REITSparts 2.docx

7/28/2019 REITSparts 2.docx

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REITS, Australian, and GermanProperty

SharesIn this article the authors examine three investment markets: Australia, Germany andtheUSA, further they compare the most important real estate investment vehicle of eachmarket.

The US Real Estate Investment Trusts (REITs)The equivalent from an investors perspective is the Australian Listed PropertyTrust (LPT).

The only real estate investment opportunity listed at German stock exchangesis the German Property Share (GPS).

HISTORY

REITs were created with the passing of the Real Estate Investment Trust Act byCongressin 1960.REITs were constrained because they were only permitted to own real3

estate, not to operate or to manage it.

The TaxReform Act of 1986 changed the real estate investment landscape in two importantways.This MADE SURE THAT REAL ESTATE investment had to be economic andincome-oriented andThe Act permittedREITs not only to own, but also to operate and manage most types of income-producingcommercial properties.REIT industry analysts often classify REITs according to one ofthree investment approaches:

Equity REITs own real estate. Their revenues deriveprincipally from rent.Mortgage REITs loan money to real estate owners. Theirrevenues stem principally from interests on their mortgage loans. Some mortgageREITsalso invest in residuals of mortgage-based securities.Hybrid REITs combine the

investment strategies of both equity REITs and mortgage REITs.

Some REITs invest in a variety of property types: shopping centers, apartments,warehouses, office buildings,hotels, etc. Other REITs concentrate on one property type only, such as shoppingcenters


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or factory outlet stores. Health care REITs specialize in health care facilities:hospitals,including intensive care, rehabilitation and psychiatric, medical office buildings,nursinghomes, as well as congregated and assisted living centers.

the Australian LPT sector began after an economic collapse had a disastrousimpact on unlisted property trusts in the mid 1990s. Most of the new activityemanatedfrom restructured and revalued previously unlisted property trusts which were thenlisted at

the Australian Stock Exchange.investors withdrew capital from unlisted

property trusts and invested in the listed property market that was dominated bytrustsinitially established by property development companies to serve as a source offinancing.The LPT market can be divided in diversified and specific trusts. Trusts seeking toavoidcyclical fluctuations in their unit prices may diversify their portfolio by owningproperties inseveral categories. Specialization takes place in retail, office, industrial, commercialorleisure and tourism properties in a variety of locations.

The majority of GPSs stem historically from the discontinuation and liquidation of thecorporations original business operations. The remaining property portfolio was thestarting point for the new property company. German real estate corporationsoriginatefrom such business as breweries, textile companies and mining companies.

For the sakeof simplicity three types of real estate business types can be-realestate investment, real estate development, real estate services.

The fields differ greatly inthe type and structure of sales, costs, and risk incurred. So far, there are noexclusiveservice/development corporations to be found on the market, rather companies areeither investment types or they combine different types within one corporate shell.


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LEGAL FORM

All three investment opportunities represent regular share certificates issued by alegalentity. Australian LPTs and US REITs can considered counterparts.REITs and the LPTs

both feature a tax-exempt status.

REITs can be modelled as corporations, business trusts, or associations

Whereasthe Australian vehicle is limited to the legal form of a trust.

In the past, German legislation has been postulating funds as the model investmentinstrument for real estate. Consequently, promotion of Property Shares has beenconducted rather timidly in the past time and capital was invested in funds which areneither listed nor does there a secondary market exist. Property Shares are the onlylisted

real estate securities in Germany but it cannot be considered as the exact equivalenttoREITs or LPTs.Specific requirements regarding dividend policy, ownership structure, andcompulsory disclosure, as well as tax benefits do not apply for the Germaninvestment vehicle.German Property Companies have the legal form of a corporation. Consequentlythey are only subject only to German Stock Corporation Law which is in the case ofrealestate not different from that of any other corporation.

NUMBER, CAPITALISATION, AND DIVERSIFICATION

Since 1986, the vast majority of REITs has been listed at the stock exchange.2 Non-listed existing partnerships which own real estate can pursue an IPO in the specialform of an Umbrella Partnership REIT (UPREIT) since 1992. Compared to theirAustralian and German counterparts the total market capitalization of REITs is hugeOnly the Equity-REITs (97% of all REITs).

The US REITs must comply with the provision of the Internal Revenue Code toqualify forthe tax-exempt status.Two of these regulations have a direct effect on liquidity. Firstly, theREIT has to have a minimum of 100 shareholders.Secondly, no more than 50 percent ofthe shares can be held by five or fewer individuals during the second half of eachtaxableyear. This regulation leads to an increased liquidity compared to GPSs.

The tendency to enlarge their size is


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accelerated by an institutional demand for liquidity and lower costs of capital.In contrast to the majority of US REITs, the tradability of existing German real estatecorporations appears restricted due to the comparatively low market capitalizationThis also represents one percent of theGerman market capitalization. Furthermore, many companies are characterized by a

relatively small free-float which still represents the historic roots of privately ownedproperty management firms.

Specialised companies focus mainly on residential property .A distinctive characteristic of the German market that is dominated by a smallnumber ofvery large corporations.In addition to the top three corporations, which are characterized by a highcapitalizationand a homogenous investor structure, there exists on the one hand a small numberof

corporations with high capitalization and a diversified investor structure, andon the other hand the investor is confronted with a large number of corporations withlowcapitalization and a homogenous investor structure.

TAX ASPECTS

The US REITs are granted an special tax exempt status. This refers to the USspecificdouble taxation on the corporate and individual level.On the corporate level a REIT canevade taxation on dividends paid to the shareholders. To retain this status a REIT

has tofulfil certain requirements from the second year of its taxation on.A REIT does not have topay corporate tax as long as75% of the company's assets are composed of real estate held for the long term,75% of the company's income is derived from real estate,a maximum of 50% of the shares is held by maximal five individuals like mentionedabove, and7

the company pays out at least 90% of its taxable income to shareholders.6The last criterion makes a REIT a clearly income-oriented investment instrument.

Australia offers a similar tax advantage for LPTs. The trust structure allows todistributepre-tax profits to investors. Although the trusts are regarded as separate entities fortaxpurposes, they are not taxable if the beneficiaries (investors) are entitled to the entiretaxable income of the trust. The beneficiaries themselves are subject to tax on theirproportionate share of the trusts taxable income which includes both income andcapitalgains.


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when calculating their taxable income, trusts,as non tax paying entities, cannot profitfrom tax deductions such as depreciation.

[GPSs] the German tax system already includes a general rule which allows to

deductthe corporate tax, paid on distributed dividends from the private income tax on thedividend. But as this is not a specific law that applies to Listed Property Companiesthey cannot profit from a comparative advantage when being compared to otherinvestment.

MANAGEMENT AND TRANSPARENCY

REIT's investments are determined by its board of directors or trustees. Directors areelected by, and responsible to, the shareholders.In turn, the directors appoint themanagement personnel. REITs management is periodically reviewed by the REIT's

boardof directors. REITs can be either internally managed or externally advised.

LPTs organisational structure is similar to that of REITs. A board of directorsperforms thesame functions as in REITs. LPTs are managed by Trust Responsible Entities (ormanagers)

the management of German PropertyCompanies consists of a management board and a supervisory board. The latter iselectedby the shareholdersAccording to German law members of the supervisory board must not be personsfrom themanagement board. That means that in contrast to REITs not even the minority ofdirectors can be involved with the management.

CONCLUSION

The market for US REITs is the most developed one due to its high transparency,

liquidity,and market capitalization. It features the highest specialization and therefore it offersbestchances for investors to diversify.From the legal and the tax perspective Australian Listed Property Trusts are similarto USREITs. Nonetheless they are characterized by a lower transparency when it comestopassing on information to investors and to management control. Their size and theirdegrees of specialization are not as high as that of their US counterparts but it isclearly

higher that of the German market.


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The German instrument is fundamentally different from US REITs and AustralianLPTs:. The average size ofthe property companies is the smallest of the three countries.Specialization is still very low

and in its beginning. Hence, the GPS is a less flexible investment instrument forportfoliodiversification...

T h e s t r u c t u r e a n d p r o v i s i o n o f s p e c u l a t i v e d e v e l o pme n t

f u n d i n g i n t h e 19 9 0 s

NEW DEVELOPMENT FUNDING TECHNIQUES IN THE

1990s: A CASE STUDY APPROACH

this paper is to demonstrate that the development financing and funding market

has evolved in the 1990's, to provide more sources and techniques of funding speculative

developments, than merely Institutional funding.

Traditional Development Funding

Traditionally the developer borrows project finance from a bank on a short term loan

secured

against the completed property and provides staged payments on the building.

This may be done by entering into a long debt or equity arrangement.

This was due mainly to:

1. Banks, and particularly overseas banks, attracted into the market by comparatively

high margins and the relative safety of a physical asset backing the loan.

2. Increasing risk limitation devices for debt facilities, including syndication for large

schemes, treasury instruments such as caps, collars, swaps and forward rate

options to hedge the risk of floating interest rate charges.

Case Study

The Developers DilemmaThe dilemma for the developers in the 1990's has been that they have demonstrated the skillto identify good development opportunities such as the above site, but lacked the financialresources to undertake the project.


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Institutional Forward Funding.

Speculative Bank Finance.

Forward Sale Commitment.

The relative characteristics, advantages and disadvantages of each method are summarised

as follows. The purpose of the summary is to demonstrate the division of financial risk and

reward between the developer and fund.

1. Institutional Forward Funding

This method involves a fund committing itself to purchasing the scheme on completion, at

which point any residual profit inherent in the scheme is divided equally between the

developer and the fund. This is calculated by applying a multiplier to the annual rent

achieved on letting of the scheme to a tenant and deducting the costs of the development.

The provider of finance for the development is the institutional fund and this technique was

arelatively common approach, adopted by funds during the 1980's and during the early

1990's.

The Developers Position - (Low Risk)

If the scheme is successfully let on the anticipated terms, then the developer may receive

50% of the development profit, which equates to approximately 2,784,000, without

actually

putting any of the developers capital at risk.

The Funds Position - (High Risk)

The advantage to the fund is that it can purchase a prospective investment at a lower price

(often by as much as 30%), than it would if the development were already up and let. This isbecause the purchase price that a fund is willing to pay for a speculative development is less

than an up and let development, because there is less certainty about the eventual letting

terms that will be achieved. This will directly affect the return on their funds invested in the

project.

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The overall risk of the development remaining unlet, is borne by the fund which pays for the

development costs. In the above example It will total approximately 18, 490,000 of

development costs, if the scheme is up and let within three years from completion. The

developer bears almost no financial risk in this scenario.

Availability - (Scarce)Few funds have the resources to commit to a speculative development of this size; those

that do often would rather retain all the profit and therefore undertake the development

themselves. In reality therefore, there are few opportunities for a developer to secure a full

forward funding offer from a fund.

2. Speculative Bank Finance

In the late 1980's the banks offered limited or non recourse finance to developers on a

project specific basis. This involved bank lending money to pay for the development costs

for

which the bank received interest on the debt. This interest along with the capital borrowed

was repaid in full by the developer out of the sale profits, once the scheme was up, let andsold.


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The Developers Position - (High Risk)

The advantage to the developer was that even though the bank charged interest on finance

at a higher rate than a fund, (and therefore the prospective development profit was

marginally lower), the developer could reap the full development profit without sharing it

with

a fund. Furthermore, the completed and let building could now be sold as a less risky

investment to a fund. A higher purchase price was therefore likely to be paid by a fund, to

reflect the lower investment risk inherent in a completed income producing investment.

Typically, this meant a higher development profit by as much as an extra 30%, all of which

would be received by the developer. However, the developer bears the liability to repay the

loan even if the building remains unlet.

The Banks Position - (High Risk)

In theory, the risk to the developer was that, if the development was unsuccessful, then the

developer would be liable to repay the debt to the bank in full. In practice, if the developer

was unable to afford this, the real risk was borne by the bank. When a development failed

tosecure a tenant, it was usually due to a general downturn in the market and any assets

relied

on by the bank as security against the debt, generally fell in value at the same time. The

usual consequence was that the bankwas left to complete the development and lose its

prospective interest payments as well as probably having insufficient capital cover to

recover

the principal outstanding. The fund which purchased the up and let investment bore little

risk

in this scenario.

Availability - (Scarce)Currently banks will not lend money on speculative development except in exceptional

circumstances.

3. Forward Sale Commitment

This technique is a hybrid between the full forward funding technique and the speculative

bank finance technique. It involves a fund committing to purchase a development once

completed whether or not a tenant has been secured.

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The Developers Position- (Low Risk)

If the development is let within the anticipated timescale then the developer will share a

profitwith the fund in the same way as the Full Forward funding technique. However, the fund

does not offer finance for the development and the developer has to arrange this through a

bank which will usually charge a higher rate than a fund would charge, which creates a

slightly lower profit to the developer if the scheme is up and let within the anticipated

timescale.

The Financiers Position - (Low Risk)

The bank does not bear the development risk as the fund has committed to pay the

developer the full development costs incurred, who is therefore in turn, able to repay the

bank. The developer bears some risk as it is necessary to ensure that the development costs

do not exceed the purchase price that the fund has guaranteed to pay. However, it is thefund who once again bears the full risk of development, in this scenario.


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The Funds Position - (High Risk)

Therefore, given the reasons just cited , there are likely to be few institutional funds

available

for a developer to secure for this speculative development project.

Availability

At the time that the case study development site was being marketed there were no

institutional funds willing to accept the inherent risks of the prospective speculative

development, and many banks were still trying to recover bad property debts. The

development funding and finance options available to the developer therefore seemed very

limited.

A Different Approach to Sharing Development Risks and Rewards:

The Risk Sharing Approach

the apparent causes of why the case study development did not

appear to be attractive to a lending bank or an institutional fund. The following table

summarises these reasons:

The Vendors Position

What this does not express is that, if the developer is unable to fund the development then

the chances of selling the site are severely diminished. Therefore, there is an implied benefit

to the vendor in finding a solution to distributing the inherent risk of speculative

development

more acceptably amongst the developer and fund.

One such method, which seeks to adopt this rationale is the Risk Sharing Approach which

is summarised as follows.

The developer pays for 50% of the site value at day one.

The vendor receives the other 50% of the site price on the successful sale of the

development.


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A financier provides a guarantee to purchase the development at the cost of the

development excluding the land.

The developer raises the bank debt backed by a guarantee from the Financier that

the development costs would be met in full by the Financier if called on to do so by

the developer.

The developer shares the development profit, equally with the vendor.

The prospective profit however, is based on a sale at the full up and let yield,

assuming the project achieves a letting and sale as anticipated.

The Vendor And Developers Position - (Medium Risk)

The risk to the developer and the vendor is that their site equity will not be paid to them

by

the Financier, as the financier is only guaranteeing to pay the costs of the development and

not the land price. The advantage to the them is that they both stand to receive the majority

of the development profit, which is enhanced due to the ability to sell at the up and let

yield.

The typical Financier will almost undoubtedly be a company with a very high credit ratingwhich will enable bank finance to be raised at almost the same rate as likely to be offered by

a fund.

The Financiers Position - (Medium risk)

The Financier is underwriting the bank loan which is a substantial amount of capital, but it is

less than the full costs as it excludes the land purchase price. This method is therefore less

risky than the full forward funding approach is to a fund. If the developer does call on the

financier to pay the bank loan in full, then the financier receives the benefit of owning a

building at the cost of the development, which does not include the land value. Therefore,

the financier owns an asset with a latent value in it which can be further enhanced on

lettingof the premises. Furthermore, the relatively cheap purchase price paid by the financier

generates a development with a profit erosion period, (the period of time before the

development becomes irreconcilably unprofitable), for a further period of four years. This in

excess of the initial three year void assumption contained in the developers original

appraisal.

Availability - ( few sources)

There are currently few sources of this type of financial underwriting, but those that do

offer

the facility tend to have very large cash resources.

7Conclusion

The different traditional development funding techniques, in theory, offer the developer a

range of funding options enabling the developer to undertake developments. However, in

practice, the sources of finance for these techniques has not been readily available in the

1990's. There has been a need to create more innovative techniques which address the

imbalance between the excessive development risks that both the funds and the banks

adopted in the late 1980's.

One such method has been outlined in this paper which seeks to address the risks which

have contributed to causing the dearth of development funding and finance. The technique

has been successfully employed in a number of developments in the UK and developers aregradually becoming more aware of its availability. The evolution of development funding


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techniques shows that it is often near the peak of a market that the funds follow the

innovators, but usually given that point in the market cycle, those funds do not achieve the

same success that the innovator achieved. However, the above technique seems to

minimise the loss that each party to the development can incur, by sharing the inherent risk

in a development. The capital implications of this are quite stark and are summarised below:

.

SECURITIZATION IN THE 1920'S

In particular, this paper quantifies the size of the market, identifies risk factors affecting the

coupon yield spread over Treasuries and utilizes a unique data set to construct a commercial

mortgage price index over the period 1926-1935.

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