Decision-making factors in the constitution of a REIT

Abstract

Real Estate Investment Trusts (hereinafter, REIT) are investment companies which enable to capitalize real estate assets by offering company shares into stock markets.

The recent positive outlook and the signs of change in the economic cycle have entailed a sharp increase of REITs constitutions. Nevertheless, real estate managers must consider its advantages compared to other alternatives of financing real estate activity. This implies the analysis of those variables affecting REITs performance such as, market price and market capitalization (compared to its net asset value), REIT expected liquidity, constitution costs, systematic risk, finance costs or tax benefits, and also other aspects like, company control, transparency requirements or regulatory limits.

REITs have become a competitive way to finance real estate activity, especially considering credit constraints this industry is still experiencing. In this context, the present paper analyses what should be taken into account in the decision of establishing a REIT.

 

 

  1. Introduction

In recent years the real estate industry has faced the worst crisis since the 1930s that impacted Real Estate Investment Trusts (hereinafter, REIT) which are investment companies that enable to capitalize real estate assets through the trading of company shares in the securities markets (Kroszner & Shiller, 2011).

However, signs of change for financial and real estate markets are being identified by incoming macroeconomic data. Joined in this positive economic trend, the reforms introduced by the Spanish government make the Spanish REIT regime, known as Sociedad Anónima Cotizada de Inversión en el Mercado Inmobiliario (hereinafter SOCIMI) more attractive, what resulted in a sharp intensification of REITs constitutions, not only for local companies, but also for large international investors.

Real estate managers must consider the advantages of establishing a REIT over other alternatives of financing real estate activity. This implies the analysis of several factors affecting REITs performance such as, market price and market capitalization (compared to its Net Asset Value (hereinafter, NAV)), REIT expected liquidity, constitution costs, systematic risk, finance costs or tax benefits, and also other aspects like, company control, transparency requirements or regulatory limits.

REITs have become a competitive way to finance real estate activity, especially considering credit constraints this industry is still experiencing. In this context, the present paper analyses what should be taken into account in the decision of establishing a REIT.

To sum up, the present paper analyses the different aspects that a manager should take into account in order to finance the real estate activity by the constitution of a REIT.

 

  1. Methodology, data and hypothesis

The methodology applied in the study is outlined below.

Firstly, it has been reviewed the global scientific literature of REITs, in particular, in reference to aspects related with the establishment of a REIT.

Secondly, despite it has been analysed the state of the art at an international level, it has been performed a market study focused on the Spanish-REITs companies to identify the positive and negative factors that implies the establishment of a Sociedades Anónimas Cotizadas de Inversión Inmobiliaria (hereinafter, SOCIMI).

Thirdly, data has been collected from the National Stock Market Comission (hereinafter, CNMV), the Alternative Investment Market (hereinafter, MAB), on-line information from Spanish REITs webs as well as interviews.

 

  1. Decision Factors that managers should analyse when studying the constitution of a REIT.

It has been analysed the main decision factors that should be taken into account by managers when studying the constitution of a REIT. This concern, that is, the most significant elements that influence manager’s decision-making, is expounded in further detail below.

3.1 Financing costs.  

Several studies have demonstrated that REITs benefit of a better and enhanced access to credit in comparison to non-traded real estate companies (Hardin and Hill, 2011; REEF Research, 2010; Deloitte, 2011). According to Hardin and Hill, the credit availability for REITs companies is associated with historic data of dividends distributions.

In such a way, when assessing the credit risk of a REIT, lenders may consider the capacity of generating dividends as an equivalent of cash flows. If it is considered that REIT managers are reluctant to shorten dividends and that law requires a greater distribution, lenders could take account dividends as a cash flow guarantee that in the worst-case scenario shall be used to repayment the debt.

Data in Figure 01 indicates credit spreads decline of REITs, a trend that started in Australia, and continued in United Kingdom and E.E.U.U. (RREEF, 2010).

 

Figure 01. Spreads of Credit Default Swaps of REITs Evolution

 

Source: RREEF, 2010.

 

3.2 Cash obtained by the sale of participations

It has been observed that the achievement of liquidity through the constitution of a REIT is a competitive alternative of real estate finance in front to others possibilities such as mortgages (Roig and Soriano, 2015).

Nevertheless, managers should analyse, in each case, if the establishment of a REIT, that involves the sale of shares in the financial markets, would be, at least, equivalent to other scenarios such as property disposals or mortgages.

3.3 Liquidity

Unlike other investment instruments in the real estate industry, such as the direct investment in properties, whose liquidity may be significantly lower to other type of assets, REITs liquidity draws closer to other listed companies in the financial markets (Marcato y Ward, 2007).

However, it can be shown that the moderate liquidity of the underlying assets have a negative impact on REITs liquidity; this results in a lower switching of shares when compared with other industry listed companies, as clearly seen in Table 01, where REITs present a clear difference with non-reit real estate companies (Ghosh, Miles y Sirmans, 1996).

This advantage in terms of liquidity of REITs versus Non-REIT companies is properly reflected in the price share of the first with a quantified impact between 12 and 22% (Beneviste, Capozza and Sequin, 2001). This is supported by the greater and improved available information that provide transparency concerning REITs.

 

Table 01. A Liquidity Comparision between REIT and Non-REIT companies

 

Year Market Value
(Millions of $)
Daily Trading Volume
(% market shares)
REIT Non-Reit Companies REIT Non-Reit Companies
1987 154 162 0,14 0,43
1988 178 186 0,09 0,25
1989 195 203 0,11 0,5
1990 160 170 0,09 0,41
1991 176 188 0,09 0,67
1992 248 265 0,14 0,41
1993 371 389 0,23 0,63
1994 402 372 0,18 0,45
1995 456 434 0,15 0,52
Mean 260 263 0,14 0,47

 

Source: Ghosh, Miles, Sirmans (1996), Real Estate Finance

 

Moreover, according to Demsetz (1968), Stoll (1978) and Ho and Stoll (1981), the factors behind liquidity are the financing costs, the expected return and risk. Consequently, the present liquidity is estimated to be moderate due to the present context that involves high financing costs, despite the fact that the Euribor is historically low, risk premium is high, the expected return is moderate and the real estate market perceived risk is high.

3.5 Discounts to Net Asset Values

REITs price in the financial markets is been affected by volatility and systematic risks that results in departures between the quotation and the NAV.

Great factors are identified in the explanation of these departures, in particular, rational factors such as the size of the REIT, country effect, liquidity or transparency or irrational factors as the investment sentiment or real estate expectations.

3.6 Flotation firm costs

The costs of being listed on the financial markets is not indifferent; first of all implies the expenses of going public and then the cost of being traded in financial markets; despite it is possible to quote in markets with less costs such as the MAB, REITs should set a not-insignificant budget and scale economies must be studied.

External audits, valuations, share issuer consultant or a fiscal advisor are some of the costs of establishing a REIT.

3.7 Company control

The sale of shares to third parties represents a transparency requirements and control company loss in some extend.

Managers should value the potential negative impact that the selling of shares framework can have to shareholders.

3.8 Transparency

Becoming a REIT involves being listed in the financial markets. Despite managers can choose to be in a lower regulated public markets, such as the MAB, information requirements would be always higher than in non-listed companies.

However the publication of greater information may be costly initially as well as the sale of shares to third parties represents a transparency requirements and the loss of company control in some extend, in the long term it must be especially effective due to reduces the perception of company risk which directly implies the increase the value of REITs (Bushman and Smith, 2003).

3.9 Legal Constraints

Being a REIT involves to fulfil the legal requirements which regulation imposes in order to take advantage of tax benefits.

This involves a reduced flexibility for managers due to its requirements such as a high percentage of dividends distribution, a minimum net capital or to allocate, at least, a 80% of the property investments for leasing.

Nevertheless, some changes in the Spanish regulation have profoundly encouraged the constitution of new REIT.

3.10 Systematic Risks

Investors should bear in mind that REITs are listed in the financial markets which implies a considerable volatility when compared to their underlying assets; in other words, REITs are affected by the systematic risk. According to Kallberg, Liu y Srinivasan (1998), volatility of REITs shares are three times greater than their underlying assets.

Daily information has an immediate impact on the shares while property valuations include the impacts to a lesser extend resulting in the appraisal smoothing effect (Quan y Quigley, 1991).

3.11 REITs Risk-Return Trade-Off

REIT managers should assess the fact that markets would demand a higher level of profitability in relation to other assets due to the volatility do not include the total risk of the asset (Table 02); that is, volatility would be necessary but not sufficient in order to make investment decisions of REITs.

 

Table 02. A Comparative of the Risk-Return Trade-Off

Period REITS Large-Cap Companies Small-Cap Companies Bonds
Return Risk Return Risk Return Risk Return Risk
1972 – 2007 13 17,4 11,2 17 14,3 22,5 8,7 11,5
1988 – 2007 12,3 17,4 11,8 16,6 13,5 19,9 9,3 10,1
1998 – 2007 10,5 20,4 5,9 17,3 10,6 22,2 7,3 8,8
2003 – 2007 18,2 22,3 12,8 9,8 17,2 25,1 5,7 4,1

Source: NAREIT, 2010.

 

The causes of this matter are explained by the real estate informational, rational and operational market inefficiencies (Figure 02) that results in a returns distribution that do not follow a log-normal law. This implies a lower diversification effect in a investment portfolio (McCoy, 2006 and Shleifer, 2000).

 

Figure 02. An Efficiency Comparison between Stock and Real Estate Markets

Source: Sabal (2008).

3.12 Departures from NAV in REIT Pricing

REIT share price is often different than its NAV. Many causes explain that differences which are valued by the Price to NAV ratio that can be divided between rational such as REIT size, the country effect, liquidity, diversification or historic returns and irrational factors such as investor expectations or investor sentiment (Fernández et al, 2012)

If managers expect a pronounced discount of the Price to NAV ratio, they would have no incentive to establish a REIT because there will be more efficient ways to finance the real estate activity such as mortgages.

The Figure 03 outlines the evolution of the Price to NAV ratio for European real estate companies proving that the relation between these two variables varies over time.

 

Figure 03. European Index of the Price to NAV Ratio (FTSE EPRA/NAREIT)

Source: RREEF, 2010.

3.9 Summarize:

Table 03 shows a summary of the decision-making factors in the constitution of a REIT.

 

Table 03. Decision-making factors in the constitution of a REIT.

    Factor Description
Positive Factors   Cash Generation The generation of liquidity by property assets without the need to selling them.
  Not accounted for as debt The sale of participations do not affect debt ratios which allows to mantain stable the financing costs and, in turn, obtain liquidity.
  Company Management Depending on the company Free-float, managers will keep the company control.
  Liquidity Real estate listed companies have more liquidity than property assets, which is positively reflected in their price.
  Financing Costs REITs historically have obtained a better competitive financing cost compared to non-traded real estate companies.
  Notoriety The constitution of a REIT implies a greater public perception of the company in front of stake-holders.
  Company Risk REITs are perceived that are more transparent than non-traded real estate companies which reduces the perceived company risk that results in a reduction of the discount of the price to Net Asset Value.
  Tax Benefits Through the fulfilment of the legal requirements, the SOCIMI and their shareholders are supported by tax benefits in front other real estate companies.
  Price-Premium to NAV In the scenario of the sale of shares with a price higher than the Net Asset Value, shareholders would obtain a greater profitability regarding the scenario of the sale of assets.

 

    Factor Description
Negative Factors   Flotation Costs of Firms. Being listed in the financial markets entails significant costs for companies, not only at the beginning but also during the time the company is listed.
  Company Control The sale of shares involves the loss of part of the company control and the increase of the information requirements and sharing to new shareholders the strategy.
  Management Costs The investors’ expectations regarding property prices are reflected not only in the appraisals but also in the stock prices. Nevertheless, the influence of future price expectations has a lower intensity to appraisers than to investors.
  Transparency Being traded in the financial Markets involves the obligation of a greater information reporting that could be an entry barrier.
  Legal Constraints The legal requirements for being a REIT reduce the management flexibility.
  Price-Discount to NAV In the scenario of the sale of shares with a price lower than the Net Asset Value, shareholders would obtain a poorer profitability regarding the scenario of the sale of assets.
  Systematic Risk REITs will not only be influences by the idiosyncratic risk but also with the systematic risk due to being traded in the financial Markets.

Source: Prepared by the authors.

 

  1. Conclusions

The establishment of a REIT involves the analysis of a great number of factors both, positive and negative, that managers should consider.

Moreover, some additional external factors represent an opportunity and a threat that influence significantly the decision-making process. That is, the economic context and the real estate cycle that, however, at present, is effecting positively, during the financial crisis it was a great threat.

It seems that the most important factor valued by managers is tax advantages and that other positive and negative aspects are not broached in the decision-making process. However, on the one hand, positive aspects as not accounted for as debt, liquidity, cash generation, financing costs, notoriety, company risk and company management, or, on the other hand, negative factors as company control, flotation costs of firms, management costs, transparency, legal constraints, price-discount to NAV and systemic risk, are also key success factors that should be taken into account.

 

References*

Beneviste, L.; Capozza, D.R.; Seguin, P.J.; 2001. The Value of Liquidity. Real Estate Economics, Vol. 29, p.p. 633-660. Available at: http://dx.doi.org/10.1111/1080-8620.00026.

Bushman, R. M., Smith, A. J.; 2003. Transparency, financial accounting information, and corporate governance. Financial Accounting Information, and Corporate Governance. Economic Policy Review, 9(1).

Deloitte; 2011. Commercial Real Estate Outlook: Top Five Issues 2011. Sustaining the recovery momentum. Available at: http://goo.gl/v6EI4.

Fernández, J., Llovera, F.J, Roig, J.; 2012. Los REITs españoles como vehículo de inversión y financiación de la actividad inmobiliaria: las SOCIMI; Intangible Capital, Vol. 8 (2), pp. 308-363.

Ghosh, C.; Miles, M.; Sirmans, S.F; 1996. Are REITs stocks?. Real Estate Finance, Vol. 13 (3), pp. 46-53.

Hardin, W.G.; Hill, M.D.; 2011. Credit Line Availability and Utilization in REITs. Journal of Real Estate Research, Vol. 33 (4), pp. 507-530.

Kallberg, J., Liu, C. H. y Srinivasan, A.; 1998. Evaluating stock price volatility: The case of REITs. Stern School of Business in its series New York University, Leonard N. Stern School Finance Department Working Paper Series with number 99-081.

Krozner, R.; Shiller, R.J.; 2011. Reforming U.S. Financial Markets: Reflections before and beyond Dodd-Frank. The MIT Press.

McCoy, Bowen H.; 2006. The Dynamics of real estate capital markets. A practitioner’s perspective. Urban Land Institute.

NAREIT; 2010. Investing for Dividends and Diversification. Available at: http://goo.gl/K9Nr1Z

Quan, D. C.; Quigley, J. M; 1991. Price formation and the appraisal function in real estate markets. The Journal of Real Estate Finance and Economics, Vol. 4 (2), pp. 127-146.

Roig, J; Soriano, J.; 2015. Liquidez y cotización respecto al valor neto de los activos de los REIT españoles (las SOCIMI). Revista Europea de Dirección y Economía de la Empresa, Vol 24 (2). Available at: http://goo.gl/kr6gQw

RREEF Research; 2010. Global Real Estate Securities: The Outlook for 2010 and Beyond. Available at: http://goo.gl/XzrXdo.

Sabal, J.; 2008. Finance in Real Estate. Programa de Licenciatura y Máster en la Escuela Superior de Administración y Dirección de Empresas (ESADE).

Shleifer; 2000. A. Inefficient Markets: An Introduction to Behavioral Finance. Oxford University Press.

Share:

Share on linkedin
LinkedIn
Share on facebook
Facebook
Share on email
Email
Share on whatsapp
WhatsApp

Related posts

Éste sitio web utiliza cookies para mejorar la experiencia del usuario. Leer más