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Investing in Real Estate Investment Trusts

Summary Mill Creek Perspectives


Real Estate Investment Trusts (REITs) offer investors exposure to a diversified portfolio of professionally managed commercial real estate properties. Unlike investing directly in real estate, REIT investors benefit from the greater transparency of publicly traded REITs, the ability of REITs to access both the debt and equity markets to finance real estate purchases, and the daily liquidity of REIT shares. REITs typically pay higher dividend yields than most other types of equity securities, owing to their unique tax structure and to requirements on the amount of REIT income which must be distributed annually to shareholders. Investment portfolios may benefit from the addition of REIT securities to their mix of assets because of their potential for producing returns that are uncorrelated to those of other asset classes. In recent periods, however, returns on REITs have been more tightly correlated to stock market returns than they have been to returns on commercial real estate. REITs have several potential disadvantages about which investors should be aware. At times, they can become overvalued and offer poor expected future returns. REITs are also reliant on the capital markets for funding, and therefore can become volatile and may decline in value when other asset classes are also suffering from periods of poor-performing financial markets.

This publication has been prepared by Mill Creek Capital Advisors, LLC (MCCA). The publication is provided for information purposes only. The information contained in this publication has been obtained from sources that MCCA believes to be reliable, but MCCA does not represent or warrant that it is accurate or complete. The views in this publication are those of MCCA and are subject to change, and MCCA has no obligation to update its opinions or the information in this publication. While MCCA has obtained information believed to be reliable, neither MCCA nor any of its respective officers, partners, or employees accept any liability whatsoever for any direct or consequential loss arising from any use of this publication or its contents.

Real Estate Investment Trusts (REITs) offer investors the ability to gain exposure to a diversified portfolio of professionally managed commercial real estate assets. Investors can benefit by adding REITs to their portfolios due to the potential for REITS to produce returns that are uncorrelated to other asset classes, thereby producing an investment portfolio with a better overall risk-adjusted return. Unlike investing directly in real estate in the private markets, REIT investors also benefit from the increased transparency and liquidity of REITs, certain tax advantages and generally above-average dividend yields, and the ability of REITs to use both the debt and equity markets to finance real estate purchases. This paper reviews the different types of REITS available for investment, provides a brief history of this asset class and describes its current composition, and discusses how Mill Creek Capital Advisors evaluates U.S. REITs. What is a Real Estate Investment Trust (REIT)? A REIT is a specific type of corporation or business trust that owns and manages real estate assets and which has elected to qualify as a Real Estate Investment Trust under certain provisions of the U.S. tax code1. REITs today collectively own a large portion of all institutionally-owned real estate assets (according to NAREIT, an industry association, REITs now own 10-15% of all commercial real estate in the United States). In general, REITs actively own and manage diversified portfolios of income-producing real estate assets; they are not a passively managed collection of real estate assets. REITs avoid taxation at the corporate level through the distribution of the vast majority of earnings to shareholders. Investors in REITs are purchasing the equity (or riskiest) portion of the REIT capital structure. Investors potentially benefit from investments in REITs because they gain exposure to a diversified portfolio of real estate assets that are professionally managed and which avoid double taxation (their net income is taxable only to REIT shareholders). The benefits for investors of REITs being exchangetraded include daily pricing and liquidity, greater underlying transparency, access to equity markets and the benefits of regulatory oversight offered on exchange-traded securities. REITs also utilize the public debt markets for financing. Generally speaking, in order to qualify as a REIT, the vast majority of a real estate trusts business must be focused on the ownership and

management of real estate assets. The specific legal requirements for qualification include:

At least 75% of gross income must come from rents, mortgages, interest income and sales of properties. REITs are allowed to derive up to 20% of revenue from other services (a change which was created by the 1999 Real Estate Modernization Act). At least 75% of assets must be invested in real estate, mortgage loans, shares of other REITs, cash or government securities. At least 90% of income, excluding capital gains from the sale of properties, must be paid to shareholders in the form of dividends. At least 100 shareholders and less than 50% of the outstanding shares may be concentrated with five or fewer shareholders.

Types of REITs REITs can be classified by strategy and by the types of property that they manage. By strategy, there are three types of REITs:

Equity: These REITs invest in and own properties. Investors in these REITs receive the economic benefits (rent; appreciation) from the properties owned. The vast majority of REITs are equity REITs (approximately 90% of the industrys current market capitalization is made up of equity REITs). Mortgage: These REITs loan money for mortgages to owners of real estate or purchase mortgage backed securities. Hybrid: There are very few if any hybrid REITs presently. They combine both equity and mortgage REIT strategies.

Given that the vast majority of REITs are equity REITs, this paper will focus on that particular strategy. Investors can also classify REITs by the types of property that they manage:

Retail: Shopping centers and malls. Some of these REITs operate retail centers owned by third parties and receive a portion of the centers revenues. Healthcare: Senior housing, hospitals, skilled nursing facilities, medical office buildings and other healthcare-oriented properties.
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Although there are both private and publicly-traded REITs, this paper will focus on the publicly-traded category

Multi-family: Apartment complexes and buildings. Office/Industrial: Commercial office buildings and industrial warehouses. Hospitality: Hotels and resorts. Other: A small number of REITs also own other property types such as storage units, manufactured housing, and movie theatres.

late-1980s; popularity of real estate caused by inflationary pressures in the 70s and early 80s had resulted in significant overbuilding, which then caused rising vacancies and stagnating rents. However, despite worsening fundamentals, REIT stock prices continued to be strong until the early 1990s. Calendar year 1990 saw the first poor performance for REITs in years, with a -15.4% return for the year amid a real estate downturn and a crisis in the savings and loan segment of the banking industry. However, REITs quickly recovered from this poor performance with +23.0% annualized returns over the next three years. While part of this quick recovery and strong subsequent performance was the result of improved property valuations following the poor performance of 1990, much of it was due to REITs ability to raise equity capital (at a time when private investors were less able to access the capital markets) and purchase assets at very distressed valuations. The net result of this was that 1990-1995 saw the real beginning of the REIT asset class as it exists today as the number of REITs and the total market capitalization of the asset class exploded. While this history adds color to the evolution of REITs, it does not show the dramatic change in size of the REIT universe from the 1960s onward. The entire capitalization of the REIT market was only $2 billion in 1980 and just $9 billion in 1990. By 2000, total REIT market capitalization had grown to $134 billion and by the end of 2010 it stood at a staggering $389 billion. The average REIT market capitalization was approximately $260 million in 1995. By the end of 2010, it was $2.5 billion. The market value of publicly traded REITS recently represented approximately 2.9% of the U.S. stock markets total value; smaller-sized REITS comprise a greater (nearly 9%) proportion of the of the U.S. equity markets Small Cap sector. This huge change in total market capitalization has come despite the fact that the number of REITs has not grown nearly as dramatically. For example, there were 119 REITs in 1990, 219 REITs in 1995, and only 153 REITs by the end of 2010. To us, this substantial evolution of the asset class across the last 5 decades implies that the REIT markets risk and return characteristics have changed over time. As such, we place more emphasis on the performance and risk of REITs over the last 15 years or so relative to their prior history. As shown in the table atop the next page, at present there are 146 publicly traded REITs (excluding 33 REITs with market capitalization less than $100 million and four timber REITs). The table provides a breakdown of these REITs by strategy type, property type and market capitalization: Todays REIT market is dominated by equity REITs (90% of the total market capitalization). By property type, the REIT market is wellPage | 2

REITs: Past and Present REITs were originally created in 1960 to enable investors to invest in diversified portfolios of commercial real estate. They represented passive investments in real estate until the Tax Reform Act of 1986 paved the way for REITs to both hold and actively manage assets. Today, the vast majority of REITs are really operating real estate businesses, not passive investments in real estate assets. In our opinion, long-term historical data on REITs is not very helpful in analyzing their performance due to the dramatic changes that have taken place in the asset class since the early 1990s. That said, a historical perspective on REITs is helpful in understanding the potential for boom and bust cycles in real estate, how REITs have responded, and how they may respond in the future. In the 1960s, there were only about 10 REITs of any real size, and they were still very small (individual market capitalizations of approximately $10-50 million). Also, unlike REITs today, they were managed by outside (unaffiliated) advisors. Starting in the late 1960s, REITs became increasingly popular as an investment. From 1968-1970, 58 mortgage REITs were created and total assets under management grew from $1 billion to $20 billion by the mid-1970s. Unfortunately, those REITs used excessive amounts of leverage, and when interest rates rose during the highly inflationary 1970s, their share prices collapsed. However, a number of equity REITs performed quite well during this period. The NAREIT Equity Index (an industry benchmark of REIT performance) produced a +11.1% annualized return from 1972-19792. But the debacle of the mortgage REITs caused most investors to turn away from REITs, and they did not gain widespread investor interest or acceptance. The 1980s witnessed very strong performance for REITs, with the NAREIT Equity Index producing a +15.6% annualized return over the decade. Real estate fundamentals started to deteriorate by the mid- to
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The inception date of the NAREIT Equity index is 1972

diversified with the bulk of REITs focused on retail, industrial/office, multi-family and health care (68% of market capitalization).
Market Cap Total ($Bn) 146 $ 419.6 122 $ 24 29 $ 26 24 16 15 14 12 4 3 3 11 $ 70 65 377.0 42.6 106.4 64.7 42.6 28.2 64.1 23.2 51.8 26.7 8.4 3.5 191.5 197.8 30.3 % by Number 100% 83.7% 16.3% 19.9% 17.8% 16.4% 11.0% 10.3% 9.6% 8.2% 2.7% 2.1% 2.1% 7.5% 47.9% 44.5% % by Market Cap 100.0% 89.9% 10.1% 25.4% 15.4% 10.2% 6.7% 15.3% 5.5% 12.3% 6.4% 2.0% 0.8% 45.6% 47.1% 7.2%

investment-grade corporate bonds across the ensuing 16 years, albeit with somewhat greater volatility: Comparison of Annualized Returns and Risks, 1996-2011
Returns Volatility Sharpe Ratio REITs U.S. Equities Commercial Real Estate High Yield Bonds Investment GradeBonds 10.4% 6.6% 9.5% 6.8% 6.1% 22.6% 18.8% 5.1% 10.5% 4.5% 0.33 0.19 1.25 0.36 0.68

Total REITs By Strategy Equity Mortgage By Property Type Retail Industrial/Office Mortgage Diversified Multi-Family Hospitality Health Care Storage Data Centers Manufactured Housing By Market Capitalization Greater than $10 billion $1-10 billion $100 mm - $1 billion

As reflected in these results, long-term returns on REITs have been comparable to those on a benchmark representative of returns earned on institutional ownership of commercial real estate properties3. Though this would seem to be instinctively logical, REITs and direct investments in a portfolio of commercial real estate properties have produced divergent returns on a year-by year basis. Most recently (2008 onward), REITs have performed more in line with large cap U.S. equities than they have commercial real estate:
40.0%

ComparisonofYearlyReturns,19962011

30.0%

20.0%

Additionally, the REIT market is dominated by 11 REITs which each have market capitalizations over $10 billion; combined these large REITS are only 7.5% of REITs by number but represent almost half (46%) of the market by capitalization. By way of contrast, the largest 10 companies comprising the S&P 500 Index represent just 22% of that benchmark. Accordingly, we caution that when investors consider investing in an index fund to gain exposure to REITs today, they should be aware that they will be receiving significant exposure to a select number of large REITs whose return profiles most likely will not resemble the historical performance of the REIT market when the typical REIT was much smaller than they are at present. Historical Investment Performance We place more emphasis on the performance of REITs starting in 1996, given the dramatic changes in the REIT universe from earlier periods as analyzed above. As reflected in the table below, REITs have cumulatively out-performed U.S. equities, high yield bonds and

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0.0% 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

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CommercialRealEstate
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S&P500 REITS

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The somewhat dissimilar year-by-year performance of REITS and a diversified portfolio of commercial real estate properties have given rise to a body of academic work which seeks to explain the different invest3

An index created and maintained by the National Council of Real Estate Investment Fiduciaries (NCREIF) Page | 3

ment outcomes. Some of the research has concluded that a lag effect (less frequent valuation of physical real estate properties versus the daily market pricing of REIT securities) accounts for some of the disparity; other research has shown that in certain economic environments investors have paid a premium for REITs perceived management skills. And on balance, much of the research concludes that REITs are not an even-up substitute for direct investments in real estate. To complicate matters even further, the correlation benefits of owning REITs have eroded over time. While the long-term correlation of REIT returns to other asset classes has been only moderate, it has increased dramatically over the last five years. As shown in the following table, REITs have been more correlated to other risky asset classes over the last five years relative to their performance in the past: 5-Year Correlation of REIT Returns to Other Asset Classes
Asset Class U.S. Equities High Yield Bonds Investment Grade Corporate Bonds Commerical Real Estate 5 Year Correlations 12/31/2000 12/31/2005 12/31/2011 0.17 0.58 0.84 0.42 0.38 0.69 0.16 0.10 0.40 -0.26 0.21 0.27

Based on this historical data, it is evident that there are some periods of time in which it is wise to discretionarily allocate assets to REITs away from other risky asset classes and some periods when it is probably best to maintain only a minimal (market weight or below) exposure. As long-term fundamental investors, we believe that this decision should be based on whether REITs are attractively valued. The next section of this paper addresses various methods investors can utilize to determine if REITs are attractively valued. Evaluating REITs: Dividends, Yields, and Earnings Given that REITs pay a regular income dividend and that many investors purchase them for this reason, many investors focus on dividend yield to determine whether REITs are attractive. We believe this is a somewhat simplistic approach. Dividend yield is just one measure of value and largely ignores both the potential riskiness of REITs and the growth characteristics of REITs earnings stream. Nevertheless, comparing a REITs current dividend yield to a risk-free rate has been a good predictor of the future performance. The table below shows the excess dividend yield of equity REITs at the beginning of each calendar year (excess dividend yield is calculated as the dividend yield less the yield on a 10 Year U.S. Treasury, a proxy for a long-term risk-free rate of return). Shown to the right of the excess dividend yield is the subsequent three year annualized performance of REITs.
Calendar Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Beginning Yield 7.4% 6.1% 5.5% 7.5% 8.7% 7.5% 7.1% 7.1% 5.5% 4.7% 4.6% 3.7% 4.9% 7.6% 3.8% 3.3% 3.9% Beginning Excess Yield 1.7% -0.5% 0.0% 2.6% 1.9% 2.1% 1.8% 3.3% 1.1% 0.9% -0.3% -1.4% 1.4% 6.2% 0.6% 0.1% 2.0% Annualized Returns (3 Yrs Forward) 10.3% -1.8% -0.2% 11.2% 14.3% 17.5% 23.3% 26.5% 25.8% 8.5% -10.8% -12.4% 0.7% 21.1% Not available Not available Not available

Given the volatility and correlation characteristics of REITs, our conclusion is that they should be treated as a sub-asset class within clients U.S. equity allocations. REITs have historically had periods of drastic under- and over-performance relative to a broader benchmark of U.S. equities, so we view it as crucial that investors be selective about when to increase exposure to the REIT sub-asset class (just as they should, for example, be subjective about when to overweight allocations to market sectors like small cap stocks). The chart below displays this performance phenomenon, comparing five year trailing annualized returns of REITs compared to large and small cap U.S. equities over three different time periods: 5-Year Trailing Annualized Returns
20.0% 17.5%

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This analysis illustrates that historically the best time to invest in REITs is when they have offered a dividend yield greater than the riskfree rate. Conceptually, this makes sense as investors have, at times, shunned risky assets (i.e., in 2002 and in 2008) and/or yield-oriented assets (in 1999) which has driven REITs to attractive valuation levels. Of course, sometimes investors drive REIT valuations to levels that make no economic sense (2006-2007) which causes them to be overvalued and leads to poor subsequent performance. While assessing the excess yield offered by REITs has been a useful gauge in predicting the subsequent performance of REITs, there are several factors that this overly-simplified method ignores. The largest of these issues is that it ignores REITs actual earnings (their funds from operations, or FFO) and focuses instead on what REITs are actually paying to their investors. We do not foresee REITs being able to sharply increase their dividends and thereby boost their dividend yields from their low (relative to history) current levels. Dividend payout ratios as a percentage of FFOs are slightly above historical norms. This implies that REITs cannot increase their dividend yields much without also increasing FFOs and/or becoming over-leveraged. We think that the key fundamental factors and events that allow REITs to grow and to increase their market value include the following: Internal growth: rental increases, tenant upgrades, property improvements, property sales and reinvestments External growth: acquisitions, development and expansion and non-rental revenue sources

investors are willing to pay for REITs have fluctuated, depending on their enthusiasm, or lack thereof, for the asset class. Another, more encompassing methodology for evaluating REITs is to calculate their FFO yield (i.e. FFO divided into price). This measure is similar to calculating an earnings yield for stocks. Given the comparable price volatility of REITs and other equity investments, we believe that investors should compare their FFO yields relative to the earnings yield offered by stocks. Based on this methodology, and as illustrated in the chart below, REITs are presently overvalued relative to stocks in an historical context:
REIT FFO Yields vs Stock Earnings Yields
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Excess Yield on REITs


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Median FFO Yield


REITs Cheap

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Yield (%)

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REITs Expensive
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These factors cause Funds from Operations (FFO), the key valuation metric typically used by investment professionals to analyze REITs, to fluctuate. FFO is meant to provide a normalized earnings figure for individual REITs. It does this by excluding the impact of capital gains or losses from the sale of real estate assets and adding back depreciation to net income. Because FFO is a simplistic method for evaluating REITs, most industry analysts also attempt to calculate adjusted funds from operations (AFFO). To calculate AFFO, items such as recurring capital expenditures, amortization of tenant improvements and leasing commissions and other items are deducted from FFO. The goal of this analysis is to determine a more accurate estimate of a REITs normalized earnings. By using market price relative to FFO or to AFFO, investors are able to analyze REIT valuations in much the same way as a stocks price to earnings (PE) ratio. Over time, the multiples of FFOs/AFFOs that

One of the benefits of REITs is their historically low volatility of FFO variation which implies a lower likelihood of dividend cuts relative to equities. During the recent recession, REITs overall exhibited a decline in FFO per share of 18.8%; in comparison, earnings of U.S. equities were -31.4% at the low point. As such, for investors who count on an income stream, REITs have the benefit of a seemingly more sustainable potential dividend relative to equities. The advantage of U.S. equities relative to REITs, however, is that they have been able to grow their earnings stream more rapidly both since 1995 and, especially, over the last five years. Since 1995, REITs have averaged +4.9% FFO per share growth versus +7.9% earnings per share growth for U.S. equities. Over the last five years this difference in earnings growth has become more pronounced: U.S. equities have grown earnings at a 5.8% annualized rate versus a +1.1% FFO rate of growth for REITs.
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Mar-10

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Excess Yield on REITs (Percentage Points)

REITs vs U.S. Equities - Growth Rates


9.0% REITs 8.0% 7.9% U.S. Equities

FFO/Earnings per Share Growth (Year over Year %)

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6.0% 4.9%

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variability and dividend payments. However, we believe that investors should be prudent, investing in REITs only when valuations are attractive relative to other asset classes and not just on the basis of an attractive current yield. We will continue to actively monitor REITs as an asset class, and look for opportunities to invest in them on behalf of our clients when REITs appear to offer attractive relative values versus other comparably risky asset classes. Mill Creek Capital Advisors, LLC February 2012

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REITs have been successful at convincing lenders to provide them with longer-term financing at attractive rates, and as a result they have increased their financial leverage over time (even as US corporations as a whole have decreased their borrowing). The additional borrowing means that REIT leverage is now at all-time highs. To us, this indebtedness is worrisome, and it makes REITs look less attractive in comparison to other types of U.S. corporations (which have lessened their risks in the event of tough financing markets). Conclusion REITs can offer investors an attractive way to gain exposure to a diversified, liquid, professionally managed portfolio of commercial real estate assets. Historically, investors have been mostly well-served to have placed a portion of their portfolio in REITs due to the high returns on and moderate correlation of these securities to other asset classes. For investors that desire a constant stream of dividend income, REITs can be a viable investment alternative due to the low levels of REIT earnings

Data used in the preparation of this report was drawn from a variety of sources, including Bloomberg Finance LP, NAREIT, and Zephyr Associates.

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