Practice Problems and Solutions - Topic 11 - REITs
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Real Estate Investments
Prof. Sinai
1
FNCE/REAL 7210: Practice Problems
Topic #11: Equity securitization and the REIT market
1. FFO
You are the CFO of a REIT that generates $5,000,000 per year in revenues, and are trying to
decide on your policy for managing reported funds from operations.
You understand you have
some flexibility, and are trying to decide how to allocate expenses to operating expenses and
capital expenses.
In the 7 years that your company has been public, you have always had
$1,000,000 in operating expenses and $1,500,000 in capital expenses.
Once again, you
anticipate $2.5 million in
total expenses.
Other information about your company:
The properties in the REIT were acquired 7 years ago for $35,714,000; $11,905,000 of
the acquisition price was attributable to land.
You anticipate $300,000 in gains from sales of property this year.
When you acquired the properties in the REIT, you financed 50 percent of their value
with a 6.5 percent mortgage, with a 30-year amortization schedule.
The structures and all capital expenses are depreciated/amortized over a 39-year
lifetime.
a)
What is the annual debt service on the mortgage?
b)
How much of this year’s debt service payment is interest?
c)
What will be the total depreciation deduction for capital expenses this year?
d)
Compute this year’s FFO.
e)
How much cash will you be able to retain this year if you stick to your historical
allocation of capital and operating expenses and pay out as little as required by the REIT rules?
f)
Assume that you have complete (and costless) flexibility in how you allocate expenses
to capital or operating expenses.
How much of the capital expenses should you reallocate to
operating expenses to make your REIT cash flow positive this year?
g)
What would your FFO be if you made that reallocation?
Real Estate Investments
Prof. Sinai
2
2. FFO and Retained Cash
You are the CFO of a large office REIT that will generate the equivalent of $1000 million in
effective gross income this year. You anticipate that at the end of the year you will need to have
retained $100 million in free cash flow to use next year. You are willing to pay out any excess
free cash above that amount in the form of dividends to shareholders. You have $100 million of
debt payments this year, all of which are interest-only.
a) Of your $400 million in expenses you will have this year, your accountants tell you that some
of that can be allocated to either the operating or capital expense categories. Your depreciation
deduction from previously accumulated depreciable basis will total $200 million this year. In
addition, you will depreciate any part of the $400 million expenses that you claim as "capital"
expenses. Your depreciation lifetime on all capital spending is 39 years. Given that you need to
retain $100 million in free cash flow, how much should you allocate as "operating" and "capital"
expense?
b) The REIT analysts who follow your stock have projected that you would achieve FFO of at
least $600 million this year. How will your FFO compare to their forecasts if you follow the
allocation you chose in (a)? Assume you received $100 million from selling properties this year
and you have no unconsolidated interests.
3. Getting to ATCFs for a REIT vs. a C-Corp.
Sarah Conner received her MBA from Wharton in 2000 with a dual major in Finance and Real
Estate.
Drawing on her real estate expertise, she started a company called Real Estate Education
Centers (“REEC”), which provides real estate classes throughout the United States.
Conner’s
real estate classes have proven to be so popular with the general public that her company has
grown substantially, and now owns and operates real estate schools in every major metropolitan
area.
It is now 2020, and Conner has now decided to take her company public.
However, she wants to
structure the public company in the most remunerative way possible.
Since REEC owns its own
school buildings, it occurred to Conner that REEC might benefit from being a REIT.
She
quickly tallied the relevant information about REEC:
REEC owns 4,000,000 square feet of school space in 80 properties.
The average market
value of the structure is $200 per square foot.
The real estate was purchased 10 years ago for $175 per square foot, excluding land.
REEC makes $30 per square foot per year (revenue minus operating expenses) on average
across all its properties.
Conner refinanced the debt on the company five years ago, replacing a host of different
mortgages with one large mortgage, secured by all 80 properties (this is called cross-
collateralization).
2020 is year 6 of the mortgage, which has a 30 year amortization term
and an interest rate of 8 percent.
The original loan amount was $500 million.
Depreciation lifetimes are 39 years for this type of property and any capital improvements.
Real Estate Investments
Prof. Sinai
3
Although REEC pays no rent since it occupies its own space, the average market rent (net
of expenses) across REEC’s markets is $14 per square foot per year.
For simplicity, assume there is no capital in the company besides the real estate.
The corporate tax rate is 21 percent.
Annual capital expenses (“CapEx”) are 5 percent of the market value of the real estate.
You should assume that REEC’s book value is reset to market value when the properties
are re-organized into the REIT structure.
(But the loan does not need to be refinanced.)
a)
Calculate REEC’s current-year (2020) funds from operations (FFO) and after-tax cash flow
from operations (ATCF) assuming the whole company is organized as a plain-vanilla REIT.
Assume that REEC keeps its current financing but that book value is reset at market.
b) Calculate REEC’s current-year ATCF from operations as if it were a regular C-corp. Assume
a corporate income tax rate of 21%.
For simplicity, keep the same assumptions as in (a).
[Hint: use the same framework to get to ATCF as we used for an individual/partnership, but
apply the corporate tax rate of 21 percent.]
Note:
You should assume that REEC’s book value is reset to market value when the properties
are re-organized into the REIT structure.
It’s as if Sarah sold REEC into a newly-formed REIT
also called REEC. Sarah can take depreciation deductions on the book value of the structure (i.e.
the market value of $200 per square foot * 4 million square feet / 39 years) as well as on the cap
ex that she put into the property during 2020 (i.e. 5% of the $200 per square foot market value *
4 million square feet / 39 years).
The cap ex that Sarah has put into the property before 2020 is
capitalized into the market value of the structure, so in taking depreciation deductions on this
market value, Sarah is implicitly taking deductions on the accumulated cap ex that she put into
the building before “selling”/converting it into the REIT in 2020.
4. UPREITs and taxes
You are thinking about selling your office building to a very large UPREIT that specializes in
office properties.
This deal has the UPREIT paying you partially in cash and partially in units.
In today’s market, you expect to be able to sell the property for $63,000,000.
Of that, you will
have to pay 2 percent deductible sales expenses to your broker.
The UPREIT is willing to give
you $45 million in cash and the remainder in operating partnership units that you plan on holding
onto until after you die.
First, some information about the property:
It has 400,000 square feet of leasable space.
You purchased the property in 1970 for $10,000,000.
65 percent of the value of the
property then (and now) was due to the land component.
You currently have
no
debt on the property.
You have fully depreciated the property down to the book value of the land,
$6,500,000.
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Real Estate Investments
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Since 1970, you have spent $15,000,000 in capital expenditures, all of which have
been fully depreciated.
Assume partnership income, with an income tax rate of 29.6 percent and capital
gains tax rates of 20 and 25 percent.
What is the value at sale?
Hint:
Assume that the present value of the dividends and capital gains from the UPREIT
operating partnership units for the rest of your life is exactly equal to the current UPREIT share
price.
Real Estate Investments
Prof. Sinai
5
Suggested Solutions:
Problem #1: FFO
Assumptions:
Company information:
Debt information:
Revenues:
5,000
Initial LTV:
50%
OpEx (per year):
1,000
Amortization schedule:
30
CapEx (per year):
1,500
Interest rate:
6.50%
Acquisition cap rate:
0.07
Year of mortgage:
7
Acquisition price:
35,714
Portion land:
11,905
Tax information:
Gains from sales of property:
300
Depreciation lifetime:
39
Payout ratio (of net income):
90%
Solutions:
a) What is the debt service on the mortgage?
[PV] = LTV x purchase price:
17,857
[I] = mortgage rate
6.50%
[N] = amortization term
30
push [PMT]
-1,367
b) How much is interest this year?
Balance at start of year:
[PMT]
-1,367
[I]
6.50%
[N]
23
push [PV]
16,095
Times interest rate:
1,046
Real Estate Investments
Prof. Sinai
6
c) What is the CapEx depreciation deduction this year?
Depreciation accrues each year with additional
capex spending…
Annual capex:
1,500
Number of years:
8
Lifetime:
39
Depreciation deduction:
308
d) What will FFO be this year?
Year:
2,000
Revenues:
5,300
Operating expenses:
-1,000
Interest expense:
-1,046
Depreciation:
-610
CapEx depreciation:
-308
Net income:
2,336
Real estate depreciation:
918
Net out gains on property sales:
-300
FFO:
2,954
e) How much cash can you retain this year?
Revenues:
5,300
Operating expenses:
-1,000
Net operating income:
4,300
Capital expenses:
-1,500
Debt service:
-1,367
Before-tax cash flow:
1,433
Net income:
2,336
Payout ratio:
0.9
Dividend payout:
-2,102
Free cash flow:
-670
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Problem #2:
a)
Let capex be C.
Effective Gross Income:
1000
Operating expenses:
-(400 – C)
Net operating income:
=600+C
Capital expenses:
-C
Debt service:
-100 (interest only)
Before-tax cash flow:
=500
Capital expenses:
+C
Depreciation:
-200
Current CapEx depreciation:
-C/39
Taxable income:
=300+(38/39)C
Payout ratio:
0.90
Dividend payout:
-(270+0.9*(38/39)C)
f) How much capex should you reallocate to opex
in order to have free cash flow be positive?
(C = amount spent on CapEx)
Revenues:
5,300
Operating expenses:
-2,500+C
Interest expense:
-1,046
Depreciation:
-610
Prior CapEx depreciation:
-269
Current year capex depreciation:
-C/39
Net income:
874+(38/39)C
Payout ratio:
0.90
Dividend payout:
-787-0.9*(38/39)C
Before-tax cash flow:
1,433
Dividend payout:
-787-0.9*(38/39)C
Free cash flow:
646-0.9*(38/39)C
Solve for Free cash flow > 0
646-0.9*(38/39)C >0
0.9*(38/39)C <646
(38/39)C <718
C <737
Current year capex:
737
Current year opex:
1,763
g) What would your FFO be?
Net income:
1,592
Real estate depreciation:
899
Net out gains on property sales:
-300
FFO:
2,190
Real Estate Investments
Prof. Sinai
8
Free cash flow:
=230-0.9*(38/39)C
You want to retain $100 million in free cash flow:
100=230-0.9*(38/39)C
C=148
b)
Taxable income (from 2a)
+Depreciation
+Capex depreciation (2a)
-Sales
FFO
444
+200
+148/39
-100
=548
So, you will underperform relative to the target set by the analyst.
Problem #3:
Assumptions:
Calendar year
2020
Financing:
Square feet (1000s):
4000
Amortization term
30
Value (psf)
200
Interest rate
0.08
Purchase price (psf)
175
Loan amount (1000s)
500000
Purchase timing
10
Year
6
NOI (psf)
30
Rent (psf)
14
Taxes:
CapEx (% of value)
0.05
Tax rate
0.21
Depreciation life
39
Real Estate Investments
Prof. Sinai
9
b)
This can be done in just two calculations.
A REIT effectively has a zero tax rate.
Replace it with
35 percent to get a corporation.
Cash flow as a REIT:
"Pro-forma" approach:
"Accounting" approach:
2020
2020
NOI
120,000
NOI
120,000
- Debt Service
-44,414
- Interest
-37,929
- CapEx
-40,000
- Depreciation
-20,513
= BTCF
35,586
- This years CapEx dep
-1,026
+ Principal
6,485
= Taxable income
60,533
+ CapEx
40,000
+ Depreciation
21,538
- Depreciation
-20,513
= FFO
82,071
- This years CapEx depr
-1,026
= Taxable income
60,533
Taxable income
60,533
+ Depreciation
21,538
* Tax rate
0
= FFO
82,071
= Tax bill
0
Taxable income
60,533
NOI
120,000
* Tax rate
0
- Debt service
-44,414
= Tax bill
0
- CapEx
-40,000
BTCF
35,586
BTCF
35,586
- Tax bill
0
- Tax bill
0
= ATCF
35,586
= ATCF
35,586
Calculations:
Depreciation:
Market value of structure:
800,000
Lifetime:
39
Annual depreciation:
20,513
CapEx depreciation:
CapEx:
40,000
Lifetime:
39
CapEx depreciation:
1,026
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Problem #4:
When OP units are used to acquire a property, the capital gain is distributed pro rata between the
cash portion and the OP unit portion.
In this case, the cash portion gets 45,000,000/63,000,000
of the capital gain and the OP unit portion gets the rest.
The capital gains tax rate on the OP
units is zero (given in the problem), so the total tax liability is just 45,000,000/63,000,000 of the
all-cash tax liability.
Cash flow as a C-Corp:
2020
Taxable income
60,533
* Tax rate
0.21
= Tax bill
12,712
BTCF
35,586
- Tax bill
-12,712
= ATCF
22,874
Assumptions:
Property Cash Flows:
Tax Considerations:
(1)
Number of square feet:
400,000
(9)
Tax rate on income:
29.6%
(2)
Purchase price:
$10,000,000
Tax rate on capital gains
(3)
Accumulated Capex:
$15,000,000
(10)
Appreciation:
20.0%
(4)
Land fraction of value:
65%
(11)
Depreciation:
25.0%
(5)
Land portion of price:
$6,500,000
(6)
Gross sales price:
$63,000,000
Debt:
(7)
Deductible sale expenses (pct):
2%
(12) Mortgage balance:
0
(8)
Amount in cash:
$45,000,000
Real Estate Investments
Prof. Sinai
11
Solutions:
Total:
Cash
Units
Gross sale price:
63,000,000
45,000,000
18,000,000
Deductible sales expenses:
-1,260,000
Net sale price:
61,740,000
Mortgage balance:
0
BTCF at sale:
61,740,000
44,100,000
17,640,000
Capital gains:
Appreciation component:
NSP:
61,740,000
PP:
Purchase price:
10,000,000
Capex spent:
15,000,000
Total:
25,000,000
NSP-PP:
36,740,000
Appreciation tax rate:
20.0%
Appreciation tax:
7,348,000
Depreciation component:
Purchase price:
10,000,000
Original land value:
6,500,000
Depreciation on purchase:
3,500,000
Depreciation on capex:
15,000,000
Total depreciation:
18,500,000
Depreciation tax rate:
25.0%
Depreciation tax:
4,625,000
Total CG tax:
11,973,000
8,552,143
0 Units not taxed
ATCF:
35,547,857
17,640,000
Total sales proceeds:
53,187,857
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