Title LM03 Investments in Real Estate Through Publicly Traded Securities IFT Notes.pdf ✅

LM03 Investments in Real Estate Through Publicly Traded Securities 2023 Level II Notes © IFT. All rights reserved 1 LM03 Investments in Real Estate Through Publicly Traded Securities 1. Introduction ....................................................................................................................................................... 2 2. Types of Publicly Traded Real Estate Securities .................................................................................. 2 REIT Structures ................................................................................................................................................ 2 Market Size......................................................................................................................................................... 2 Benefits and Disadvantages of Investing in REITs ............................................................................. 2 3. Valuation: Net Asset Value Approach ....................................................................................................... 4 Accounting for Investment Properties .................................................................................................... 4 Net Asset Value per Share: Calculation ................................................................................................... 5 Net Asset Value per Share: Application .................................................................................................. 6 4. Valuation: Relative Value (Price Multiple) Approach ........................................................................ 7 Relative Value Approach to Valuing REIT Stocks ............................................................................... 7 Funds from Operations and Adjusted Funds from Operations ..................................................... 7 P/FFO and P/AFFO Multiples: Advantages and Drawbacks ........................................................ 10 5. REIT Mini Case Study: Example of Disclosures and Valuation Analysis .................................. 10 6. Private vs. Public: A Comparison ............................................................................................................ 12 Summary ............................................................................................................................................................... 14 This document should be read in conjunction with the corresponding reading in the 2022 Level II CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2021, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute. Version 1.0
LM03 Investments in Real Estate Through Publicly Traded Securities 2023 Level II Notes © IFT. All rights reserved 2 1. Introduction This reading focuses on public real estate investments. 2. Types of Publicly Traded Real Estate Securities Publicly traded real estate securities allow investors to gain indirect exposure to real estate equity and debt, by purchasing shares of companies that own real estate, real estate loans, or both. The main types of publicly traded real estate securities are:  Real estate investment trusts (REITs)  Real estate operating companies (REOCs)  Mortgage-backed securities (MBS) REIT Structures Most REITs are structured as corporations or trusts. They are tax-efficient vehicles for distributing earnings from rental income to shareholders. A company must meet a number of criteria in order to qualify as a REIT. In most countries, REITs must distribute 90%–100% of their otherwise taxable earnings, invest at least 75% of their assets in real estate, and derive at least 75% of their income from real estate rental income or mortgage interest. The main types of REITs are:  Equity REITs: Have ownership position in income-producing real estate.  Mortgage REITs: Invest the bulk of their assets in loans secured by real estate. Market Size As of May 2019, the market value of publicly traded REITs and REOCs in developed markets was approximately $2.6 trillion. Whereas, the total face value of residential and commercial MBS in the United States was approximately $9.8 trillion. Benefits and Disadvantages of Investing in REITs The benefits of publicly traded equity real estate securities (both REIT and REOC) over private real estate investments are:  Greater liquidity: Shares are traded on stock exchanges which provide greater liquidity.  Transparency: Share prices and transaction history are readily available.  Diversification: REITs allow investors to diversify real estate portfolios by geography and property type.  High-quality portfolios: Many companies own high-quality assets in leading markets.  Active professional management: Properties are managed by professional
LM03 Investments in Real Estate Through Publicly Traded Securities 2023 Level II Notes © IFT. All rights reserved 3 managers; no real estate expertise or asset/property management skills are required by the investor.  High, stable income: Well occupied properties, with long-term leases are expected to generate stable predictable income.  Tax efficiency: REIT and passthrough structures avoid corporate income taxation. Taxes are payable only on dividends received by investors. The main disadvantage for REITs is the lack of retained earnings. REITs often need to access capital markets for equity and debt to fund growth. REITs are also constrained in the types of assets they can own. Example: Advantages of Publicly Traded Real Estate Investments (This is a knowledge check example from the curriculum.) 1. Which of the following assets requires the most expertise in real estate on the part of the investor? A. A REOC share B. An equity REIT share C. A direct investment in a single property 2. Which of the following has the most operating and financial flexibility? A. A REOC B. An equity REIT C. A direct investment in a single property 3. Investors seeking broad diversification would invest in the securities of which of the following companies? A. A company that owns multi-family rental properties in Hong Kong SAR B. A company that owns large office properties in New York City, San Francisco, Los Angeles, and Chicago C. A company with a mix of office and retail properties in urban and suburban markets Solution to 1: C is correct. Direct investment in a single property requires a high level of real estate expertise. Solution to 2: A is correct. REOCs are free to invest in any kind of real estate or related activity without limitation. Solution to 3: C is correct. A mix of assets—office and retail—with exposure to urban and suburban markets offers the best diversification. Example: Publicly Traded Real Estate Investments (This is a knowledge check example from the curriculum.) 1. Which of the following best represents an advantage of REITs over a direct investment in an income-producing property?
LM03 Investments in Real Estate Through Publicly Traded Securities 2023 Level II Notes © IFT. All rights reserved 4 A. Diversification B. Operating flexibility C. Income growth potential Solution to 2: A is correct. Example: Investment Objectives (This is a knowledge check example from the curriculum.) Investor A’s primary objective is liquidity. Investor B’s primary objective is maximum growth/capital gain potential. State which investment type is most suitable for each investor among the following: REOC, REIT, or direct investment in an income-producing property. Solution: For investor A, REITs and REOCs are most appropriate. For investor B, REOCs and direct property investment are most appropriate. 3. Valuation: Net Asset Value Approach Approaches to value shares of REITs and REOCs are: asset value estimates, price multiple comparisons, and discounted cash flow. Two measures of value are: book value per share (BVPS), which is based on reported accounting values, and net asset value per share (NAVPS), which is based on market value of assets. NAVPS is used to value REITs and REOCs. The actual share price can be different from NAVPS. Shares can trade either at a discount or a premium to NAVPS. NAVPS is the largest component of the intrinsic value of the stock. The balance is investor’s assessment of value of any non-asset-based income stream, the value added by management, and the value of any contingent liabilities. Accounting for Investment Properties Analysts should understand the basis on which REIT’s investment properties are valued. If the accounting is on a fair value basis, then the accounting values may be relevant for asset- based valuation. However, if accounting is on historical cost basis, then the accounting values are generally not relevant. Under IFRS, investment property is defined as property that is owned for the purpose of earning rentals or capital appreciation or both. Companies are allowed to value investment properties using either a cost model (based on historical cost basis) or fair value model. Under US GAAP, there is no formal definition of investment property. Most companies in the United States value investment properties using the historical cost accounting model. Net Asset Value per Share: Calculation