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FinQuiz - Item-Set Answers, Study Session 15, Reading 44
FinQuiz - Item-Set Answers, Study Session 15, Reading 44
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CFA Level II Item-set - Solution
Study Session 15
June 2017
A is incorrect. In general, publically traded real estate securities (equity REITs and REOCs) provide
the ability to trade on stock exchanges. Thus REITs and REOCs both provide liquidity.
C is incorrect. Because REITs are constrained in their operations, investment choices and
distributions, REITs are prevented from maximizing their returns.
The most appropriate response to Concern 2 is No. Investments in publically traded REITs are not
suitable for investors seeking control over property-level investment decisions. Investors desiring
control should opt for a direct investment in the underlying property.
A is incorrect. Insurance costs are incorporated in the NOI calculation and are thus an element of
AFFO.
B is incorrect. Straight-line rent is an element of NOI and AFFO. It is the average contractual rent
over a lease term. Subtracting cash rent paid from straight-line rent produces non-cash rent; thus
straight-line rent is the sum of cash rent paid and non-cash rent, in other words it is equivalent to the
gross rental revenue.
To determine which type of REITs is most undervalued, it is necessary to determine the level of
discount to the average subsector P/AFFO:
Given that the economy is in an expansionary phase, short remaining lease terms provide mark-to-
market opportunities on term rent. All three properties have lease terms exceeding a year and are thus
almost equivalent in this respect; the three REITs do not provide attractive mark-to-market
opportunities.
Low-in place rents provide upside potential to cash flows upon lease re-negotiation while high in-
place rents represent additional risk to maintaining current cash flows. Office REITs and residential
REITs have low-in place rents and are desirable from this perspective while healthcare REITs are
least desirable.
The properties underlying office REITs have the highest percentage of tenant occupancy while
healthcare REITs' properties have the lowest percentage occupancy. Thus healthcare REITs are
undesirable from this perspective.
Based on in-place vs. market rent and percentage of occupied space, healthcare REITs are the least
desirable form of investment.
A is correct. REIT shares can be traded on the stock exchange and therefore they provide greater
liquidity than buying and selling real estate in property markets. Due to their large lot sizes, a direct
investment in real estate represents a relatively illiquid form of investment.
B is incorrect. The maintenance of a REIT structure is costly and may not be offset by the benefits.
C is incorrect. The stock market of a REIT is more volatile than the appraised value of a REIT.
Therefore, one would expect the REIT shares to have higher price and return volatility.
B is correct. Investment in REITs allows investors to diversify their real estate portfolios by
geography and property type. This type of diversification is hard to achieve in direct property
investing because of the large size and value of each property.
A is incorrect. Because REITs are associated with high dividend yields, there is less income available
for reinvestment. This low rate of reinvestment will reduce income growth potential.
C is incorrect. Because investors in REITs have their interests managed by professional managers,
control over property-level investment decisions no longer remains in their hands. This contrasts with
investors acquiring a direct investment in real estate; the latter are actively involved in the
management of the underlying property.
B is correct. Trends in government funding influences the value of an investment in a health care
REIT and is not relevant for the purposes of analysis.
A is incorrect. Job creation will lead to an increase in the use of storage space as personal and small
businesses need space to rise.
P/AFFO = Market price per share/[(NOI General and administrative expenses interest expense
non-cash rent maintenance-type capital expenditures)/Shares outstanding]
The warehouse appears to be relatively undervalued as it has a lower P/AFFO multiple compared to
the average industry.
Lewis is inaccurate regarding to Reason 1. FFO estimates are readily available through market data
providers.
Lewis is accurate regarding Reason 2. Applying a multiple to the FFO and AFFO may not capture the
intrinsic value of real estate assets held by the REIT or REOC. An example of this includes a parcel
of land and empty building which do not produce current income and thus do not contribute to FFO
but have value.
Lewis is accurate regarding Reason 3. The recent increase in one-time items such as gains as well as
new revenue recognition rules have affected the income statement making the P/FFO and P/AFFO
multiples more difficult to compute and complicating comparisons between companies.
The repositioning strategy will be dilutive to earnings because the cap rate at which the properties
will be sold is higher than yields at which they are reinvested reflecting lower risk premiums.
Therefore, the REIT will most likely face cash flow growth pressures in the near term as a material
portion of the portfolio is reinvested into higher-quality properties.
Prior to discounting the dividends, the required rate of return will need to be determined
using CAPM:
Current value of office REIT share = $0.7970 + $0.9671 + $2.0608 + $130.94 = $134.76
B is correct. A higher long-term growth rate will decrease the current value of each REIT share.
A is incorrect. The cap rate does not influence the intrinsic value of a REIT share calculated using the
dividend discount model.
B is correct. Observation 1 will have an indeterminate impact on NAVPS while Observation 2 will
increase NAVPS. A higher future rental income stream will increase NOI and thus NAVPS; the latter
includes the next 12 months expected NOI as a component. On the other hand, a higher cap rate
resulting from a higher rental income stream will reduce the NAVPS. The dividend growth rate does
not affect the NAVPS calculation. Therefore, the observation does not have a clear cut impact on the
NAVPS measure.
Observation 2 will serve to increase NAVPS. Land held for future development is added to the
estimated value of operating real estate to arrive at net asset value. Therefore, an increase in the land
value will serve to increase NAVPS.
A is incorrect. The NAVPS includes the next 12 months growth in NOI as a component in its
calculation.
C is incorrect. NAVPS includes the value of land as a component. Where the market value of land
cannot be reliably estimated, book value is used instead.
C is correct. National GDP growth is one of the main drivers influencing the value of an office REIT
as businesses are prepared to pay more rent as well as demand office space to accommodate more
business in a stronger economy.
A and B are incorrect. The value of an office REIT is least affected by retail sales growth and
population growth.
REITs are characterized by high dividend yields often paying a significant portion of their income as
dividends. Therefore, this makes the dividend discount model an appropriate valuation tool.
Penn should invest in either the REIT or REOC to achieve diversification. On the other hand,
diversification is hard to achieve in direct property investing because of the large size and value of the
property.
Unlike REITs, REOCs as well as direct property investors are free to invest in any kind of real estate
subject only to the limitations that may be imposed by their articles of incorporation and/or the
market. In contrast to REOCs, REITs are constrained in their investments, operations, and
distributions.
REOCs are free to use a wider range of capital structures and degrees of financial leverage.
For his personal investment portfolio, Penn should select either a REOC or REIT investment. Both
types of structures permit investors to purchase shares that represent fractional interests with a much
lower investment than a single commercial property. On the other hand, large lot sizes of real estate
considerably increase the cost of investment making it difficult for investors such as Penn to
purchase.
B is correct. Equity markets of most countries have shown a preference for the tax advantages, high-
income distributions and stringent operating and financial mandates that come with the REIT status.
Therefore, REOCs have less access to equity capital and lower market valuations relative to REITs.
C is incorrect. REOCs are ordinary taxable corporations thus subjecting investors to the taxation of
their dividend income.
C is correct. Given that the management of the underlying properties is delegated to subsidiary
REITs, due diligence of senior management serving the parent REIT is not relevant.
A is incorrect. Because the income of a hotel REIT is variable and demand is cyclical, analysts need
to be wary of structures that use a high degree of financial leverage. Therefore, a review of the
REITs balance sheet and leverage levels need to be examined.
B is incorrect. Compared to other real estate, hotels have the shortest lease terms. Short-term leases
are a positive consideration in an expansionary economy and/or rental market and a negative
consideration in a declining economy and/rental market.
Penn is accurate with respect to Reason 1 but inaccurate with respect to Reason 2.
One of the main reasons of why REIT shares trade at a premium or discount relative to their NAV is
that public equity market investors ascribe a different value to the REIT relative to the private buyers.
When the value ascribed by the public equity market is lower relative to private buyers, REIT shares
trade at a discount to their NAV.
When the underlying property market is illiquid, estimating a NAV becomes difficult as the estimates
can become quite subjective.