Issues in Estimating the Cost of Capital for Equity REITs F. C. Neil Myer Cleveland State University and The Townsend Group www.csuohio.edu/finance_department/myer/ f.myer@popmail.csuohio.edu neil@townsendgroup.com Mike Young The RREEF Funds James R. Webb Cleveland State University April 1998
Issues in Estimating the Cost of Capital for Equity REITs Introduction: The recent contest between public and private capital for dominance in the real estate markets has given rise to numerous questions concerning the advantages and disadvantages of each of the forms. One of the advantages often cited for public capital has been lower cost. In this study we discuss the issue of the cost of public capital raised by Real Estate Investment Trusts (REITs) and the cost of private capital raised by Real Estate Advisory firms primarily from pension funds. If REITs do possess a distinct risk adjusted cost of capital advantage, it would be one factor in favor of pension funds switching their method of investing in real estate from direct investment through advisory firms to investment through REITs. In fact, if this lower cost of capital persisted it would eventually lead to a situation in which advisory firms doing direct investment could not compete with REITs for new acquisitions, and therefore would eventually no longer be players in the markets. Indeed, some have suggested that day has already come, or is just around the corner, but presently these comments seem to be more wishful thinking on the part of REIT backers base on antidotal evidence than an empirically verifiable trend. 2
Although numerous articles have look at cost of capital estimates for industrial companies, and even more have studied regulated industries where cost of capital plays a role in rate regulation, few have looked at REITs. There has also been little consideration of the cost of capital from private sources such as pension funds. We provide simple estimate of the cost of equity capital for REITs based on two standard methods widely employed in corporate finance, the CAPM method and the DCF method and discuss their relationship to the cost of equity capital typically required by pension funds for real estate investments. We also discuss the question of whether the REIT have and advantage concerning their cost of debt over pension funds. Cost of Capital: In traditional corporate finance applications a firm s cost of capital is estimated in two steps. First the cost of each of the components in the capital structure is estimated. Then these components are combined to yield a single weighted average cost of capital. The two main components in the capital structure of most REITs and of most pension fund investments in real estate are debt and equity. Cost of Debt: One of the most common arguments today for REITs advantage in cost of capital over private market sources is their increasing ability to acquire investment grade rating for unsecured debt. Although this may give them an advantage over 3
private owners/operator/developers, it seems unlikely that it gives them an advantage over pension funds. Pension funds have even more options than REITs available to them, if they want to place leverage on their real estate portfolio. They have borrowed at the portfolio level rather than mortgaging individual properties and have employed recourse debt (which is essentially borrowing against the credit worthiness of the overall fund). They can and do employ 100% equity investing when leverage provides no advantages. Even in the case of owner/operator/developers, it must be remembered that a cost of capital that is simply lower or higher is not in it s self and advantage. The advantage is only achieved if the cost of capital is lower on a risk-adjusted basis. Comparing mortgage debt, unsecured corporate debt, and borrowing from floating rate lines of credit, are comparing apples and oranges unless risk adjustments are applied. Given the above arguments, its seems clear that REITs enjoy no advantage over pension fund in terms of their cost of debt. If some day REITs become taxable, this might provide an area of advantage, but this would no doubt present many other problems for the REITs. Cost of Equity: This leaves the question of whether REITs enjoy and advantage in terms of the cost of equity over pensions funds. 4
REITs: We have estimated the cost of capital for 55 equity REITs using the two most widely used techniques: the CAPM method, and the DCF method. The results are given in Exhibits one through four. The first step in creating a CAPM estimate of the cost of equity capital for a company is estimating the stock s beta. We have estimated the beta using the market model equation. Daily data over the two year period 1995-1996 were used and the CRSP value weighted index was used as the market proxy. The relatively short period and the use of daily data were determined by the need to capture the impacts of the dynamic changes that have resulted in a large increase in the number and size of REIT that took place over the period form 1991-1994. Once the betas have been estimated, the security market line equations is used to estimate the cost of capital. The use of the SML equation requires an estimate of risk-free rate and the market risk premium (the excess return of the market over the risk-free rate). The considerable controversy of what numbers to used for these estimated is extensively discussed in Cornell, Hirshleifer, and Jones (1997). We have chosen to use their estimate of the expected long term yield on 20-year Treasury bonds at the end of 1996 of 6.73% as the risk-free rate of interest and their estimate of the market risk premium of 5.5%. 5
The results for these estimates are disappointing. Beta estimates are quite low for all the four sectors, although most estimates are statistically significant. R- square values for the market model regression are also low. Although low R- square value are typical when using daily data, these are even lower than usual. Two possible explanations for the low estimates are a time period effect and the inability of the market proxy (the CRSP value weighted index) to fully explain systematic risk of the REITs. These could be addressed by using a longer time periods and employing a multi-factor risk model. DFC estimate of the cost of capital involve finding the discount rate that equates the present value of future expected dividends to current stock price. This model requires knowledge of the current stock price, the current dividend, and the expected future pattern of growth in dividends. Price, dividend, and one year growth rate forecasts for FFO as of the end of 1996 were obtained from the SNL database. SNL was also the source for determining the property type sector into which each REIT was placed. The cost of equity capital was then estimated assuming that the dividend would grow at the forecast rate for FFO growth over the first year and would decline linearly to the over all growth rate of the economy over the next twenty years. We used Cornell, Hirshleifer, and James s estimate for the long term growth of the economy of 5.61%. The results of these estimates are presented in column labeled DCF ke 1 of the Exhibits. Again the results are disappointing. This time the numbers are more realistic, but would likely be considered high with respect to most estimates of future REIT performance. This may have resulted for estimates of FFO growth that were 6
quite aggressive for the following year, but were perhaps expected to decline to an average rate more quickly than over 20 years. In order to test this hypothesis, we reduced the time to convergence to 10 years, and given the nature of REIT investments we reduced the long run growth assumptions to 3%, a reasonable estimate of the long term inflation rate. The results of using these estimates appear in column DCF ke 2 of the tables. As expected, this lead to a drop in the cost of capital, but many still remain high. Pension Funds: Pension funds required returns on properties are somewhat more difficult to pin down. As a general rule of thumb, the required return on properties that have similar risk characteristics to those of the average REIT is probably in the 9%- 11% range. This number is much higher than the CAPM estimates for the cost of equity for the REITs and it is much lower than the DFC model one estimates. The DCF model two estimates are closer to these number but most still exceed the pension fund costs. Conclusions: There do not seem to be convincing arguments that REITs enjoy an advantage in cost of debt over pension funds even before adjusting for risk. Pension funds have at least as much flexibility in leveraging their real estate portfolios as do REITs. 7
The question of the cost of equity is still an open question. Better estimates of the cost of equity for REITs are necessary. CAPM type estimates might be improved by using a more complete model of systematic risk. They also might improve form using a longer or more stable period of time to estimate betas, when that becomes possible. DCF estimate would benefit from longer term and more detailed forecast of FFO growth. 8
References Cornell, Bradford, John I. Hirshleifer, and Elizabeth P. James. 1997. Estimating the Cost of Equity Capital., Contemporary Finance Digest. Vol. 1:1, 5-26 9
Exhibit One:Cost of Capital Estimates for Apartments Name Beta T R2 96 PRC 96 DIV 96 GE CAPM ke DCF ke 1 DCF ke 2 Amli Residential Properties 0.210 2.320 0.0106 23.375 1.720 6.84% 7.89% 14.01% 11.82% Associated Estates Realty 0.184 2.444 0.0117 23.750 1.800 5.88% 7.74% 13.75% 11.75% Avalon Properties 0.505 5.382 0.0544 28.750 1.490 5.78% 9.51% 11.15% 9.00% Bay Apartment Comm. 0.379 4.242 0.0345 36.000 1.610 9.63% 8.81% 11.86% 9.06% Camden Property Trust 0.275 3.294 0.0211 28.625 1.900 6.82% 8.24% 13.20% 10.97% Charles E. Smith Residential 0.308 4.391 0.0368 29.250 1.980 6.72% 8.42% 13.30% 11.09% Equity Residential 0.310 3.770 0.0274 41.250 2.400 7.02% 8.44% 12.37% 10.06% Essex Property Trust 0.297 3.117 0.0189 29.375 1.720 4.65% 8.36% 11.39% 9.46% Gables Residential Trust 0.232 2.877 0.0162 29.000 1.940 10.45% 8.01% 15.13% 12.21% Home Properties of N.Y. 0.262 3.300 0.0211 22.500 1.690 7.14% 8.17% 14.34% 12.10% Irvine Apt. Communities 0.334 3.580 0.0248 25.000 1.440 4.68% 8.57% 11.30% 9.36% Merry Land & Invst. 0.244 3.107 0.0188 21.500 1.480 9.24% 8.07% 14.73% 12.05% Mid-America Apt. Comm 0.225 3.001 0.0176 28.875 2.040 8.33% 7.97% 14.46% 11.97% Oasis Residential 0.381 4.789 0.0435 22.750 1.740 11.85% 8.83% 17.18% 13.98% Post Properties 0.185 3.015 0.0177 40.250 2.110 7.51% 7.75% 11.93% 9.50% Security Capital Pacific Tr. 0.352 4.097 0.0322 22.875 3.400 13.79% 8.67% 27.86% 24.51% Summit Properties 0.233 2.682 0.0141 22.125 1.540 12.65% 8.01% 16.72% 13.34% United Dominion Realty 0.149 1.733 0.0059 15.500 0.950 10.17% 7.55% 14.26% 11.38% Walden Residential 0.286 3.381 0.0222 24.875 1.860 9.80% 8.30% 15.77% 13.00%
Exhibit Two: Cost of Capital Estimates for Neighborhood Shopping Centers Name Beta T R2 96 PRC 96 DIV 96 GE CAPM ke DCF ke 1 DCF ke 2 Alexander Haagen Properties 0.279 2.197 0.0095 14.750 1.440 7.801 8.26% 17.28% 15.01% Burnham Pacific 0.186 1.639 0.0053 15.000 1.000 2.941 7.75% 11.45% 9.85% Developers Diversified 0.292 4.036 0.0313 37.125 2.400 10.075 8.33% 14.64% 11.79% Excel Realty Trust 0.461 5.031 0.0478 25.375 1.810 5.195 9.27% 12.94% 11.02% Federal Realty 0.429 5.057 0.0483 27.125 1.650 6.145 9.09% 12.27% 10.12% IRT Property 0.197 1.978 0.0077 11.500 0.900 1.923 7.81% 12.04% 10.72% JDN Realty 0.288 3.320 0.0214 27.625 1.880 8.451 8.32% 14.22% 11.69% Kimco Realty 0.200 3.105 0.0188 34.875 1.560 9.390 7.83% 11.77% 9.01% Kranzco Realty Trust 0.228 2.399 0.0113 16.875 1.920 6.047 7.98% 17.92% 16.09% Mark Centers Trust 0.327 2.874 0.0161 10.125 1.080 2.484 8.53% 14.94% 13.77% New Plan Realty 0.190 2.732 0.0146 21.250 1.410 8.844 7.78% 14.21% 11.60% Price REIT 0.116 1.668 0.0055 38.500 2.800 6.333 7.37% 13.66% 11.55% Regency Realty 0.393 4.114 0.0325 26.250 1.620 5.641 8.89% 12.14% 10.08% Saul Centers 0.319 3.239 0.0204 15.875 1.560 10.180 8.48% 18.90% 16.12% Weingarten 0.239 4.072 0.0318 40.625 2.480 6.383 8.04% 12.40% 10.22% Western Investment 0.177 2.012 0.0080 13.000 1.120 5.469 7.70% 14.63% 12.76%
Exhibit Three: Cost of Capital Estimates for Regional Malls Name Beta T R2 96 PRC 96 DIV 96 GE CAPM ke DCF ke 1 DCF ke 2 CBL & Associates Properties 0.369 4.751 0.0429 25.875 1.680 5.263 8.76% 12.31% 10.33% Crown American 0.268 1.836 0.0066 7.500 0.800-4.027 8.20% 11.42% 11.26% General Growth 0.324 3.751 0.0272 32.250 1.720 7.614 8.51% 12.08% 9.64% Glimcher 0.265 3.091 0.0186 22.000 1.920 6.306 8.19% 15.22% 13.20% JP Realty 0.200 2.401 0.0113 25.875 1.700 8.065 7.83% 13.74% 11.28% Macerich 0.206 2.728 0.0145 26.125 1.700 11.050 7.86% 15.22% 12.16% Mills Corporation 0.373 3.215 0.0201 23.875 1.890 9.091 8.78% 15.90% 13.29% Taubman Centers 0.385 3.770 0.0274 12.875 0.890 3.158 8.85% 11.77% 10.17% Urban Shopping Centers 0.104 1.441 0.0041 29.000 1.980 4.348 7.30% 12.23% 10.43%
Exhibit Four:Cost of Capital Estimates for Office/Industrial Name Beta T R2 96 PRC 96 DIV 96 GE CAPM ke DCF ke 1 DCF ke 2 Centerpoint Properties 0.024 0.261 0.0001 32.7500 1.6200 12.1547 6.86% 13.63% 10.36% First Industrial Realty Trust 0.501 4.888 0.0453 30.3750 1.9700 8.0000 9.48% 13.61% 11.15% Highwoods Properties 0.347 4.140 0.0329 33.7500 1.8600 12.0930 8.64% 14.40% 11.14% Liberty Property Trust 0.270 3.729 0.0269 25.7500 1.6100 12.3596 8.22% 15.58% 12.25% Security Capital Industrial 0.168 1.775 0.0062 21.3750 1.0100 12.3894 7.65% 13.42% 10.11% Spieker Properties 0.181 2.033 0.0081 36.0000 1.7200 4.3062 7.72% 10.19% 8.20% Weeks Corporation 0.053 0.732 0.0011 33.2500 1.6000 11.2903 7.02% 13.04% 9.94%