Capital Structure 0709

Capital Structure in the REIT Sector
July 1, 2009
DJIA: 8,504 | RMZ: 435
Old Habits are Hard to Break

A Cultural Affinity for Leverage: Until about twenty years ago, the structural make-up of the real
estate industry (i.e. small players, fragmented ownership, no outside equity sources, etc.) dictated
that debt, not equity, serve as the primary source of external capital. As a result, market partici-
pants grew accustomed to operating with far more leverage than is found in virtually any other in-
dustry. Now that financing options for major real estate companies are very similar to what is avail-
able to other large corporations, there are several reasons to believe that less debt and more equity
should be the norm going forward.
Financial Theory: There is no reason why a non-taxable entity (e.g. a REIT) should have any debt,
yet the costs associated with credit crunches (both in the form of distress and missed opportunities)
provide ample reason to limit leverage to relatively low levels. These costs have proven to be so high
that optimal leverage targets for most REITs likely fall in the 0-30% (debt/asset value) range.
Best Practices in Corporate America: Most corporations have a strong incentive to utilize debt –
interest expense helps minimize their corporate tax bill – yet it represents less than one-quarter of
the typical corporation’s capital structure. REITs, by contrast, have no reason to use debt, yet it
typically comprises about half the capital structure. There is no justifiable reason why financing
practices should differ as much as they do.
The Real World Lab Experiment: Higher leverage should be accompanied by higher returns in or-
der to compensate for its added risk. This has not been the case, however, in the REIT sector, as
more levered REITs failed to provide meaningfully better returns even in the ten-year period pre-
ceding the peak of the asset valuation bubble. Lower levered REITs have substantially outper-
formed over the last fifteen years.
De-leveraging & Value Creation Ahead: The REIT sector has commenced what is likely to be a
multi-year de-leveraging process. It should unfold in three stages: 1) de-lever to ensure survival; 2)
de-lever to return to prior leverage targets; and 3) acknowledge that prior leverage targets were too
high and de-lever to achieve new, lower targets. Much progress has been made on the first phase,
yet most companies are not yet entirely out of the woods. The subsequent stages will entail massive
amounts of equity issuance, as leverage ratios need to decline by more than 1500 bps to return to
prior norms, and a substantial reduction beyond prior targets is appropriate. At a time when other
real estate market participants lack access to capital, REITs that aggressively de-lever as they articu-
late thoughtful strategic objectives with regard to their long-term capital structures will be well-
rewarded.
660 Newport Center Drive, Suite 800, Newport Beach, CA 92660 Important disclosure on page 16
T 949.640.8780 F 949.640.1773 © 2010, Green Street Advisors, Inc.
This report contains copyrighted subject matter and is covered under the Green Street Advisors' Terms of Use.
Green Street Advisors reserves all rights not expressly granted.
Capital Structure in the REIT Sector — July 1, 2009 2
"The pizza deliverer says to Yogi Berra: 'Do you want the pizza cut into quarters or eighths?'
Yogi answers: 'Cut it into eight pieces. I'm feeling hungry tonight.' "
Merton Miller
I. Overview
The real estate industry has historically relied primarily on debt, rather than equity, to satisfy its financ-
ing needs. Key structural differences that have long separated real estate from broad capital markets ex-
plain why this has been true, although in the last 15-20 years, most of those differences have been elimi-
nated. Despite that, the industry has been slow to question whether adherence to historical practices is
appropriate in light of how much the world has changed. This report explores that question, specifically
as it pertains to REITs, and concludes that the capital structure of most REITs typically contains too
much debt and too little equity. Three key arguments support this conclusion:
1. Well-accepted financial theory suggests that there is no reason why non-taxable entities such as
REITs need to have any debt. While there is nothing objectionable about the use of modest lever-
age, the costs associated with credit crunches have proven to be so high for leveraged operators
that optimal leverage ratios for most REITs likely fall in the 0-30% range. Above those levels, the
weighted average cost of capital begins to increase (albeit, slowly at first) and firm value declines.
2. Despite the fact that most corporations have a powerful incentive to utilize debt (i.e. interest ex-
pense helps minimize the double taxation of corporate profits), they typically employ far less lever-
age than REITs. The simple fact that real estate can support relatively high debt levels has nothing
to do with whether it should.
3. The historic track record from the REIT industry shows that leverage is associated with lower re-
turns. Considering that leverage should enhance returns in order to compensate for the higher
risk, these results are very surprising.
• Over the last fifteen years, more leveraged REITs have substantially underperformed REITs
with less leverage.
• A similar review of total returns in the ten years preceding the early ’07 peak of the asset valua-
tion bubble shows that leverage may have provided a very small boost to total returns, but this
finding is not statistically significant. Considering that cap rates dropped from 9% to 6% over
that period, leverage should have provided a powerful turbocharger for returns, yet this clearly
did not occur. If it didn’t substantially enhance returns over that time frame, when will it?
The deleveraging process that is now underway in the REIT sector is in the very early stages, with a lot of
work to be done before most capital structures resemble their pre-credit crunch make up. After that
work is done, well-run REITs will continue the process, as they increasingly acknowledge that their prior
leverage targets were too high. Those REITs that articulate thoughtful strategic objectives with regard to
their optimal leverage ratios will be well rewarded in the marketplace, which is why we will ascribe
higher warranted share prices to companies that operate at lower leverage levels.
WWW.GREENSTREETADVISORS.COM © 2010, Green Street Advisors, Inc. - Use of this report is subject to the Terms of Use listed at the end of the report.
II. History of Real Estate Finance – An Affinity for Leverage
Real estate market participants have long employed capital structures that utilize much more leverage
than is typical elsewhere in corporate America. Three attributes that have historically differentiated the
world of real estate help explain why this has been the case.
• The localized nature of the business led to highly fragmented ownership, with the vast majority of the
commercial real estate in the US owned by small developers/operators.
• Traditional external sources of equity capital (e.g. the public market & institutional investors) have
historically been very limited in size and not well suited to finance an industry with such fragmented
ownership.
• The aversion that small players would normally have against high debt levels has been minimized
due to the fact that most mortgage financings are “non recourse”.
As a result, the vast majority of outside capital utilized by the real estate industry has long come in the
form of debt, not equity, and most of today’s participants in the real estate industry grew up amidst a cul-
ture in which the only question anyone asked about leverage was, “how much can I get?”
Much has changed since that time. The coming of age of public REITs introduced a new source of equity
capital far larger than any that preceded it. Yet another source of equity capital came in the form of much
greater interest in real estate by pension funds, endowments and other institutional sources of capital.
Meanwhile, the development of a large market for securitized mortgages (i.e. CMBS) and the rapid ex-
pansion in the ability of REITs to tap corporate (i.e. unsecured) debt markets inextricably linked the
world of real estate finance with broad global capital markets. As a result, the industry has become less
fragmented and the menu of financing options available for large real estate companies is very similar to
what is available to any large corporation.
Old habits can, however, be hard to break. Despite the powerful arguments that follow as to why REITs
should have less leverage than most companies, even today’s more conservatively levered REITs utilize a
lot more debt than is common at other corporations. It is clear that the historic culture of the real estate
industry continues to play a big role when it comes to how real estate companies are financed, much in
the same way that the equity-heavy historic culture of the Tech industry continues to cause even mature
companies (e.g. Microsoft, Oracle, Cisco, etc.) with now-predictable income streams to utilize little or no
long-term debt. Cultural norms that no longer make sense can persist for a long time, but ultimately the
companies that have done the best job of reacting to the changed conditions eclipse the firms that are
stuck in the ways of the past. “How much debt can I get?” is certainly the wrong question. Companies
that instead ask, “How much debt should I have?” will be the winners.
III. How Does the Rest of Corporate America Do It?
Whereas real estate execs have historically had to choose from an abbreviated menu of financing options
(what flavor of secured debt do you prefer?), other large companies have enjoyed a lengthy list of ala
carte options. Now that REITs are allowed to order off the adult menu, there is presumably much to be
learned by looking to see which items are preferred by the long-time diners.
REITs use far more debt than most companies. Tech companies use a lot less. It appears that
the history of the two sectors has created cultures that arguably no longer make sense.
Key Leverage Ratios for S&P 500 Constituents
60% 54% Net Liabilities as a % of Total Mkt Capitalization 10.0

Net Liabs % of Tot Mkt Cap
Net Liabilities/EBITDA
50%
Net Liabilities/EBITDA
8.0
8.3
40%
6.0
30%
21% 4.0
20%
9% 2.0
10%
1.6 0.9
0% 0.0
REITs S&P 500 (ex financials) Tech Companies
The figures shown for REITs and the S&P are the median value. For tech companies it’s the average. The median
value for tech companies is zero. Net liabilities equals total liabilities less current assets and excludes preferred equity.
% of S&P Constituents (ex Financials) that Use More

Leverage than REITs
50%
18%
25%
2%
0%
Net Liabilities % of Tot Mkt Cap Net Liabilities/EBITDA
The key takeaway is that, excepting companies engaged in the business of finance (e.g. banks and insur-
ance companies), most corporations maintain a conservative posture with regard to leverage. The me-
dian leverage ratio (net liabilities/total market capitalization) for non-financial members of the S&P 500
is 21%, a figure that is well below the 54% median for the REITs in that index. Similarly, the median Net
Liabilities/EBITDA multiple of 1.6X for S&P members stands in stark contrast to the 8.3X figure for
REITs. Only 2% of S&P members have higher Net Liabilities/EBITDA multiples than the typical REIT!
At least as interesting as these averages is the fact that a large number of this country’s premier corpora-
tions (e.g. Microsoft, Cisco, Johnson & Johnson, Coke, McDonalds, Exxon Mobil, etc.) choose to operate
with little or no debt at all (Appendix B provides these statistics for each of the 50 largest US corpora-
tions). Considering that each of these blue-chips, and virtually every member of the S&P 500, is a tax-
able corporation (and not a pass-through vehicle like a REIT), the conservative leverage stance stands in
stark contrast with the norms of the REIT industry.
A common refrain heard from real estate industry participants goes something like, “the stability of real
estate cash flows allows higher debt levels for REITs”, which purportedly explains why REITs have
higher debt levels than most companies. However, this point is relevant only when asking, “How much
debt can I get”? It has nothing to do with answering the far more important question, “How much
should I have?”
IV. What Would Miller & Modigliani Have to Say?
Merton Miller and Franco Modigliani had a profound impact on modern finance theory, and nowhere
was their work more pioneering, nor enduring, than the insights they provided on leverage. In a paper
(which was instrumental in winning its authors the Nobel Prize in Economics) published in 1958, Mssrs.
Miller and Modigliani (M&M) postulated that, in a perfect world, the level of debt at a company should
have no impact on the value of the company, i.e. the price of the stock. Put differently, the value of a firm
is tied to the value of its assets (both tangible and intangible), and how one chooses to divide this value
between debt holders and equity holders has no bearing on overall value. Very simply, as debt increases,
risk-averse investors demand a higher return on the equity, and any improvement in net income per
share generated by taking on more debt is fully offset by a decline in the multiple the market will award
the shares.
M&M: The Boost Leverage Provides to FFO is Offset by Lower Multiples
FFO per Share P/FFO Multiple

$2.50 14.0
12.0
$2.00
10.0
P/FFO Multiple
$1.50 $1.33
FFO/Sh
8.0
$1.06
$0.89 $0.95 6.0
$1.00 $0.86
4.0
$0.50
2.0
$0.00 0.0
0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
Leverage as % of Assets
In subsequent revisions to their initial theorem, M&M acknowledged that their “perfect world” assump-
tion was not realistic, and that there are two big exceptions that result in the conclusion that an “optimal
leverage ratio” exists for most companies. The two exceptions:
1. Taxes: Tax laws in most countries allow companies to deduct interest expense but not dividend
payments. This creates an “interest tax shield” that has very real value to any taxable company that
has debt. Taken on its own, this issue would suggest that all taxable corporations should be very
highly leveraged so as to minimize the entity’s tax bill.
2. Costs of Severe Financial Distress: The odds that a firm will incur sizable costs associated with se-
vere financial distress (e.g. bankruptcy) increase as leverage goes higher. This puts a cap on how
much leverage any firm should have and serves to offset the value of the interest tax shield at
higher leverage ratios.
The M&M View of Optimal Leverage for REITs

Across much of the leverage spectrum, non-taxable entities (e.g. REITs) should be indifferent
with regard to debt levels. However, the recurring nature of credit crunches shows that: 1) the
costs of financial distress can begin to kick in at relatively low leverage ratios; and 2) times of
distress create opportunities for very well-capitalized entities. While distress-related costs may
not be very material for REITs operating at leverage ratios in the 50% ballpark, there is material
value in having a bullet-proof balance sheet with which to play offense. As a result, optimal lev-
erage ratios may well be no higher than, say, 30%.
12%
The Effect of Leverage on WACC
Wtd Avg Cost of Capital
11% Cost of Financial

Distress
Cost of Missed
Opportunities
10%
9%
10% 20% 30% 40% 50% 60% 70% 80%
Leverage Ratio
Impact of Leverage on Enterprise Value

0%
Impact on Enterprise Value
-5%
Cost of Financial Distress

-10% Cost of Missed Opportunities
-15%
-20%
10% 20% 30% 40% 50% 60% 70% 80%
Leverage Ratio
The optimal capital structure for a taxable corporation is where these two offset each other, and, as out-
lined earlier, corporate America currently seems to believe that answer is, on average, somewhere in the
15-25% ballpark.
The fact that REITs do not pay corporate income taxes effectively removes one of the two participants in
this tug of war. Just like every other corporation, there is a ceiling on REIT leverage ratios, but unlike
other corporations, there is no reason why a REIT should have any debt1. REITs provide a special case in
an M&M world, one where extremely low leverage ratios make perfect sense.
1 While the majority of REIT income is exempt from corporate income taxes, it is not uncommon for REITs to generate some taxable income.
In such instances, a REIT could benefit from having some debt.
While it is clear that acceptable leverage ratios for REITs go all the way to zero, determining the point at
which M&M’s costs of financial distress start to put a cap on this number is a tougher task. However, if
we’ve learned nothing else in recent years, we’ve learned that what we used to think of as 100-year credit
crunches have a nasty habit of occurring every 15-20 years (‘73/’74, ‘90/’91 & ‘07/’08 all represent times
of extreme turmoil in real estate credit markets). In M&M-speak, the costs of distress are very high, and
they kick in at leverage ratios that are probably well below where most have long assumed.
To boot, there is yet another reason to limit leverage, one which M&M described as “the need for pre-
serving flexibility” which, “will normally imply the maintenance by the corporation of a substantial re-
serve of untapped borrowing power”. Credit crunches have proven to be such disruptive events, that
they create wonderful opportunities for companies that keep large amounts of “untapped borrowing
power”. The tendency of markets to transition from bubble to bust and back again has never been more
obvious, and companies with balance sheets that allow them to play offense amidst the worst busts are
likely to create a lot more value for shareholders than companies that are on their heels the whole time.
In summary, the theories that underpin the way corporate America addresses capital structure suggest
that leverage ratios for REITs are constrained by two factors, the cost of severe financial distress and the
cost of lost opportunities, whereas there is no factor working in the other direction. In other words, a
REIT with no leverage is probably managing its balance sheet no better or worse than one with, say, 25%
leverage.
However, at some point – a point that we’ve learned is a lot lower than people used to think – the costs
of distress and lost opportunities begin to kick in, and a leverage ratio above that point is clearly subopti-
mal. REITs that operate with leverage in excess of that threshold will have higher weighted average costs
of capital and lower share prices than REITs with “bulletproof” balance sheets.
V. The Real World Lab Experiment
Most of the arguments spelled out above are not new. Indeed, we published a report (There is No Free
Lunch – A Discussion of Leverage in the REIT Sector) back in 1998 that pretty much raised all the same
points. While it is safe to speculate that about the only time M&M has been mentioned since that time in
most REIT boardrooms has been when a candy bowl is being passed around, the passage of time now
affords the opportunity to measure the impact that leverage has had. After all, a large number of REITs
now have 15-year track records as public companies, and their performance provides a real world lab ex-
periment.
Leverage & Returns: The Real World Lab Experiment

REITs with higher leverage should be expected to deliver higher returns in order to warrant the
higher risk leverage brings. Otherwise, Merton Miller’s crack about making a pizza bigger by cut-
ting it into more pieces would actually work.
The Hypothetical Impact of Leverage on REIT Returns
Leverage should goose shareholder returns.

13% A 65% levered REIT needs to deliver a return
Return on Equity
12% of over 11% to match the risk/reward of a 40%

levered REIT that delivers 9.5%.
11%
10%
9%
8%
25% 30% 35% 40% 45% 50% 55% 60% 65% 70%
Leverage
Hypothetical REIT returns assume average unleveraged return on real estate and other assets of 9.0%, average
debt cost of 7.0%, and G&A of 50 bps.
Leverage and Returns

Over the last 15 years, every
20% 100 bp increase in leverage has
PSA
15YR Total Return (ann.)
AVB REG VNO been accompanied by a 40 bp

15% HOT FRT
SKT ELST CO SPG decrease in annual returns.
R2 = 0.50
EQR KIM
10% W RE CBL MAC
BRE CUZ CPT SUI UDR
W RI
5% PPS DRE
CLP
HST AEC
PLD
0% DDR
-5%
GGP
-10%
30% 35% 40% 45% 50% 55% 60% 65% 70% 75%
Avg Leverage Ratio
2 A look at ten-year total returns ending at a point near the bubble peak (12/31/06) provides further evidence that risk-adjusted returns for
leveraged companies are inadequate (see Appendix C).
Over the last fifteen years, however, higher leverage has been closely associated with
lower returns. Considering that cap rates today stand at about the same level they did at
the beginning of this period (i.e. the cycle has come full circle), the track record suggests
there must be powerful reasons why leverage is undesirable.
VI. Lessons Learned in This Downturn

As recently as 2007, total leverage (including preferreds) equated to a conservative-sounding 45% for a
typical REIT. While this was notably higher than the 30-40% levels that prevailed through most of the
‘90s, it was not high enough to trigger alarm bells. Knowing what we now know – that real estate values
were poised to decline by 35-40% and that capital markets were about to lock up – it is clear that the
alarm bells should have sounded. Why they didn’t provides two key lessons that REIT investors are
unlikely to forget for a long time to come.
Lesson One: Whatever used to be considered to be a prudent leverage target is

probably too high. Considering that real estate values plunged by 30% in the early ‘90s and
nearly 40% so far in this downturn, it is clear that seemingly safe loan-to-value figures can
quickly shoot higher. When they do, companies that were operating at, say, 50% leverage ratios
are forced to take desperate measures (i.e. sales of properties at distressed prices, issuance of
very costly debt/equity, etc.) in order to repair their balance sheets. These measures can be very
harmful to shareholder wealth, and they can be avoided by REITs employing more conservative
levels of debt.
Lesson Two: It is important to use a measure of leverage that can’t be fooled by as-
set valuation bubbles. Two such metrics are Debt/NOI and Debt/EBITDA. Going forward,
all of our snapshots of balance sheet strength will include at least two measures of leverage: lever-
age as a % of asset value and Debt/EBITDA. In most environments, they will send similar sig-
nals, but both views are critical at moments when this is not the case.
What have we learned? First, companies with seemingly conservative leverage ratios (leverage/
asset value) can get into a lot of trouble during credit crunches. Second, it is important to em-
ploy a measure of leverage that can’t be fooled by asset valuation bubbles.
Average REIT Leverage

(Debt + Pref)/Asset Value Debt/NOI (right axis)
70% 8x
The amount of debt outstanding 63%
relative to the cash flow
60% 7x
available to support it increased
from 5X to 7X this decade. 53%
6x
50% 45%
5x
39%
40%
32%
4x
30% 3x
20% 2x
'89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09
Debt/NOI ratio shown is an approximation. It understates actual leverage because it assumes that all assets generate income. We use this
Debt/NOI metric throughout the remainder of this report, as opposed to Debt/EBITDA multiples that were used earlier for comparisons with the
S&P because we don't have a historical time series of the latter.
VII. Answers to Commonly Heard Objections from the Old School
The industry’s cultural affinity toward leverage has deep roots, and it may well take one or two more real
estate debacles and a new generation of leaders to completely change the old habits. Meanwhile, the fol-
lowing objections to the arguments posed herein will be commonplace.
Old School Objection (OSO): Low leverage might be okay for the next few years, but eventually
REITs will need to increase leverage in order to compete with the numerous market participants who
employ leverage in pursuit of higher levered returns.
Response: Not being able to buy something because someone else wants to overpay for it doesn’t mean
you should find an excuse to outbid them. If M&M taught us one thing it is that investors who focus on
levered returns have their eye on the wrong ball. The fallout from the leverage-fueled asset valuation
bubble serves as a strong validation of this view. When price levels are boosted by the use of high lever-
age, the last thing a REIT should be doing is buying assets. An unwavering focus on unlevered returns,
and how those returns stack up with other capital market alternatives, will lead to superior long-term
capital allocation decisions. REIT execs that instead pursue levered earnings growth objectives are far
more likely to underperform.
OSO: REITs employing lower leverage will not be able to grow their FFO/AFFO as quickly as their
more levered brethren.
Response: While true, it does not provide a reason to use leverage (see M&M section of report). Re-
gardless of whatever pressure executives may think they are getting from “Wall Street”, they should
never compromise the goal of value creation in the name of maximizing earnings. These two goals often
conflict, and companies that utilize earnings growth targets for any reason, including exec comp, should
trade at lower valuations.
OSO: Because real estate appreciates in a fairly reliable fashion over a long period of time, long-term
equity returns can be boosted by adding leverage.
Response: Actually, the long-term evidence suggests that real estate does not appreciate at all. By the
time this year is up (i.e. appraisers acknowledge what has hit them), the NCREIF Index will likely show
that total returns on unleveraged real estate have averaged only about 8%/yr over a 30-year time frame,
with virtually all of that return coming from income, not appreciation. Participants in the real estate
market routinely overhype the returns that investors can reasonably expect to achieve in this asset class,
and the overly bullish outlook probably has something to do with the sector’s overly aggressive capital
structures.
OSO: Because cash flows are predictable, real estate can support more leverage than most operating
businesses.
Response: This has everything to do with the, “how much can I get?” mindset, and nothing to do with,
“how much should I have?” If there was an identifiable advantage toward using debt, this would be a
very interesting point. That there is not renders it moot.
OSO: Real estate is a capital-intensive business, unlike, say, Tech, which means that real estate com-
panies likely need more leverage.
Response: It’s highly questionable if this oft-repeated statement is even true. Intel & Cisco seemingly
have plenty of places to invest capital, yet they barely use any debt. Even if it is true, it really doesn’t
change anything. The fact that capital is needed does not impact whether that capital should be debt or
equity.
OSO: REITs are in the business of financing real estate, and financial service firms always employ
high leverage.
Response: Equity REITs are engaged primarily in the businesses of owning and operating real estate,
not financing it. Equity REITs are not finance companies.
OSO: A REIT that is 45% levered generates higher FFO/AFFO than one that is 20% levered, yet inves-
tors don’t really worry enough at that level to cause them to ascribe a lower P/E multiple.
Response: This is the “free lunch” that M&M debunked. While costs of severe financial distress may
not be excessive (though they are likely present) at a 45% leverage ratio, higher leverage makes the cash
flow stream more volatile/risky, which will cause investors to ascribe a lower P/E multiple.
OSO: Non-recourse debt affords the opportunity to enjoy the benefits of leverage without putting my
firm at risk (or, in M&M speak, raising the risk of severe financial distress).
Response: Non-recourse debt can, indeed, lower the potential cost/risk of severe financial distress,
thus allowing a REIT to operate with more debt before exceeding the maximum end of the optimal lever-
age range. However, there are a number of reasons why non-recourse debt is not tantamount to some
sort of free lunch:
• The lack of personal recourse is akin to an insurance policy that is implicitly sold by the lender to
the borrower. Lenders charge for this insurance and it is presumptuous to believe that it is system-
atically mispriced.
• Heavy reliance on non-recourse debt precludes REITs from accessing other important sources of
REIT debt, specifically the unsecured corporate debt market. REITs that keep all financing options
on the menu are better positioned to weather full cycles, as evidenced by the current state of affairs
wherein unsecured markets are receptive, while secured markets are likely to remain treacherous
for several more years.
• Just like every other type of debt, any boost non-recourse debt provides to earnings will be entirely
offset by a reduction in the P/E multiple.
In summary, there are pros and cons associated with non-recourse debt, but its existence does not in any
way change the fact that there is no compelling reason for REITs to have debt.
VIII. Where We Go From Here
The REIT industry is in a very early stage of what will prove to be a lengthy deleveraging process. The
process is best thought of as taking place in three distinct stages. While some companies are at different
points than others in this process, the comments below pertain to the industry in general:
• Phase One: This is the stage we’re still in, and re-equitization at this point still centers primarily
around survival. Most REITs have made great strides in enhancing their own prospects for surviv-
ing a credit crunch that could persist through 2012, but many have unfinished business on this
front.
• Phase Two: From ’97-’02, REITs operated at leverage ratios below 50% and Debt/NOI multiples
below 5.0X. Assuming that REITs merely strive to return their balance sheets to a state of nor-
malcy, massive de-leveraging (a 1700 bp reduction in LTV and a 210 bps reduction in the Debt/
NOI multiple) needs to take place just to return to the capital structures of yore. This goal should
serve as the absolute minimum amount of deleveraging any management team should strive to
achieve. Otherwise, they will face the challenging task of explaining why leverage ratios of the past
were overly conservative.
• Phase Three: Two catalysts are likely to cause REITs to eventually adopt leverage targets that are
substantially more conservative than what conventional wisdom dictated as appropriate in the ’97-
’02 period. First, the industry will continue to learn from the best practices of corporate America
and the cultural affinity for leverage will eventually become an historic relic. Second, the painful
lessons learned in recent years all point toward reduced leverage targets going forward. There is no
magic number that all REITs should adopt as a target, but it is clear that whatever seemed appro-
priate in the past was almost certainly too high.
The Phases of the Re-Equitization Process
Avg Debt/Asset Value Avg Debt/NOI
80% 6.9 8
6.7
6.2
Debt/Asset Value
60% 6
4.6 62% 60% 4.6 Debt/NOI
55%
40% 3.2 4
43%
43%
30%
20% 2
0% 0
'97-'02 Avg 4/1/09 Today Phase I Phase II Phase III
Survival Back to Lower
Targets Targets
Each of the phases of the de-leveraging process will involve battles on multiple fronts, including property
sales and joint venture formations. However, the most effective way to de-lever is to issue equity, and
the needs of the industry are so large that the equity issuance wave is certain to last longer and be larger
in scale than most observers likely anticipate. The good news, however, is that REITs will increasingly
garner a competitive edge in the real estate market place, as only they have direct access to the biggest
and cheapest pool of equity capital – the public market.
Mike Kirby
Appendix A: Optimal Leverage Targets are Both Sector- and Company-Specific
The body of this report addresses optimal leverage targets for the typical REIT, but there are numerous
factors that have an impact on the amount that a given REIT can prudently borrow. Examples include:
• Operating Leverage: Real estate with lower operating leverage (e.g. apartments) can bear more debt
than real estate with high operating leverage (e.g. hotels).
• Lease Terms: Companies with long-lived leases can bear more debt.
• Business Lines: The business of owning and operating real estate is safer than developing.
• Non-recourse Debt: Though the embedded insurance policy comes at a cost, non-recourse debt al-
lows a REIT to operate prudently at higher leverage.
To the extent a REIT stacks up favorably on these variables, it translates into an ability to operate at
higher leverage before costs of financial distress become an issue. However, the fact that a REIT can op-
erate with higher leverage has nothing to do with whether it should.
REITs with access to Fannie Mae/Freddie Mac (primarily owners of apartments) provide the only exam-
ple of companies that not only can borrow more than average, but they also should. The government
“subsidized” enterprises (GSEs) have proven to be relatively reliable sources of financing even at times
when other providers of capital have locked their doors. This means that the odds/costs of severe finan-
cial distress are not as problematic for owners in sectors with GSE access as is the case elsewhere. The
value of the government subsidy (i.e. below-market interest rates) increases as a REIT utilizes more GSE
financing, a fact that provides strong motivation to have at least moderate levels of debt.
The optimal leverage target for apartment REITs is well above zero. It occurs at the leverage ra-
tio where costs associated with distress and/or missed opportunities begin to outweigh the
benefits proffered by borrowing at subsidized interest rates.
The Effect of Leverage on WACC - Apartment REITs

11%
Wtd Avg Cost of Capital
Optimal Leverage
Cost of Distress
10%
Cost of M issed
Opportunities
9% Cost of Not
M aximizing GSE
Subsidy
8%
0% 10% 20% 30% 40% 50% 60% 70% 80%
Leverage Ratio
Appendix B: Leverage Ratios for the 50 Largest Companies in the S&P 500 (ex Financials)
Net Liabilities
Equity as a % of Net Liabilities/
Rank Company Market Cap Total Market Cap EBITDA
1 Exxon Mobile Corp $341 BN 10% 0.5
2 Microsoft Corp 212 0% 0.0
3 Wal-Mart Stores Inc 192 20% 1.6
4 Johnson & Johnson 155 5% 0.4
5 Proctor & Gamble Co/The 151 25% 2.5
6 AT&T Inc 147 50% 3.4
7 International Business Machines Corp 140 25% 2.2
8 Chevron Corp 134 22% 0.8
9 Google Inc 131 0% 0.0
10 General Electric Co 126 82% 18.2
11 Apple Inc 125 0% 0.0
12 Coca-Cola Co/The 111 7% 0.8
13 Cisco Systems Inc 110 0% 0.0
14 Oracle Corp 108 3% 0.4
15 Pfizer Inc 103 9% 0.5
16 Intel Corp 91 0% 0.0
17 Hewlett-Packard Co 91 20% 1.6
18 Verizon Communications Inc 88 52% 3.1
19 Philip Morris International Inc 84 11% 0.9
20 PepsiCo Inc/NC 84 13% 1.5
21 QUALCOMM Inc 77 0% 0.0
22 Abbot Laboratories 74 10% 0.9
23 Schlumberger Ltd 66 3% 0.2
24 McDonald's Corp 63 15% 1.5
25 Conoco Phillips 62 52% 1.8
26 Wyeth 60 2% 0.2
27 Merck & Co Inc/NJ 56 11% 0.8
28 Occidental Petroleum Corp 53 12% 0.5
29 Amgen Inc 53 2% 0.1
30 United Parcel Service Inc 49 25% 2.3
31 United Technologies Corp 49 24% 1.7
32 CVS Caremark Corp 45 18% 1.3
33 Walt Disney Co/The 44 28% 1.9
34 Gilead Sciences Inc 43 0% 0.0
35 Bristol-Myers Squibb Co 41 6% 0.5
36 Monsanto co 41 2% 0.3
37 Comcast Corp 41 63% 5.2
38 3M Co 41 12% 0.9
39 Eli Lilly & Co 41 20% 1.5
40 Home Depot Inc 40 20% 1.6
41 Schering-Plough Corp 40 14% 2.2
42 Medtronic Inc 39 8% 0.6
43 Kraft Foods Inc 38 44% 5.0
44 Colgate-Palmolive 36 11% 1.3
45 Amazon.com Inc 35 0% 0.0
46 Altria Group Inc 34 28% 2.6
47 Exelon Corp 34 48% 4.1
48 Baxter International Inc 32 6% 0.6
49 Lockheed Martin Corp 32 39% 3.3
50 Boeing Co/The 31 49% 5.4
Median - Top 50 12% 0.9

Median - REITs in the S&P 500 54% 8.3
Notes: Net liabilities is calculated as total liabilities less current assets. Preferred equity is not considered a liability. Total market capitalization is calculated as
Appendix C: If Leverage Doesn’t Turbocharge Returns During a Bubble, When Will It?
As discussed in Section V, REITs with higher leverage have substantially underperformed their less lev-
ered brethren over the last 15 years. A potential criticism of this finding is that REIT pricing suffered an
unprecedented decline near the end of the time period studied, thus raising the prospect that results by
levered companies would look a lot better during a “normal” time period. While this gripe is not entirely
without merit, concerns should be minimized by the fact that cap rates today are very close to where they
were 15 years ago. Against a flat-cap-rate backdrop, leverage should have boosted returns, but it appears
to have impaired them.
At least as surprising is the fact that leverage did not significantly enhance returns in the ten years pre-
ceding January ‘07, the peak of the asset valuation bubble. Considering that cap rates went from roughly
9% to 6% over this time frame, causing asset values to skyrocket, leverage should have served as a return
turbocharger. As shown below, there is some weak evidence that more levered REITs outperformed dur-
ing this period, but the findings are not statistically significant. That leverage failed to clearly boost
REIT returns during a period when it should have provided a huge boost provides yet one more reason to
think that the costs associated with debt (at the leverage ratios typical for REITs) must be sizable.
Leverage and Returns Before the Bust

25 % VNO GGP
T CO
KIM DDR
CBL M AC
Total Return '97-'06 (ann.)
SK T
AVB FRT
20 % R EG
SPG
PSA BRE CPT
CUZ
W RE PLD UDR
EQR ELS
15 % LRY W RI
DR E CL P
CLI Best fit line +/- 2 St.
HIW Deviations
10 % PPS 2
R = 0.09
5%
30% 35% 40 % 4 5% 5 0% 55% 60% 6 5% 7 0%
Av g Le v e rage Ra tio
Green Street’s Disclosure Information
Analyst Certification – I, Mike Kirby, hereby certify that all of the views expressed in this research report accurately reflect my personal views about any and all of the subject companies
or securities. I also certify that no part of my compensation was, is, or will be directly or indirectly related to the specific recommendation(s) or view(s) in this report.
Issuers of this Report: US and EEA: This report has been prepared by analysts working for Green Street Advisors (GSA (US)) and/or Green Street Advisors (U.K.) Limited (GSA (UK)),
both of which are subsidiaries of Green Street Holdings, Inc.
This report is issued in the USA by GSA (US). GSA (UK) accepts no responsibility for this report to the extent that it is relied upon by persons based in the USA. GSA (US) is
regulated by FINRA and the United States Securities and Exchange Commission, and its headquarters is located at 567 San Nicolas Drive, Suite 200, Newport Beach, CA 92660.
This report is issued in the European Economic Area (EEA) by GSA (UK). GSA (US) accepts no responsibility for this report to the extent that it is relied upon by persons
based in the EEA. GSA (UK) is registered in England, (Company number. 6471304), and its registered office is 22 Grosvenor Square, London, W1K 6LF. GSA (UK) is authorized and
regulated by the Financial Services Authority in the United Kingdom and is entered on the FSA’s register (no. 482269]).
References to “Green Street” in Disclosures in this section and in the Other Important Information section apply to:
● GSA (US) to the extent that this report has been disseminated in the USA; or
● GSA (UK) to the extent that this report has been disseminated in the EEA by.
Green Street reserves the right to update the disclosures and policies set out in this document at any time. We encourage a careful comparison of these disclosures and policies with those
of other research providers, and welcome the opportunity to discuss them.
Affiliate Disclosures: Green Street does not directly engage in investment banking, underwriting or advisory work with any of the companies in our coverage universe. However, the
following are potential conflicts regarding our affiliates that should be considered:
● Green Street is affiliated with Eastdil Secured, a real estate brokerage and investment bank that sometimes engages in investment banking work with companies in Green Street’s
coverage universe. Green Street does not control, have ownership in, or make any business or investment decisions for, Eastdil Secured.
● Green Street has an advisory practice servicing investors seeking to acquire interests in publicly-traded companies. Green Street may provide such valuation services to prospective
acquirers of companies which are the subject(s) of Green Street’s research reports. Green Street may receive fees that are contingent upon the successful completion of a transact-
ion or other fees for its work on behalf of prospective acquirers.
● An affiliate of Green Street is the investment manager of an equity securities portfolio on behalf of a single client. The portfolio contains securities of issuers covered by Green Street’s
research department. The affiliate is located in a separate office, employs an investment strategy based on Green Street’s published research, and does not trade with Green Street’s
trading desk.
Other Important Information
Management of Conflicts of Interest: Conflicts of interest can seriously impinge the ability of analysts to do their job, and investors should demand unbiased research. In that spirit,
Green Street adheres to the following policies regarding conflicts of interest:
● Green Street employees are prohibited from owning the shares of any company in our coverage universe.
● Green Street employees do not serve as officers or directors of any of our subject companies.
● Green Street does not commit capital or make markets in any securities.
● Neither Green Street nor its employees/analysts receives any compensation from subject companies for inclusion in our research.
● Green Street does not directly engage in investment banking or underwriting work with any subject companies.
Please also have regard to the Affiliate Disclosures listed above when considering the extent to which you place reliance on this research report and any research recommendations made
herein.
A number of companies covered by Green Street research reports pay an annual fee to receive Green Street’s research reports. Green Street may periodically solicit this business from
the subject companies. In the aggregate, annual fees for GSA (US) and GSA (UK) research reports received from subject companies represent less than 3% of each of GSA (US)’s and
GSA (UK)'s respective total revenues.
Green Street publishes research reports covering issuers that may offer and sell securities in an initial or secondary offering. Broker-dealers involved with selling the issuer’s securities or
their affiliates may pay compensation to GSA upon their own initiative, or at the request of Green Street's clients in the form of “soft dollars,” for receiving research reports published by
Green Street.
The information contained in this report is based on data obtained from sources we deem to be reliable; it is not guaranteed as to accuracy and does not purport to be complete. This
report is produced solely for informational purposes and is not intended to be used as the primary basis of investment decisions. Because of individual client requirements, it is not, and it
should not be construed as, advice designed to meet the particular investment needs of any investor. This report is not an offer or the solicitation of an offer to sell or buy any security.
Green Street Advisors is an accredited member of the Investorsidesm Research Association, whose mission is to increase investor and pensioner trust in the
U.S. capital markets system through the promotion and use of investment research that is financially aligned with investor interests.
Green Street generally prohibits research analysts from sending draft research reports to subject companies. However, it should be presumed that the analyst(s) who
authored this report has(/have) had discussions with the subject company to ensure factual accuracy prior to publication, and has(/have) had assistance from the
company in conducting due diligence, including visits to company sites and meetings with company management and other representatives. Certified Provider
Terms of Use
Protection of Proprietary Rights: To the extent that this report is issued by GSA (US), this material is the proprietary and confidential information of Green Street Advisors, Inc., and is
protected by copyright. To the extent that this report is issued by GSA (UK), this material is the proprietary and confidential information of Green Street Advisors (U.K.) Limited, and is
protected by copyright.
This report may be used solely for reference for internal business purposes. This report may not be reproduced, re-distributed, sold, lent, licensed or otherwise transferred without the prior
consent of Green Street. All other rights with respect to this report are reserved by Green Street.
EEA Recipients: For use only by Professional Clients and Eligible Counterparties: GSA (UK) is authorized by the Financial Services Authority of the United Kingdom to issue this
report to "Professional Clients" and "Eligible Counterparties" only and is not authorized to issue this report to "Retail Clients", as defined by the rules of the Financial Services Authority.
This report is provided in the United Kingdom for the use of the addressees only and is intended for use only by a person or entity that qualifies as a "Professional Client" or an "Eligible
Counterparty". Consequently, this report is intended for use only by persons having professional experience in matters relating to investments. This report is not intended
for use by any other person. In particular, this report intended only for use by persons who have received written notice from GSA (UK) that he/she/it has been classified, for
the purpose of receiving services from GSA (UK), as either a "Professional Client" or an "Eligible Counterparty". Any other person who receives this report should not act on
the contents of this report.
Review of Recommendations:
• Unless otherwise indicated, Green Street reviews all investment recommendations on at least a monthly basis.
• The research recommendation contained in this report was first released for distribution on the date identified on the cover of this report.
• Green Street will furnish upon request available investment information supporting the recommendation(s) contained in this report.
Green Street’s Disclosure Information
At any given time, Green Street publishes roughly the same number of “BUY” Green Street’s “BUYs” have historically achieved far higher total returns
recommendations that it does “SELL” recommendations. 1, 2
than its ”HOLDs”, which, in turn, have outperformed its “SELLs”.
Total Return of Green Street's Recommendations

Green Street Recommendation Distribution Year Buy Hold Sell NAREIT Eqty
4
(as of 5/29/09) 2009 YTD3 2.8% 0.7% -21.5% -8.8%

2008 -27.8% -30.7% -53.2% -37.7%
2007 -6.5% -22.3% -27.6% -15.7%
2006 45.4% 29.9% 18.4% 35.1%
2005 26.3% 18.3% -1.9% 12.2%
50% 2004 42.3% 28.4% 15.6% 31.6%
% of companies
under coverage
38%
Year Ended December 31:

2003 42.7% 37.2% 20.9% 37.1%
2002 17.7% 2.6% 1.9% 3.8%
31% 31% 2001 35.7% 19.1% 11.9% 13.9%
2000 53.6% 29.3% 4.4% 26.4%
25% 1999 14.2% -9.2% -20.2% -4.6%
1998 -0.6% -15.1% -16.4% -17.5%
1997 37.1% 14.2% 5.8% 20.3%
1996 47.3% 30.2% 17.5% 35.3%
1995 23.6% 14.3% -0.4% 15.3%
0% 1994 20.5% -0.7% -9.3% 3.2%
19933 29.4% 5.4% 6.7% 12.4%
BUYs HOLDs SELLs Total Return
3
2701.3% 218.0% -58.9% 234.8%
Annualized 22.6% 7.3% -5.3% 7.7%
1) Historical results through January 3, 2005 were independently verified by Ernst & Young, LLP. E&Y did not verify stated results subsequent to January 3, 2005. Past performance results cannot be used to predict future performance.
For a complete explanation of study, see 5/9/03 report "How are We Doing?".
2) Company inclusion in the calculation of total return has been based on whether the companies were listed in the primary exhibit of Green Street’s "Real Estate Securities Monthly”, pg. 11-14. Beginning with May 2000, Gaming C-Corps
and Hotel C-Corps, with the exception of Starwood Hotels and Homestead Village, are not included in the primary exhibit and therefore not included in the calculation of total return. Beginning with March 2003, all Hotel companies are
excluded.
3) Study uses recommendations given in Green Street's "Real Estate Securities Monthly" from January 29, 1993 through May 29, 2009.
4) Not directly comparable to Green Street's performance indices because NAREIT includes more companies and uses market-cap weightings. Green Street's returns are equally-weighted averages.
Green Street Advisors - North American Team*
Research (Newport Beach) + 1 (949) 640-8780
General:
Mike Kirby, Director of Research mkirby@greenst.com
Craig Leupold, President cleupold@greenst.com
Peter Rothemund, CFA, Senior Associate prothemund@greenst.com
Kawika Tarayao, Senior Associate** ktarayao@greenst.com
Matthew Wokasch, CFA, Senior Associate mwokasch@greenst.com
Office/Industrial/Self Storage:
Michael Knott, CFA, Senior Analyst mknott@greenst.com
Cedrik Lachance, Senior Analyst clachance@greenst.com
John Stewart, CFA, Analyst jstewart@greenst.com
Steve Frankel, Senior Associate sfrankel@greenst.com
Lukas Hartwich, Associate lhartwich@greenst.com
Enrique Torres, Associate etorres@greenst.com
Alexandra Coupe, Associate acoupe@greenst.com
Retail/Health Care:
Jim Sullivan, Managing Director jsullivan@greenst.com
Nicholas Vedder, Analyst nvedder@greenst.com
Rosemary Pugh, Senior Associate rpugh@greenst.com
Andrew Johns, Associate ajohns@greenst.com
Residential:
Andrew McCulloch, CFA, Senior Analyst amcculloch@greenst.com
Chris Van Ens, CFA, Senior Associate cvanens@greenst.com
Laura Clark, Associate** lclark@greenst.com
Stephen Bakke, Associate** sbakke@greenst.com
Lodging:
John Arabia, Managing Director jarabia@greenst.com
Bob Grundstrom, Senior Associate bgrundstrom@greenst.com
Trading & Institutional Sales (Dallas) 1 (800) 263-1388

Lynn Lewis, Managing Director of Sales and Trading lynnlewis@greenst.com
Sherman Burns, Managing Director & Trading Manager sburns@greenst.com
Laurie Hauck, Vice President, Trading lhauck@greenst.com
Carol Parker, Vice President, Trading cparker@greenst.com
David Alexander, Vice President, Trading dalexander@greenst.com
David Auerbach, Vice President, Trading dauerbach@greenst.com
Anthony Scalia, Vice President & Institutional Sales Manager ascalia@greenst.com
Tim Joy, Vice President, Institutional Sales tjoy@greenst.com
Scott Bell, Vice President, Institutional Sales sbell@greenst.com
Murrie Holland, Institutional Sales mholland@greenst.com
Seth Laughlin, Institutional Sales slaughlin@greenst.com
Consulting (Newport Beach) +1 (949) 640-8780

Adam Markman, Managing Director amarkman@greenst.com
Brad Soltis, Associate bsoltis@greenst.com
Paul Harmeling, Associate pharmeling@greenst.com
Administration (Newport Beach) +1 (949) 640-8780

Warner Griswold, CFA, Chief Operating Officer wgriswold@greenst.com
Michael Kao, Director, Technology mkao@greenst.com
Damon Scott, Director, Marketing dscott@greenst.com
Dan Malloy, Manager, Marketing dmalloy@greenst.com
Robyn Francis, Manager, Compliance rfrancis@greenst.com
Kathy Chamberlain, Human Resources kchamberlain@greenst.com
Headquarters/Research Trading & Institutional Sales Europe - Research & Trading

567 San Nicolas Drive, Suite 200 600 North Pearl Street, Suite 2310 22 Grosvenor Square, 3rd Floor
Newport Beach, CA 92660 Dallas, TX 75201 London, W1K 6LF, UK
+1 (949) 640-8780 Trading: 1 (800) 263-1388 Main: +44 (0) 20 7290 6540
Sales: +1 (214) 855-5905 Trading: +44 (0) 20 7290 6555
www.greenstreetadvisors.com
* This page contains a roster of most Green Street employees. However, only those listed in the "Research" section without an
asterisk (*) are registered representatives / research analysts.
** These research employees operate in a support capacity and are not yet registered representatives / research analysts.

Capital Structure 0709

Hochgeladen von

Dokumentinformationen

Originalbeschreibung:

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

Capital Structure 0709

Hochgeladen von

Copyright:

Verfügbare Formate

Capital Structure in the REIT Sector

Old Habits are Hard to Break

II. History of Real Estate Finance – An Affinity for Leverage

III. How Does the Rest of Corporate America Do It?

60% 54% Net Liabilities as a % of Total Mkt Capitalization 10.0

% of S&P Constituents (ex Financials) that Use More

IV. What Would Miller & Modigliani Have to Say?

M&M: The Boost Leverage Provides to FFO is Offset by Lower Multiples

FFO per Share P/FFO Multiple

The M&M View of Optimal Leverage for REITs

11% Cost of Financial

Impact of Leverage on Enterprise Value

Cost of Financial Distress

In such instances, a REIT could benefit from having some debt.

V. The Real World Lab Experiment

Leverage & Returns: The Real World Lab Experiment

The Hypothetical Impact of Leverage on REIT Returns

Leverage should goose shareholder returns.

12% of over 11% to match the risk/reward of a 40%

Leverage and Returns

AVB REG VNO been accompanied by a 40 bp

Avg Leverage Ratio

leveraged companies are inadequate (see Appendix C).

VI. Lessons Learned in This Downturn

Lesson One: Whatever used to be considered to be a prudent leverage target is

Average REIT Leverage

VII. Answers to Commonly Heard Objections from the Old School

VIII. Where We Go From Here

The Phases of the Re-Equitization Process

Avg Debt/Asset Value Avg Debt/NOI

Appendix A: Optimal Leverage Targets are Both Sector- and Company-Specific

The Effect of Leverage on WACC - Apartment REITs

Median - Top 50 12% 0.9

Leverage and Returns Before the Bust

Other Important Information

Total Return of Green Street's Recommendations

(as of 5/29/09) 2009 YTD3 2.8% 0.7% -21.5% -8.8%

Year Ended December 31:

Trading & Institutional Sales (Dallas) 1 (800) 263-1388

Consulting (Newport Beach) +1 (949) 640-8780

Administration (Newport Beach) +1 (949) 640-8780

Headquarters/Research Trading & Institutional Sales Europe - Research & Trading

Das könnte Ihnen auch gefallen