl with equities usually 0.6 so can say that REIT sector is generally less volatile than eq mkt but then as mkts move through cycles (economic fundamentals, debt, equity mkts, supply/demand conditions prevailing in the prop mkt) that correl value changes too, so have to constantly re-evaluate Rs of listed REITs

Question 40

What are the common ways for investors to invest in international RE?

Answer 40

can do it through A-REIT index

or managed funds that invest in global REIT mkts on behalf of investors)

investing in international RE is an increasing emerging trend for Australians

Question 40

What are the common ways for investors to invest in international RE?

Answer 40

can do it through A-REIT index

or managed funds that invest in global REIT mkts on behalf of investors)

investing in international RE is an increasing emerging trend for Australians

Question 41

Discuss the 4 main arguments for investing in international re.

Answer 41

* oppo for outperformance (Rs are diff across diff mkts so oppo to outperform A-REIT invs)
* diversification (lower pf risk)
* increased mkt size
* diff risk profiles ( diff liquidity, diff re cycles, diff supply and demand fundamentals)

so instead of restricting re inv to domestic mkt only, we should look into oppo to invest in institutional-grade re in the other mkts (esp. developed world) but just like domestic invs, investing internationally also comes with risks (re risk, economic risk, default risk, legal risk, political risk, currency risk, tax risk, liquidity risk, mkt transparency risk, vehicle risk)