Debunking Reit Yields (CCC)

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Lessons for 2010: Yields, Breakdown historical yields – compare indirect dividend yields from REITs with direct-yields from property funds. Market Backdrop, Discuss long-term trends, contrast recent recover with 2008 performance, total return composition and lessons learned. Position, Explore the prevailing opportunities in REITs and suggest best practices for investing REIT Funds in the future..

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Debunking Reit Yields (CCC)

  1. 1. REITS Debunking REIT Yields Lessons learned in 2008 for post 2009 investing.. <ul><ul><li>Yields, Breakdown historical yields – compare indirect dividend yields from REITs with direct-yields from property funds. </li></ul></ul><ul><ul><li>Market Backdrop, Discuss long-term trends, contrast recent recover with 2008 performance, total return composition and lessons learned. </li></ul></ul><ul><ul><li>Position, Explore the prevailing opportunities in REITs and suggest best practices for investing REIT Funds in the future.. </li></ul></ul>
  2. 2. About REITs Real Estate Investment Trusts REITS About REITs: Over nearly half a century, the U.S. real estate investment trust (REIT) industry has become an important segment of the U.S. economy and investment markets. U.S. REITs have seen their equity market capitalization soar from $90 billion to more than $300 billion in just the past 10 years. In the process, that growth has set the stage for the adoption of the REIT approach to securitized real estate investment across the globe. Congress created REITs in the U.S. in 1960 as a way to make investment in large-scale, income-producing real estate accessible to all investors in the same way they typically invest otherwise – through the purchase and sale of liquid securities.  In its early years, the industry was dominated by mortgage REITs, which provide debt financing for commercial or residential properties through their investments in mortgages and mortgage-backed securities. The market’s interest in equity REITs, which today usually both own and manage commercial properties, initially was limited because the ownership and management of assets were required to remain separate. That restriction changed with the passage of the Tax Reform Act of 1986, which permitted REITs to both own and manage their properties as vertically integrated companies and helped set the stage for a secular wave of equity REIT IPOs in the mid-1990s. Currently, more than 90 percent of the nearly 200 publicly traded U.S. REITs are equity REITs that own and most often manage commercial real estate and derive most of their revenue and income from rents. In aggregate, these companies own properties across all major property sectors and all major geographic regions. Quick Facts: May 2008 US REITs still dominate returns and constitute approx 50-60% of the world REIT market. However many of the fastest growing and best performing markets have been outside of the US warranting a global strategy.    NYSE listed REITs equity market capitalization = $322 billion REITs own approximately $600 billion of commercial real estate assets, or 10 to 15 percent of total institutionally owned commercial real estate   149 REITs are in the FTSE NAREIT All REIT Index . 127 REITs are traded on the New York Stock Exchange     The FTSE NAREIT All REIT Index dividend yield equals 5.2 percent, compared to the S&P 500 dividend yield of 2.1 percent. REITs paid out approximately $15.5 billion in dividends in 2006. As of the fourth quarter 2007, the coverage ratio of EBITDA divided by interest expense for all REITs is 3.3. The fixed charge ratio of EBITDA divided by interest expense plus preferred dividends is 2.9. Rising Average daily dollar trading volume, April 2008 = $3.2 billion   April 2003 = $684 million   April 1998 = $443 million Source: National Association of Real Estate Investment Trusts
  3. 3. the UK UK Authorised Real Estate Investment Trusts (as at 2007-2008) REITS <ul><li>UK REIT Tax Facts </li></ul><ul><li>A UK REIT will be a UK tax-resident company, listed on one of the UK government's recognised stock exchanges (not AIM) </li></ul><ul><li>To convert into a UK REIT, a property company will have to pay a charge of 2% of the value of the property owned by the company </li></ul><ul><li>At least 75% of income must be rental income from property (this is classified as ‘property rental income'), and 75% of assets must be classified as investment properties </li></ul><ul><li>UK REITs will not pay tax on property rental income or valuation gains of assets </li></ul><ul><li>UK REITs will have to distribute at least 90% of rental profits to investors, who will pay tax at their normal rates. 22% withholding tax will be applied on dividends (some exceptions apply), as is the case with all dividends of UK companies </li></ul><ul><li>UK REITs will have to pay standard tax on any non-rental income, for example ancillary services they offer </li></ul><ul><li>Development activity is permitted, so long as it is done for the purpose of letting, and retained for three years </li></ul><ul><li>The use of debt will be limited by an interest cover ratio of 1.25 times (profits on rental income must be 1.25 times their loan interest payable) </li></ul><ul><li>The maximum ownership of a REIT by any single investor is 10% (some exceptions apply). This is to avoid the loss of tax revenue for the UK Government under double-taxation treaties with certain countries in respect to significant shareholders </li></ul>Source: National Association of Real Estate Investment Trusts
  4. 4. Real Estate Funds – Answers Should REIT investors buy for Income or Total Return? REITS Property Property Manager Property Fund Level Yield Earnings Yield Property REIT Distribution Rental Income Earnings Share Price REIT Fund Variable Yield The payment of income in a REIT Fund is then more akin to an Equity Income Fund or conventional Property Share Fund such as the long-running Fund offered by Aberdeen. Whereas virtually all total return in property funds is income derived, in REIT’s it made up only 50%, on average. Property and Real Estate Funds (Regular Direct Income = Level Yield) Rental Income Operating Profit Total Return Capital Values Dividend Yield Profit Equity and REITs (Regular In-Direct Income = Variable Yield) It is common theme (such as in the UK) for tax structures to encourage REITs to pass all yields onto their investors – however those yields remain variable..
  5. 5. Historical Dividend Yields A Falling trend – cyclical behaviour REITS Source: National Association of Real Estate Investment Trusts NAREIT (National Association of Real Estate Investment Trusts) provides dividend history for REITs going back to 1972. In that span, the US economy has seen three notable recessions: 1974-1977, 1990 - 1991 and 2001-2002. In May 1974 REITs were yielding 19.11% and by January 1977 this had dropped to 7.64%. In October 1990, REITs yielded 12.83% and by October 1993 this had fallen by half to 6.83%. In January 2000, REITs were yielding 8.71% and by June 2002 only 6.50%. In February 2007 Yields were only 3.78% and climbed to 4.70% by August 2007. Following the sub-prime crisis yields again recovered to 5.57% by March 2008. The overall trend is one of falling yields during periods of rising liquidity and price appreciation. Yields currently trade well below the historical mean with increased potential of recovery. . Monthly Yield Avg. = 8.28% Low = 3.78% High = 19.11% (Spread = 15.33%) Monthly Average Trend Including 1974 Bull Rally Trend Excluding 1974 Bull Rally Note: Indicates monthly average Yield Periods of Falling Yields
  6. 6. Market Correlated v uncorrelated volatility REITS Lipper Hindsight © 2008 (a Reuters company) What, Where and When? Between January 2007 to 16 th August 2007 (‘the credit crunch’) the S&P/Citigroup global index lost approximately 10%, by January 2008 the market had dropped a further 9%. Meanwhile the established FTSE EPRA/NAREIT index displayed steadier returns until 2007, fell back only -15.5% during the ‘crunch’. By the 18 th January 2008 the NAREIT index was down -25.5% but subsequently recovered 11.5% within 11 days. In reality REIT returns had begun to cool by 8 th January 2007, well before sub-prime fears had hit the headlines. By the time ‘sub-prime’ and mortgage concerns started to emerge the REIT sector had already began to recover. From March to August falling returns were largely correlated to broader risk fears in the market. From September 2007 until January 2008 the significant falls were more specific to contagion from mortgages fears. Although that hangover remains; we do not believe REITs are being accurately priced since a vast proportion of the index is unrelated to residential mortgages nor significantly exposed to the corporate loan squeeze . Why? Expansion and the opening up of REIT investments markets, outside of the US, had been steadily growing in a protracted fashion since 2004. Investors quickly drew to the ‘uncorrelated class’ in a bid to replicate 2004-2006 growth. By the time REITs fully began to roll out, in the latter half of 2006, relatively large volumes of liquidity had already entered the market. Liquidity brings correlation; soon global REITs were overtaking US returns and becoming quickly inflated and susceptible to downside. Meanwhile the US market was finding itself uncomfortably close to fall-out from non-discriminatory real estate news flow. A reflection of liquidity; of investor sentiment and varying comfortability with REITs worldwide? FTSE EPRA/NAREIT United States TR (IN) S&P/Citigroup BMI Global REIT TR (IN) NAREIT All REITs TR (IN) Percentage Growth Total Return, Tax Default, In LC 515 Days From 01/01/2007 To 30/05/2008 Percentage Growth -45 -40 -35 -30 -25 -20 -15 -10 -5 0 5 10 15 02/2007 03/2007 04/2007 05/2007 06/2007 07/2007 08/2007 09/2007 10/2007 11/2007 12/2007 01/2008 02/2008 03/2008 04/2008 05/2008 ?
  7. 7. A new Cyclicality of Return Total Return has soared as yields dipped REITS Source: National Association of Real Estate Investment Trusts Since 1972 the size of the REIT market exploded from 2003 – 2007. The change in the market outlines a textbook total return strategy for investors (as opposed to income-only strategy). Supported? Can Total Returns continue to be supported when yields have fallen – are fundamentals suitably robust?
  8. 8. Price return Yields and Capital Growth are regularly converse REITS Source: National Association of Real Estate Investment Trusts Like 1974 – REIT capital growth through 2005 and 2006 looked unsustainable based on earnings – movements look broadly correlated to inflation cycles. Capital returns have become increasingly important to the total return of REIT Funds but this trend may correct! Bubble? Liquidity and rising share prices brought rising correlation with mainstream equities. Prices declined as liquidity retracted from mortgage-contagion and falling markets Rebound? Yields are at historical lows – forced down by soaring prices – is a rebound around the corner? Yields Prices Total Return =
  9. 9. Components 1972 - 2007 REITS Source: National Association of Real Estate Investment Trusts Income has always been a component of total return in REITs but that contribution has been steady since 1972. However as listed stocks – the overall total return can prove cyclical and correlated to equity markets; while REIT dividends remain less correlated to the earnings growth of conventional equities. We have seen the cyclical downturn in capital growth before; the recent downturn in income is less common. Soaring liquidity and trading volumes, over the last few years, had skewed returns through 2006-2007
  10. 10. Sector Backdrop – past external commentary REIT Yields heading into 2007 REITS www.marketthoughts.com www.marketthoughts.com, Feb 2007 “ yield on equity REITs is now trading at a negative spread vs. the yield of the 10-year treasuries – suggesting that most investors are now speculating on continued appreciation of REIT prices as opposed to seeking income.  Interestingly, the last time REIT spreads were at current levels was in 1997 – when REIT prices made a secular peak.  The REIT market as a whole would decline by more than 18% in 1998 and another 6.5% in 1999.”  Henry To (CFA), February 2007 2007 Concern: Historically High Valuations; fall-off in yields. Speculation of a rebound?
  11. 11. Lessons learned for 2010 - <ul><li>REITs provided modest historical returns up to 2005 </li></ul><ul><li>The pattern of performance, becoming cyclical with a beta >1 </li></ul><ul><li>Property became increasingly liquidity driven 2006-2008 </li></ul><ul><li>REITs globalised and available in multiple markets; may be sensitive to the purchasing power of sovereign funds </li></ul><ul><li>Yields display similar attributes to high yield bonds in 2007-08 </li></ul><ul><li>Prone to herding and suit a contrarian approach </li></ul><ul><li>For income - REIT yields differ to traditional property payments </li></ul><ul><li>They can diversify the illiquidity of conventional property funds </li></ul><ul><li>Re-read what went wrong in REITs during 2007-2008 and recognise when to buy/sell into/against the market </li></ul><ul><li>Buy as a means to ADD risk to your portfolio </li></ul>
  12. 12. External Links What might your clients be talking about? REITS National Association of Real Estate Investment Trusts www.reit.com NAREIT Chart Book (Jan 2008) http://www.reit.com/portals/0/files/nareit/htdocs/library/performance/CB0801.pdf Market Watch - ‘REIT shares fall on rising bond yields, bubble fears’ Aug 2008 http://archives.econ.utah.edu/archives/a-list/2005w32/msg00006.htm Safe Haven - ‘REIT Yields: The Frightening Truth’, Feb 2007 http://www.safehaven.com/article-7017.htm Market Thoughts – ‘REIT Market Overheating?’ Feb 2007 http://www.marketthoughts.com/z20070201.html

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