Lecture 3 Revision - Important Concepts

Real Estate Ownership Structures Pt2

INDIRECT OWNERSHIP STRUCTURES

Investor types: Wholesale

Wholesale Investor Types:

• Sophisticated investor:
  • Deemed to have sufficient investing experience and knowledge to weigh the risks and merits of an investment opportunity.
    • Net assets of at least $2.5m or;
    • Gross income for each of last two financial of at least $250,000
• Professional Investor:
  • Australian financial services licensee;
  • A body regulated by APRA outside of Superannuation;
  • A body registered under the Financial Corporations Act 1974
  • Trustees of superannuation funds with assets >$10m

Wholesale Funds: Overview:

• Institutional investors make investments to wholesale funds based on a view that unlisted private equity format accurately represents the true returns of the underlying real estate assets
• Wholesale unlisted property trusts are aimed at institutional investors
  • Predominantly AU superannuation funds or foreign pension and sovereign wealth funds
  • May include Ultra High Net Worth Individuals

Clubs/Mandates

• e.g. selling the national broadband network. Mandate might come together to create a management vehicle (fund) under a mandate to acquire a particular fund
• Bring in people that have particular skills. Some funds want to partner with entities that have expertise

Syndicates

Fund investment strategies

Core

• Primarily invest in:
  • Stabilised existing properties
  • Current cash flows
  • Low vacancy
  • Located in major metropolitan areas
• Invest in a wide variety of property types
• Use limited leverage - low risk

Core Plus

• Core plus properties can be a minor component of core fund:
  • Core assets in need of minor improvements
  • “a B property in an A location”
  • Core property that includes current undeveloped land

Value Add:

• Take on more risk by purchasing properties which:
  • Carry current vacancies
  • Have upcoming major tenant rollovers
  • In need of renovation and capital outlay
• Funds create value by renovating and leasing up the property
• Use more leverage compared to core plus

Opportunistic

• Take on even more risk by doing ground up development projects
• Expose the fund to additional construction risks:
  • Entitlements
  • Construction delays
  • Cost overruns
  • Complex JV management issues, etc.
• High degree of financial leverage
• May be less diversified and concentrate in certain geographic areas or property types
• Strategy may involve purchasing “distressed property assets”

A-REIT

• A Real Estate Investment Trust (REIT) is an investment vehicle that allows investors to purchase an interest in a diversified and professionally managed portfolio of real estate that is listed on the stock exchange.
• A-REITs were established to allow investors to gain exposure to high-grade real estate both domestically and offshore, without the need for large levels of capital, and with the addition of liquidity.

REIT characteristics

• Legal Form
  • No specific REIT rules in Australia - can be listed or unlisted
    • May be sector specific or diversified
  • Corporations Act states a REIT must be registered as a Managed Investment Scheme
• Capital Requirements
  • No capital requirements for a REIT if listed (but must meet ASX requirements)
  • Capital requirements for a manager
• Listing Requirements
  • No listing requirements – REITs can be listed or unlisted
• Restrictions on investors
  • No investment restrictions on investors
• Restrictions on foreign assets
  • No restrictions on foreign assets
• Distribution requirements
  • Undistributed income on gains taxed at 46.5%
    • gains are taxed at your prevailing personal tax rate
  • Full distribution of income and gains by REITS generally occurs

REIT Distributions

• Trusts distribute 90% to 100% of earnings
• AREIT trusts do not have franking credits – income is not taxed at trust
• Distributions taxed at the individual income tax rate
• REIT distribution includes a tax deferred component
• Tax deferred component – represents the return of capital rather than income
  • Plant and equipment depreciate which reduces taxable income - can be distributed to beneficiaries of the REIT - can get some of the capital back too
• As REITs collect income – manager can decide if the payments made to investor are income collected or capital invested

A-REIT forms

• Broadly speaking, A-REITs comprise one of two forms:
  • Externally Managed (passive); or
  • Stapled (active).

RHS:

• investors put money into the trust
• trustees purchase properties and hire a manager
• entity managing the property is not necessarily the same as the trustee that owns the property

LHS:

• unit holder holds shares in the trust and the management company
  • have an equity position in the company also
• unit in the trust, and shares in the management company
• most common

Stapled securities

• Some trusts adopt hybrid structures called ‘stapled securities’ funds.
• Stapled securities A-REITs provide investors with exposure to a funds management and/or a property development company, as well as a real estate portfolio.
• A share in a stapled securities fund usually consists of one trust unit and one share in the funds management company.
• These securities are ‘stapled’ and cannot be traded separately.
• The trust holds the portfolio of assets, while the related company carries out the fund’s management functions and/or manages any development opportunities.

Externally Managed model:

• Management taken on by separate entity to the property trust
• Slowly collapsing over time
• Often conflicts of interest between management and trust
• Can provide better resourcing and management services than some REITs have capacity for

Modern Portfolio Theory

Capital Return

The change in capital value of an investment over a holding period as a percentage between any change in capital value and the purchase price or value at the beginning of the measurement period.

Capital Return=

$$\frac{CV_{1} - CV_{0}}{CV_{0}} \times 100$$

Income Return

• Net income over the measurement period divided by the purchase price or capital value at the beginning of the measurement period.

Income return =

$$\frac{NI}{CV_{0}} \times 100$$

Total Return

Percentage relationship between any capital gain or loss and income over the capital value at the beginning of the measurement period.

• True return to the investor on their money.

Total return =

$$\frac{CV_{1} - CV_{0} + NI}{CV_{0}} \times 100$$

CV = capital value at the beginning of the measurement period CV1 = capital value at end of the measurement period NI = net income received during the period

Initial Yield and Reversionary Yield

Initial Yield

• The income yield for the asset. Shows the ratio of the current passing rent to the current property value
  • IY = passing rent / property value
  • passing yield - how much rent I am currently versus from the current property value

Reversionary Yield

• The market yield for the asset. Shows the ratio of the market rent to the current property value (on properties rented below market)
• RY = market rent / property value

Example A property is valued at $2.5m and has a current net income of $150,000 p.a. The assessed market income for the property is $175,000 p.a. Compute the initial yield and reversionary yield for the asset.

$$IY = \frac{\$150,000}{\$2,500,000}$$

$$RY = \frac{\$175,000}{\$2,500,000}$$

Asset Yields vs Asset Returns

• Yield reflects the relationship between a current net income and the purchase price and does not take into account any capital loss or gain made.
• Return usually reflects any income, expenditure and/or capital gain or loss made on investments.
• Return gives a clear indication of the financial position of the investor.
• Yields are used to estimate the market value of an investment while a return is used as a means of comparing the financial attractiveness of different investments to an investor.

Portfolio returns

• Return is a weighted average of expected return on each asset.
• Consider two assets with weights, w 1 w 2 and returns r 1 r 2 .

Portfolio return:

$$r_{p}=(w_{1}r_{1})+(w_{2}r_{2})+...$$