Funding Real Estate Development: WB/IFC Housing Finance Conference Washington, D.C. March 15 – 17,...

Funding Real Estate Development:Funding Real Estate Development:

WB/IFC Housing Finance ConferenceWB/IFC Housing Finance ConferenceWashington, D.C.Washington, D.C.

March 15 – 17, 2006March 15 – 17, 2006Michael BookstaberMichael Bookstaber

Real Estate Investment Trusts

March 2006March 2006 22

What is a REIT What is a REIT (1)(1) ? ? An Investment ClubAn Investment Club

Needing cash in big, irregular increments, not a steady stream of Needing cash in big, irregular increments, not a steady stream of cash flowcash flow

Can be open ended or closed endedCan be open ended or closed ended Vertically integrated: property development, property management, Vertically integrated: property development, property management,

and portfolioand portfolio

Sources of Funds:Sources of Funds: Capital markets, equity subscriptionsCapital markets, equity subscriptions Private investorsPrivate investors Little or no debt (“equity” REITs)Little or no debt (“equity” REITs)

Uses of Funds:Uses of Funds: Buys land and develops projects, rents out unitsBuys land and develops projects, rents out units Expenses in staff costs are minimalExpenses in staff costs are minimal Expenses for property management are incremental costs to the Expenses for property management are incremental costs to the

hard asset.hard asset.

MBookstaber

A Reit is an investment vehicle for large scale and big-ticket property development and ownership.A REIT needs cash in increments, not in a steady flowIts funding is used primarily for property development. This means buying land, investing in soft items such as archetecture, urban design, permitting and approvals, engineering and quantity specificiations and the like, and doing the development and leasing out or renting out units.Basic sources of funds are equity subscriptions if the REIT is traded or capital calls if it is closely held. The variety of REIT that most suits residential real estate development is equity REITs. Typically, the hold little or no debt of their own, although individual properties would have mortgages.The uses of funds are for land acquisition and project build out. Expenses of running the REIT and expenses for the property management function are small compared to cash needs for development, and these operational expenses are an offset to rental income.


What is a REIT What is a REIT (2)(2) ? ? The balance sheet consists of The balance sheet consists of

Investment in developed properties on the asset side, and Investment in developed properties on the asset side, and Equity capital on the liability sideEquity capital on the liability side

Profitability, measured by two items:Profitability, measured by two items: Cashflow from operations: equals….Cashflow from operations: equals….rents less: (a) cost of property rents less: (a) cost of property

maintence. (b) payments on any mortgage debt, (c) staff expensemaintence. (b) payments on any mortgage debt, (c) staff expense Gains from sales of (matured) propertiesGains from sales of (matured) properties

Staff costs are minimal because Staff costs are minimal because REITs outsource many key functions: property maintenance, project REITs outsource many key functions: property maintenance, project

management of development of new propertiesmanagement of development of new properties Property management function is highly leveraged, similar to Property management function is highly leveraged, similar to

mortgage loan servicingmortgage loan servicing

As a result, REITs don’t need to retain “earnings”, they do need As a result, REITs don’t need to retain “earnings”, they do need access to large pools of cash on an intermittent basisaccess to large pools of cash on an intermittent basis

MBookstaber

The Balance sheet of a typical REIT would show value of properties on the asset side and capital on the liability side.Profitability is measured by two items: cashflow from operations: namely all rental income less expenditures on property maintenance, mortgage debt and staff expense, AND gains from sale of properties,when management judges that they have "matured"REITs typically have small staffs because key funcitons like property development are outsourced. In addition, property management is highly leveraged, relying on standard procedures and technology to achieve high productivity. In this sense, it is very similar to mortgage loan servicing.


The DisconnectThe Disconnect

Mortgage finance and property development Mortgage finance and property development are out of synch:are out of synch:

Lack of Affordable and Bankable Housing Solutions(supply/demand imbalance)

Mortgage markets are under-developed due to scarcity of housing

stock

Developers not producing due to lack of long term mortgage takeout

MBookstaber

In many emerging market economies, particularly in many countries of Sub-Saharan Africa, there is a disconnect between mortgage markets and property development.By this I mean a standoff or a logjam. Because mortgage markets in many of these countries have been inoperative for so long, the invisible hand of the free and unfettered market place has responded in kind: property developers have mostly gone where mortgage finance is operating. In order to get mortgage markets operating again, developers must begin to produce banakable homes. But developers will hestitiate to re-enter moribund markets until mortgage money starts flowing.Our strategy is these markets to is to address both side simultaneously.


The NeedThe Need Investment in real estate developmentInvestment in real estate development

Needs patient, long-term capitalNeeds patient, long-term capital Can be highly risky, calling for equity-like returnsCan be highly risky, calling for equity-like returns Requires a focus on property type to leverage Requires a focus on property type to leverage

experience and expertise of managementexperience and expertise of management

Capital is needed forCapital is needed for Land acquisitionLand acquisition Land developmentLand development Funding soft costsFunding soft costs In-site infrastructureIn-site infrastructureThese expenses typically comprise 35 to 50 percent of These expenses typically comprise 35 to 50 percent of

total project coststotal project costs

MBookstaber

So, to complement efforts in mortgage market development, there is a strong need for investment in property.These investments, similar in many respects to ideal funding for mortgage lending, are long-term in tenor. However, investors must also be patient. They must be willing to wait for developed properties to become leased up and mature.In addition, since this kind of investment can be very risky, investors must be courageous and be rewarded with equity-like returns.


The ProjectsThe Projects Large scale, expensive to executeLarge scale, expensive to execute Commercial income-producing propertiesCommercial income-producing properties Residential, community formatResidential, community format

1.1. Large scale projects (1,000 housing units or more) delivered in rational production Large scale projects (1,000 housing units or more) delivered in rational production stagesstages

a.a. Achieve economies of scaleAchieve economies of scale

b.b. Utilize mass production techniquesUtilize mass production techniques

c.c. Spread cost of infrastructure over many housing units, financed in the mortgageSpread cost of infrastructure over many housing units, financed in the mortgage

2.2. World class urban design, incorporatingWorld class urban design, incorporating

a.a. mix of housing styles and options, mix of housing styles and options,

b.b. mix of socio-economic groups, mix of socio-economic groups,

c.c. providing for quality of life amenities, green areas, recreation and community facilities, providing for quality of life amenities, green areas, recreation and community facilities,

d.d. retail and commercial spacesretail and commercial spaces

3.3. Ongoing support services will be incorporated into each project:Ongoing support services will be incorporated into each project:

Waste management, Maintenance of common areas, securityWaste management, Maintenance of common areas, security

CONCLUSION:CONCLUSION: Value of housing will be perserved and enhanced by Value of housing will be perserved and enhanced by design and urban planning, ensuring good storehouse of value for design and urban planning, ensuring good storehouse of value for lenders and homeowners (avoiding the creation of future slums)lenders and homeowners (avoiding the creation of future slums)

MBookstaber

The kind of projects we are talking about are large-scale, comprising 1000 or more units. They feature world class design, and a full range of community amenities. Large scale is important in order to achieve economies, and bring higher affordability, in both production of units and ongoing property management.If the investors can pull it off, homeowners, mortgage lenders and developers/real estate investors all win, both today and in the long-run.


The ProblemThe Problem

Investment vehicles to effectively fund and Investment vehicles to effectively fund and manage projects are typically not available manage projects are typically not available in developing markets. in developing markets. WhyWhy??

Absence of long-term capitalAbsence of long-term capital Governmental investment in urban planning and Governmental investment in urban planning and

in big-ticket infrastructure is often lacking in in big-ticket infrastructure is often lacking in developing marketsdeveloping markets

Nascent equity marketsNascent equity markets Reluctance to use tax policy to foster investmentReluctance to use tax policy to foster investment

MBookstaber

What's wrong with this picture?They key pieces of the puzzle are typically not found in many emerging market economies.These pieces are: (1) long-term capital, (2) investment (typically by government) in long-term, visionary urban planning, and in big-ticket infrastructure, like roads, utilities and transport,(3) under-developed equity markets, and (4) a reluctance by governments to use tax policy to at least jump-start, if not foster these kinds of investment.


The SolutionThe SolutionReal Estate Investment Trusts (REITs, USA-style)Real Estate Investment Trusts (REITs, USA-style)

Attract long-term, patient capitalAttract long-term, patient capital

Offer specialization by property typeOffer specialization by property type

Offer development and on-going managementOffer development and on-going management

Tax pass-through feature offers dividend-like returns to Tax pass-through feature offers dividend-like returns to investors and equity-like upside of a medium to long-term investors and equity-like upside of a medium to long-term horizonhorizon

Attract investors who need current income and can Attract investors who need current income and can shelter it for tax purposesshelter it for tax purposes

Attract total return investors who benefit from upside Attract total return investors who benefit from upside stemming from turnover of value-enhanced propertiesstemming from turnover of value-enhanced properties

MBookstaber

Equity REITs can be a viable solution.They offer many of the needed features for successful production of quality and bankable real estate, as well as for its ongoing viability.Key among these features is a tax-passthrough feature that have cause the US REIT industry to blossom.In short, if REITs pass along to their investors 95 percent of cash flow from operations, these earnings are taxed only at the individual investor level. This avoids double-taxation, and improves the economic returns to investors. So, REITs will dividend out their current earnings, giving investors a steady, predicatable yield. This is why REITs typically are valued and trade like a fixed income investment, yet imbedded in the value is the upside stemming from property appreciation.


The REIT WorldThe REIT WorldThe REIT concept is gaining acceptance around the world, in

many developed countries, but also some emerging markets….

CountryCountry Year IntroducedYear Introduced

Asia-Pacific

Australia 1971

Hong Kong 2003

Japan 2000

Korea 2001

Malaysia Late 1980’s

Singapore 2002

Taiwan 2003

Latin America

Mexico 2004

Brazil 1993

CountryCountry Year IntroducedYear Introduced

Europe

Belgium 1995

France 2003

Germany 2006

Italy 1994

Luxembourg 1988

Netherlands 1969

Spain 1994

United Kingdom 2006

North America

Canada 1994

United States 1960


The RationaleThe Rationale

Why are REITs the right investment Why are REITs the right investment vehicle for real estate development?vehicle for real estate development?

PRINCIPLE ONE: Value enhancement comes from refurbishing old properties or creating new properties, and managing either until cash flow is established.

PRINCIPLE TWO: Dividend yield from REITs is a payout of current cash flow, which does not need to be retained.

• maintenance of properties is an expense item offsetting rental income• cash from creation of new properties is obtained from selling mature properties

in portfolio or raising new equity from investors.

CONCLUSION: Fixed income and medium to long-term upside combine to give investors a unique total return package, WHICH IS A GOOD PROXY FOR DIRECT INVESTMENT IN REAL ESTATE

MBookstaber

The key to understanding the inherent logic of REITs are the following two notions:One....value added comes from creating new or refurbished income-producing propertiesTwo...dividend payout makes cash flow sense, since the real estate investment business doesn't need to hold onto current income.As a result, the REIT as an investment vehicle is an excellent proxy for actually owning properties, with none of the sweat.


The RiskThe RiskReal estate development can be risky, yet Real estate development can be risky, yet

REITs can offer risk mitigating features:REITs can offer risk mitigating features:

Equity REITS use little or no debt, except for construction finance

Focus on property type, leveraging management experience and expertise

Diversification in funding sources stemming from either: pooled investment from a closed group of investors sale of stock to many, diverse individual shareholders

Diversification in multiple property investments

Income is generated from income produced via rents, fees from management of properties, and capital appreciation of properties

MBookstaber

Yes, real estate development is a highly risky business, but ordinary people can participate.In addition, the REIT vehicle can offer other valuable mitigating features such as diversification and professional management.You can read the slide for details.


The Tax AngleThe Tax Angle

Under U.S. REIT law:Under U.S. REIT law:

Payment of tax on REIT net earnings occurs Payment of tax on REIT net earnings occurs only once, at the shareholder level, not at only once, at the shareholder level, not at the corporate level…the corporate level…

……provided that the REIT distributes at least 90 provided that the REIT distributes at least 90 percent of its net income in dividends to percent of its net income in dividends to shareholders. shareholders.

How critical is this tax “break” to the successful use of REITs as investment vehicles for real estate development?


The Tax “Break” ValueThe Tax “Break” Value

WITH THE TAX “BREAK”…WITH THE TAX “BREAK”… Pension funds (not taxable) can boost their investment yields Pension funds (not taxable) can boost their investment yields

using REITs. Real estate development thus draws on a using REITs. Real estate development thus draws on a significant pool of long-term investment fundssignificant pool of long-term investment funds

Listed REITs add additional value of liquidity, thus becoming a Listed REITs add additional value of liquidity, thus becoming a form of securitized real estate. Their trading value is form of securitized real estate. Their trading value is determined by dividend yield.determined by dividend yield.

REITs represent an efficient use of capital REITs represent an efficient use of capital by taxing returns only onceby taxing returns only once earnings from investment in income-producing properties is earnings from investment in income-producing properties is

recycled immediately, not warehoused for new projectsrecycled immediately, not warehoused for new projects..


The Tax “Break” ValueThe Tax “Break” Value

WITHOUT THE “TAX BREAK”… Encourages short term holdings in long-term assets.

Encourages property development and divestiture before properties have matured, or before they have started to generate income.

Long-term investors are disuaded from participating due to quick property turnover

REITs of this type will undertake more risky investments, stemming from quick turnover.

Funding Real Estate Development: WB/IFC Housing Finance Conference Washington, D.C. March 15 – 17,...

Documents

Transcript of Funding Real Estate Development: WB/IFC Housing Finance Conference Washington, D.C. March 15 – 17,...