Reading 44 Publicly Traded Real Estate Securities FinQuiz.

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CFA Level II Item-set - Solution
Study Session 15
June 2017

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Reading 44 Publicly Traded Real Estate Securities FinQuiz.com

FinQuiz Level II 2017 Item-sets Solution

Reading 44: Publicly Traded Real Estate Securities

1. Question ID: 17980

Correct Answer: B
The contractual nature of REITs' rental income combined with high income payout rates makes
REITs the most stable and highest yielding of publically traded equities.

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.

2. Question ID: 17981

Correct Answer: C
The most appropriate response to Concern 1 is Yes. The stock market value of publically traded
REITs is more volatile than the appraised net asset value of privately traded REITs. Net asset values
based on appraised values rather than actual transaction prices tend to underestimate volatility.

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.

3. Question ID: 17982

Correct Answer: C
NOI is a figure calculated before the deduction of general and administrative expenses.

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.

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Reading 44 Publicly Traded Real Estate Securities FinQuiz.com

4. Question ID: 17983

Correct Answer: C
Total NAV = $25.40 5,000,000 = $127,000,000

Total NAV = $25.40 5,000,000 $127,000,000

Plus: debt and other liabilities $2,345,000
Less: Prepaid and other assets $760,000
Less: Land held for future development $9,000,000
Less: Accounts receivable $2,125,000
Less: Cash and equivalents $120,000
Estimated value of operating real estate (1) $117,340,000
Assumed cap rate (2) 7%
Estimated next 12 months cash NOI (1 2) $8,213,800
Less: General and administration expenses $200,000
Less: interest expense $45,000
FFO $7,968,800
FFO per share ($7,968,800/5,000,000) $1.59376
P/FFO ($33.50/1.59376) 21.02x

5. Question ID: 17984

Correct Answer: B
Residential REITs are most undervalued relative to their average subsector P/AFFO multiple.

To determine which type of REITs is most undervalued, it is necessary to determine the level of
discount to the average subsector P/AFFO:

Office Residential Healthcare

REITs' P/AFFO* 16.8x 15.3x 21.6x
Average subsector P/AFFO (given) 18.9x 17.7x 22.4x
REITs (Discount)/Premium to average subsector REITs (11.1%) (13.6%) (3.57%)

P/AFFO = Current share price/AFFO per share

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Reading 44 Publicly Traded Real Estate Securities FinQuiz.com

6. Question ID: 17985

Correct Answer: C
Healthcare REITs are the least desirable from an investment perspective.

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.

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Reading 44 Publicly Traded Real Estate Securities FinQuiz.com

FinQuiz Level II 2017 Item-sets Solution

Reading 44: Publicly Traded Real Estate Securities

7. Question ID: 48926

Correct Answer: A

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.

8. Question ID: 48927

Correct Answer: B

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.

9. Question ID: 48928

Correct Answer: B

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.

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Reading 44 Publicly Traded Real Estate Securities FinQuiz.com

10. Question ID: 48929

Correct Answer: C
To determine whether the warehouse property is mispriced, the P/AFFO multiple of the property
relative to the average industry needs to be calculated and compared.

P/AFFO = Market price per share/[(NOI General and administrative expenses interest expense
non-cash rent maintenance-type capital expenditures)/Shares outstanding]

*Non-cash rent = Straight-line rent cash rent

P/AFFO (Warehouse) = $47.56/[{$175,000 $4,250 $2,250 ($40,000 $35,000)

$1,080}/52,000] = $15.23

P/AFFO (Average Industry) = $52.09/[{$180,000 $4,780 $1,890 ($45,000 $25,000)

$2,010}/50,000] = $17.21

The warehouse appears to be relatively undervalued as it has a lower P/AFFO multiple compared to
the average industry.

11. Question ID: 48930

Correct Answer: B

NAV = NOI/Market cap rate = $175,000/0.08 = $2,187,500

NAVPS = $2,187,500/52,000 = $42.07

12. Question ID: 48931

Correct Answer: B

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.

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Reading 44 Publicly Traded Real Estate Securities FinQuiz.com

FinQuiz Level II 2017 Item-sets Solution

Reading 44: Publicly Traded Real Estate Securities

13. Question ID: 48933

Correct Answer: A

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.

14. Question ID: 48934

Correct Answer: B

Prior to discounting the dividends, the required rate of return will need to be determined
using CAPM:

Required rate of return = 2.20% + 0.65(6.85%) = 6.6525% = 6.6525%

Present value (PV) of Divided (2015) = $0.85/(1.066525) = $0.7970

PV of Dividend (2017) = $1.10/(1.066525)2 = $0.9671
PV of Dividend (2017) = $2.50/(1.066525)3 = $2.0608
PV of perpetual dividend in 2017 = $2.5(1.05)/(0.066525 0.05) = $158.85

PV of perpetual dividend today = $158.85/(1.066525)3 = $130.94

Current value of office REIT share = $0.7970 + $0.9671 + $2.0608 + $130.94 = $134.76

15. Question ID: 48935

Correct Answer: B

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.

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Reading 44 Publicly Traded Real Estate Securities FinQuiz.com

16. Question ID: 48936

Correct Answer: B

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.

17. Question ID: 48937

Correct Answer: C

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.

18. Question ID: 48938

Correct Answer: A

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.

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Reading 44 Publicly Traded Real Estate Securities FinQuiz.com

FinQuiz Level II 2017 Item-sets Solution

Reading 44: Publicly Traded Real Estate Securities

19. Question ID: 48940

Correct Answer: B

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.

20. Question ID: 48941

Correct Answer: C

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.

21. Question ID: 48942

Correct Answer: B

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.

A is incorrect. See above.

C is incorrect. REOCs are ordinary taxable corporations thus subjecting investors to the taxation of
their dividend income.

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Reading 44 Publicly Traded Real Estate Securities FinQuiz.com

22. Question ID: 48943

Correct Answer: C

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.

23. Question ID: 48944

Correct Answer: A

Estimated next 12 months cash NOI $325,280

Assumed cap rate 10%
Estimated value of operating real estate $3,252,800
Cash and cash equivalents + $50,088
Land held for future development + $30,100
Prepaid assets + $19,200
Total debt - $1,560,500
Other liabilities - $150,780
Net asset value $1,640,908
Shares outstanding 60,000
Net asset value per share $27.35

24. Question ID: 48945

Correct Answer: B

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.

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