Capital Structure in the REIT Sector - Green Street Advisors

Capital Structure in the REIT SectorJuly 1, 2009DJIA: 8,504 | RMZ: 435Old Habits are Hard to BreakA Cultural Affinity for Leverage: Until about twenty years ago, the structural make-up of the realestate industry (i.e. small players, fragmented ownership, no outside equity sources, etc.) dictatedthat debt, not equity, serve as the primary source of external capital. As a result, market participantsgrew accustomed to operating with far more leverage than is found in virtually any other industry.Now that financing options for major real estate companies are very similar to what is availableto other large corporations, there are several reasons to believe that less debt and more equityshould 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 highthat 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 ofthe typical corporation’s capital structure. REITs, by contrast, have no reason to use debt, yet ittypically comprises about half the capital structure. There is no justifiable reason why financingpractices should differ as much as they do.The Real World Lab Experiment: Higher leverage should be accompanied by higher returns in orderto compensate for its added risk. This has not been the case, however, in the REIT sector, asmore levered REITs failed to provide meaningfully better returns even in the ten-year period precedingthe peak of the asset valuation bubble. Lower levered REITs have substantially outperformedover the last fifteen years.De-leveraging & Value Creation Ahead: The REIT sector has commenced what is likely to be amulti-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 toohigh 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 massiveamounts of equity issuance, as leverage ratios need to decline by more than 1500 bps to return toprior norms, and a substantial reduction beyond prior targets is appropriate. At a time when otherreal estate market participants lack access to capital, REITs that aggressively de-lever as they articulatethoughtful strategic objectives with regard to their long-term capital structures will be wellrewarded.660 Newport Center Drive, Suite 800, Newport Beach, CA 92660T 949.640.8780 F 949.640.1773Important disclosure on page 16© 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, 20092"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 MillerI. OverviewThe real estate industry has historically relied primarily on debt, rather than equity, to satisfy its financingneeds. Key structural differences that have long separated real estate from broad capital markets explainwhy this has been true, although in the last 15-20 years, most of those differences have been eliminated.Despite that, the industry has been slow to question whether adherence to historical practices isappropriate in light of how much the world has changed. This report explores that question, specificallyas it pertains to REITs, and concludes that the capital structure of most REITs typically contains toomuch 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 asREITs need to have any debt. While there is nothing objectionable about the use of modest leverage,the costs associated with credit crunches have proven to be so high for leveraged operatorsthat optimal leverage ratios for most REITs likely fall in the 0-30% range. Above those levels, theweighted 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 expensehelps minimize the double taxation of corporate profits), they typically employ far less leveragethan REITs. The simple fact that real estate can support relatively high debt levels has nothingto do with whether it should.3. The historic track record from the REIT industry shows that leverage is associated with lower returns.Considering that leverage should enhance returns in order to compensate for the higherrisk, these results are very surprising.• Over the last fifteen years, more leveraged REITs have substantially underperformed REITswith less leverage.• A similar review of total returns in the ten years preceding the early ’07 peak of the asset valuationbubble shows that leverage may have provided a very small boost to total returns, but thisfinding is not statistically significant. Considering that cap rates dropped from 9% to 6% overthat period, leverage should have provided a powerful turbocharger for returns, yet this clearlydid 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 ofwork to be done before most capital structures resemble their pre-credit crunch make up. After thatwork is done, well-run REITs will continue the process, as they increasingly acknowledge that their priorleverage targets were too high. Those REITs that articulate thoughtful strategic objectives with regard totheir optimal leverage ratios will be well rewarded in the marketplace, which is why we will ascribehigher 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.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, 20093II. History of Real Estate Finance – An Affinity for LeverageReal estate market participants have long employed capital structures that utilize much more leveragethan is typical elsewhere in corporate America. Three attributes that have historically differentiated theworld 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 thecommercial real estate in the US owned by small developers/operators.• Traditional external sources of equity capital (e.g. the public market & institutional investors) havehistorically been very limited in size and not well suited to finance an industry with such fragmentedownership.• The aversion that small players would normally have against high debt levels has been minimizeddue 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 theform of debt, not equity, and most of today’s participants in the real estate industry grew up amidst a culturein 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 equitycapital far larger than any that preceded it. Yet another source of equity capital came in the form of muchgreater 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 expansionin the ability of REITs to tap corporate (i.e. unsecured) debt markets inextricably linked theworld of real estate finance with broad global capital markets. As a result, the industry has become lessfragmented and the menu of financing options available for large real estate companies is very similar towhat is available to any large corporation.Old habits can, however, be hard to break. Despite the powerful arguments that follow as to why REITsshould have less leverage than most companies, even today’s more conservatively levered REITs utilize alot more debt than is common at other corporations. It is clear that the historic culture of the real estateindustry continues to play a big role when it comes to how real estate companies are financed, much inthe same way that the equity-heavy historic culture of the Tech industry continues to cause even maturecompanies (e.g. Microsoft, Oracle, Cisco, etc.) with now-predictable income streams to utilize little or nolong-term debt. Cultural norms that no longer make sense can persist for a long time, but ultimately thecompanies that have done the best job of reacting to the changed conditions eclipse the firms that arestuck in the ways of the past. “How much debt can I get?” is certainly the wrong question. Companiesthat instead ask, “How much debt should I have?” will be the winners.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.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, 20094III. 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 alacarte options. Now that REITs are allowed to order off the adult menu, there is presumably much to belearned 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 thatthe history of the two sectors has created cultures that arguably no longer make sense.Key Leverage Ratios for S&P 500 ConstituentsNet Liabs % of Tot Mkt Cap60%50%40%30%20%10%0%54%Net Liabilities as a % of Total Mkt CapitalizationNet Liabilities/EBITDA8.321%9%1.60.9REITs S&P 500 (ex financials) Tech Companies10.08.06.04.02.00.0Net Liabilities/EBITDAThe figures shown for REITs and the S&P are the median value. For tech companies it’s the average. The medianvalue for tech companies is zero. Net liabilities equals total liabilities less current assets and excludes preferred equity.50%% of S&P Constituents (ex Financials) that Use MoreLeverage than REITs25%0%18%Net Liabilities % of Tot Mkt Cap2%Net Liabilities/EBITDAThe key takeaway is that, excepting companies engaged in the business of finance (e.g. banks and insurancecompanies), most corporations maintain a conservative posture with regard to leverage. The medianleverage ratio (net liabilities/total market capitalization) for non-financial members of the S&P 500is 21%, a figure that is well below the 54% median for the REITs in that index. Similarly, the median NetLiabilities/EBITDA multiple of 1.6X for S&P members stands in stark contrast to the 8.3X figure forREITs. 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 corporations(e.g. Microsoft, Cisco, Johnson & Johnson, Coke, McDonalds, Exxon Mobil, etc.) choose to operatewith little or no debt at all (Appendix B provides these statistics for each of the 50 largest US corporations).Considering that each of these blue-chips, and virtually every member of the S&P 500, is a taxablecorporation (and not a pass-through vehicle like a REIT), the conservative leverage stance stands instark contrast with the norms of the REIT industry.A common refrain heard from real estate industry participants goes something like, “the stability of realestate cash flows allows higher debt levels for REITs”, which purportedly explains why REITs havehigher debt levels than most companies. However, this point is relevant only when asking, “How muchdebt can I get”? It has nothing to do with answering the far more important question, “How muchshould I have?”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.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, 20095IV. What Would Miller & Modigliani Have to Say?Merton Miller and Franco Modigliani had a profound impact on modern finance theory, and nowherewas 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 shouldhave no impact on the value of the company, i.e. the price of the stock. Put differently, the value of a firmis tied to the value of its assets (both tangible and intangible), and how one chooses to divide this valuebetween 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 pershare generated by taking on more debt is fully offset by a decline in the multiple the market will awardthe shares.M&M: The Boost Leverage Provides to FFO is Offset by Lower Multiples$2.50FFO per ShareP/FFO Multiple14.0FFO/Sh$2.00$1.50$1.00$0.50$0.86$0.89$0.95$1.06$1.3312.010.08.06.04.02.0P/FFO Multiple$0.000% 10% 20% 30% 40% 50% 60% 70% 80% 90%Leverage as % of Assets0.0In subsequent revisions to their initial theorem, M&M acknowledged that their “perfect world” assumptionwas not realistic, and that there are two big exceptions that result in the conclusion that an “optimalleverage ratio” exists for most companies. The two exceptions:1. Taxes: Tax laws in most countries allow companies to deduct interest expense but not dividendpayments. This creates an “interest tax shield” that has very real value to any taxable company thathas debt. Taken on its own, this issue would suggest that all taxable corporations should be veryhighly 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 severefinancial distress (e.g. bankruptcy) increase as leverage goes higher. This puts a cap on howmuch leverage any firm should have and serves to offset the value of the interest tax shield athigher leverage ratios.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.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, 20096The M&M View of Optimal Leverage for REITsAcross much of the leverage spectrum, non-taxable entities (e.g. REITs) should be indifferentwith regard to debt levels. However, the recurring nature of credit crunches shows that: 1) thecosts of financial distress can begin to kick in at relatively low leverage ratios; and 2) times ofdistress create opportunities for very well-capitalized entities. While distress-related costs maynot be very material for REITs operating at leverage ratios in the 50% ballpark, there is materialvalue in having a bullet-proof balance sheet with which to play offense. As a result, optimal leverageratios may well be no higher than, say, 30%.12%The Effect of Leverage on WACCWtd Avg Cost of Capital11%10%Cost of FinancialDistressCost of MissedOpportunities9%10% 20% 30% 40% 50% 60% 70% 80%Leverage RatioImpact of Leverage on Enterprise ValueImpact on Enterprise Value0%-5%-10%-15%-20%Cost of Financial DistressCost of Missed Opportunities10% 20% 30% 40% 50% 60% 70% 80%Leverage RatioThe optimal capital structure for a taxable corporation is where these two offset each other, and, as outlinedearlier, corporate America currently seems to believe that answer is, on average, somewhere in the15-25% ballpark.The fact that REITs do not pay corporate income taxes effectively removes one of the two participants inthis tug of war. Just like every other corporation, there is a ceiling on REIT leverage ratios, but unlikeother corporations, there is no reason why a REIT should have any debt 1 . REITs provide a special case inan 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.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.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, 20097While it is clear that acceptable leverage ratios for REITs go all the way to zero, determining the point atwhich M&M’s costs of financial distress start to put a cap on this number is a tougher task. However, ifwe’ve learned nothing else in recent years, we’ve learned that what we used to think of as 100-year creditcrunches have a nasty habit of occurring every 15-20 years (‘73/’74, ‘90/’91 & ‘07/’08 all represent timesof extreme turmoil in real estate credit markets). In M&M-speak, the costs of distress are very high, andthey 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 preservingflexibility” which, “will normally imply the maintenance by the corporation of a substantial reserveof untapped borrowing power”. Credit crunches have proven to be such disruptive events, thatthey create wonderful opportunities for companies that keep large amounts of “untapped borrowingpower”. The tendency of markets to transition from bubble to bust and back again has never been moreobvious, and companies with balance sheets that allow them to play offense amidst the worst busts arelikely 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 suggestthat leverage ratios for REITs are constrained by two factors, the cost of severe financial distress and thecost of lost opportunities, whereas there is no factor working in the other direction. In other words, aREIT 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 costsof distress and lost opportunities begin to kick in, and a leverage ratio above that point is clearly suboptimal.REITs that operate with leverage in excess of that threshold will have higher weighted average costsof capital and lower share prices than REITs with “bulletproof” balance sheets.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.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, 20099Over the last fifteen years, however, higher leverage has been closely associated withlower returns. Considering that cap rates today stand at about the same level they did atthe beginning of this period (i.e. the cycle has come full circle), the track record suggeststhere must be powerful reasons why leverage is undesirable.VI. Lessons Learned in This DownturnAs recently as 2007, total leverage (including preferreds) equated to a conservative-sounding 45% for atypical 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 valueswere poised to decline by 35-40% and that capital markets were about to lock up – it is clear that thealarm bells should have sounded. Why they didn’t provides two key lessons that REIT investors areunlikely to forget for a long time to come.Lesson One: Whatever used to be considered to be a prudent leverage target isprobably too high. Considering that real estate values plunged by 30% in the early ‘90s andnearly 40% so far in this downturn, it is clear that seemingly safe loan-to-value figures canquickly shoot higher. When they do, companies that were operating at, say, 50% leverage ratiosare forced to take desperate measures (i.e. sales of properties at distressed prices, issuance ofvery costly debt/equity, etc.) in order to repair their balance sheets. These measures can be veryharmful to shareholder wealth, and they can be avoided by REITs employing more conservativelevels of debt.Lesson Two: It is important to use a measure of leverage that can’t be fooled by assetvaluation 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: leverageas a % of asset value and Debt/EBITDA. In most environments, they will send similar signals,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 employa measure of leverage that can’t be fooled by asset valuation bubbles.Average REIT Leverage(Debt + Pref)/Asset ValueDebt/NOI (right axis)70%60%50%40%30%The amount of debt outstandingrelative to the cash flowavailable to support it increasedfrom 5X to 7X this decade.32%39%53%45%63%8x7x6x5x4x3x20%'89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '092xDebt/NOI ratio shown is an approximation. It understates actual leverage because it assumes that all assets generate income. We use thisDebt/NOI metric throughout the remainder of this report, as opposed to Debt/EBITDA multiples that were used earlier for comparisons with theS&P because we don't have a historical time series of the latter.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.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, 200910VII. Answers to Commonly Heard Objections from the Old SchoolThe industry’s cultural affinity toward leverage has deep roots, and it may well take one or two more realestate debacles and a new generation of leaders to completely change the old habits. Meanwhile, the followingobjections to the arguments posed herein will be commonplace.Old School Objection (OSO): Low leverage might be okay for the next few years, but eventuallyREITs will need to increase leverage in order to compete with the numerous market participants whoemploy leverage in pursuit of higher levered returns.Response: Not being able to buy something because someone else wants to overpay for it doesn’t meanyou should find an excuse to outbid them. If M&M taught us one thing it is that investors who focus onlevered returns have their eye on the wrong ball. The fallout from the leverage-fueled asset valuationbubble serves as a strong validation of this view. When price levels are boosted by the use of high leverage,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-termcapital allocation decisions. REIT execs that instead pursue levered earnings growth objectives are farmore likely to underperform.OSO: REITs employing lower leverage will not be able to grow their FFO/AFFO as quickly as theirmore levered brethren.Response: While true, it does not provide a reason to use leverage (see M&M section of report). Regardlessof whatever pressure executives may think they are getting from “Wall Street”, they shouldnever compromise the goal of value creation in the name of maximizing earnings. These two goals oftenconflict, and companies that utilize earnings growth targets for any reason, including exec comp, shouldtrade at lower valuations.OSO: Because real estate appreciates in a fairly reliable fashion over a long period of time, long-termequity returns can be boosted by adding leverage.Response: Actually, the long-term evidence suggests that real estate does not appreciate at all. By thetime this year is up (i.e. appraisers acknowledge what has hit them), the NCREIF Index will likely showthat 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 estatemarket 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 capitalstructures.OSO: Because cash flows are predictable, real estate can support more leverage than most operatingbusinesses.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 avery interesting point. That there is not renders it moot.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.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, 200911OSO: Real estate is a capital-intensive business, unlike, say, Tech, which means that real estate companieslikely need more leverage.Response: It’s highly questionable if this oft-repeated statement is even true. Intel & Cisco seeminglyhave plenty of places to invest capital, yet they barely use any debt. Even if it is true, it really doesn’tchange anything. The fact that capital is needed does not impact whether that capital should be debt orequity.OSO: REITs are in the business of financing real estate, and financial service firms always employhigh 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 investorsdon’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 maynot be excessive (though they are likely present) at a 45% leverage ratio, higher leverage makes the cashflow 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 myfirm 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 leveragerange. However, there are a number of reasons why non-recourse debt is not tantamount to somesort of free lunch:• The lack of personal recourse is akin to an insurance policy that is implicitly sold by the lender tothe borrower. Lenders charge for this insurance and it is presumptuous to believe that it is systematicallymispriced.• Heavy reliance on non-recourse debt precludes REITs from accessing other important sources ofREIT debt, specifically the unsecured corporate debt market. REITs that keep all financing optionson the menu are better positioned to weather full cycles, as evidenced by the current state of affairswherein unsecured markets are receptive, while secured markets are likely to remain treacherousfor several more years.• Just like every other type of debt, any boost non-recourse debt provides to earnings will be entirelyoffset 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 anyway change the fact that there is no compelling reason for REITs to have debt.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.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, 200912VIII. Where We Go From HereThe REIT industry is in a very early stage of what will prove to be a lengthy deleveraging process. Theprocess is best thought of as taking place in three distinct stages. While some companies are at differentpoints 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 primarilyaround survival. Most REITs have made great strides in enhancing their own prospects for survivinga credit crunch that could persist through 2012, but many have unfinished business on thisfront.• Phase Two: From ’97-’02, REITs operated at leverage ratios below 50% and Debt/NOI multiplesbelow 5.0X. Assuming that REITs merely strive to return their balance sheets to a state of normalcy,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 shouldserve as the absolute minimum amount of deleveraging any management team should strive toachieve. Otherwise, they will face the challenging task of explaining why leverage ratios of the pastwere overly conservative.• Phase Three: Two catalysts are likely to cause REITs to eventually adopt leverage targets that aresubstantially 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 Americaand the cultural affinity for leverage will eventually become an historic relic. Second, the painfullessons learned in recent years all point toward reduced leverage targets going forward. There is nomagic number that all REITs should adopt as a target, but it is clear that whatever seemed appropriatein the past was almost certainly too high.The Phases of the Re-Equitization ProcessAvg Debt/Asset ValueAvg Debt/NOI80%6.9 6.76.28Debt/Asset Value60%40%20%4.643%62% 60%55%4.643%3.230%642Debt/NOI0%'97-'02 Avg 4/1/09 Today Phase ISurvivalPhase IIBack toTargetsPhase IIILowerTargets0Each of the phases of the de-leveraging process will involve battles on multiple fronts, including propertysales and joint venture formations. However, the most effective way to de-lever is to issue equity, andthe needs of the industry are so large that the equity issuance wave is certain to last longer and be largerin scale than most observers likely anticipate. The good news, however, is that REITs will increasinglygarner a competitive edge in the real estate market place, as only they have direct access to the biggestand cheapest pool of equity capital – the public market.Mike KirbyWWW.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.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, 200913Appendix A: Optimal Leverage Targets are Both Sector- and Company-SpecificThe body of this report addresses optimal leverage targets for the typical REIT, but there are numerousfactors 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 debtthan 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 allowsa 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 athigher leverage before costs of financial distress become an issue. However, the fact that a REIT can operatewith 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 exampleof 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 timeswhen other providers of capital have locked their doors. This means that the odds/costs of severe financialdistress are not as problematic for owners in sectors with GSE access as is the case elsewhere. Thevalue of the government subsidy (i.e. below-market interest rates) increases as a REIT utilizes more GSEfinancing, 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 ratiowhere costs associated with distress and/or missed opportunities begin to outweigh thebenefits proffered by borrowing at subsidized interest rates.11%The Effect of Leverage on WACC - Apartment REITsWtd Avg Cost of Capital10%9%Cost of NotMaximizing GSESubsidyOptimal LeverageCost of DistressCost of MissedOpportunities8%0% 10% 20% 30% 40% 50% 60% 70% 80%Leverage RatioWWW.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.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, 200914Appendix B: Leverage Ratios for the 50 Largest Companies in the S&P 500 (ex Financials)RankNet Liabilitiesas a % ofTotal Market CapEquityCompanyMarket Cap1 Exxon Mobile Corp $341 BN 10% 0.52 Microsoft Corp 212 0% 0.03 Wal-Mart Stores Inc 192 20% 1.64 Johnson & Johnson 155 5% 0.45 Proctor & Gamble Co/The 151 25% 2.56 AT&T Inc 147 50% 3.47 International Business Machines Corp 140 25% 2.28 Chevron Corp 134 22% 0.89 Google Inc 131 0% 0.010 General Electric Co 126 82% 18.211 Apple Inc 125 0% 0.012 Coca-Cola Co/The 111 7% 0.813 Cisco Systems Inc 110 0% 0.014 Oracle Corp 108 3% 0.415 Pfizer Inc 103 9% 0.516 Intel Corp 91 0% 0.017 Hewlett-Packard Co 91 20% 1.618 Verizon Communications Inc 88 52% 3.119 Philip Morris International Inc 84 11% 0.920 PepsiCo Inc/NC 84 13% 1.521 QUALCOMM Inc 77 0% 0.022 Abbot Laboratories 74 10% 0.923 Schlumberger Ltd 66 3% 0.224 McDonald's Corp 63 15% 1.525 Conoco Phillips 62 52% 1.826 Wyeth 60 2% 0.227 Merck & Co Inc/NJ 56 11% 0.828 Occidental Petroleum Corp 53 12% 0.529 Amgen Inc 53 2% 0.130 United Parcel Service Inc 49 25% 2.331 United Technologies Corp 49 24% 1.732 CVS Caremark Corp 45 18% 1.333 Walt Disney Co/The 44 28% 1.934 Gilead Sciences Inc 43 0% 0.035 Bristol-Myers Squibb Co 41 6% 0.536 Monsanto co 41 2% 0.337 Comcast Corp 41 63% 5.238 3M Co 41 12% 0.939 Eli Lilly & Co 41 20% 1.540 Home Depot Inc 40 20% 1.641 Schering-Plough Corp 40 14% 2.242 Medtronic Inc 39 8% 0.643 Kraft Foods Inc 38 44% 5.044 Colgate-Palmolive 36 11% 1.345 Amazon.com Inc 35 0% 0.046 Altria Group Inc 34 28% 2.647 Exelon Corp 34 48% 4.148 Baxter International Inc 32 6% 0.649 Lockheed Martin Corp 32 39% 3.350 Boeing Co/The 31 49% 5.4Net Liabilities/EBITDAMedian - Top 50 12% 0.9Median - REITs in the S&P 500 54% 8.3Notes: Net liabilities is calculated as total liabilities less current assets. Preferred equity is not considered a liability. Total market capitalization is calculated asWWW.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.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, 200915Appendix 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 leveredbrethren over the last 15 years. A potential criticism of this finding is that REIT pricing suffered anunprecedented decline near the end of the time period studied, thus raising the prospect that results bylevered companies would look a lot better during a “normal” time period. While this gripe is not entirelywithout merit, concerns should be minimized by the fact that cap rates today are very close to where theywere 15 years ago. Against a flat-cap-rate backdrop, leverage should have boosted returns, but it appearsto have impaired them.At least as surprising is the fact that leverage did not significantly enhance returns in the ten years precedingJanuary ‘07, the peak of the asset valuation bubble. Considering that cap rates went from roughly9% to 6% over this time frame, causing asset values to skyrocket, leverage should have served as a returnturbocharger. As shown below, there is some weak evidence that more levered REITs outperformed duringthis period, but the findings are not statistically significant. That leverage failed to clearly boostREIT returns during a period when it should have provided a huge boost provides yet one more reason tothink that the costs associated with debt (at the leverage ratios typical for REITs) must be sizable.Leverage and Returns Before the BustTotal Return '97-'06 (ann.)25%20%15%10%PSAW RECUZAVBBREVNOKIMSK TFRTR EGCPTEQR PLDLRYDR EW RICLIPPST CODDRCBLM ACSPGUDRELSCL PHIWGGPBest fit line +/- 2 St.DeviationsR 2 = 0.095%30% 35% 40% 45% 50% 55% 60% 65% 70%Avg Leverage RatioWWW.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.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.

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Green Street’s Disclosure InformationAt any given time, Green Street publishes roughly the same number of “BUY”recommendations that it does “SELL” recommendations.Green Street’s “BUYs” have historically achieved far higher total returnsthan its ”HOLDs”, which, in turn, have outperformed its “SELLs”. 1, 2% of companiesunder coverageGreen Street Recommendation Distribution(as of 5/29/09)50%25%0%31%38%31%BUYs HOLDs SELLsYear Ended December 31:Total Return of Green Street's RecommendationsYear Buy Hold Sell NAREIT Eqty 42009 YTD 3 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%2004 42.3% 28.4% 15.6% 31.6%2003 42.7% 37.2% 20.9% 37.1%2002 17.7% 2.6% 1.9% 3.8%2001 35.7% 19.1% 11.9% 13.9%2000 53.6% 29.3% 4.4% 26.4%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%1994 20.5% -0.7% -9.3% 3.2%1993 3 29.4% 5.4% 6.7% 12.4%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-Corpsand 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 areexcluded.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.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.

Green Street Advisors - North American Team*Research (Newport Beach) + 1 (949) 640-8780General:Mike Kirby, Director of Researchmkirby@greenst.comCraig Leupold, Presidentcleupold@greenst.comPeter Rothemund, CFA, Senior Associateprothemund@greenst.comKawika Tarayao, Senior Associate**ktarayao@greenst.comMatthew Wokasch, CFA, Senior Associatemwokasch@greenst.comOffice/Industrial/Self Storage:Michael Knott, CFA, Senior Analystmknott@greenst.comCedrik Lachance, Senior Analystclachance@greenst.comJohn Stewart, CFA, Analystjstewart@greenst.comSteve Frankel, Senior Associatesfrankel@greenst.comLukas Hartwich, Associatelhartwich@greenst.comEnrique Torres, Associateetorres@greenst.comAlexandra Coupe, Associateacoupe@greenst.comRetail/Health Care:Jim Sullivan, Managing Directorjsullivan@greenst.comNicholas Vedder, Analystnvedder@greenst.comRosemary Pugh, Senior Associaterpugh@greenst.comAndrew Johns, Associateajohns@greenst.comResidential:Andrew McCulloch, CFA, Senior Analystamcculloch@greenst.comChris Van Ens, CFA, Senior Associatecvanens@greenst.comLaura Clark, Associate**lclark@greenst.comStephen Bakke, Associate**sbakke@greenst.comLodging:John Arabia, Managing Directorjarabia@greenst.comBob Grundstrom, Senior Associatebgrundstrom@greenst.comTrading & Institutional Sales (Dallas) 1 (800) 263-1388Lynn Lewis, Managing Director of Sales and Tradinglynnlewis@greenst.comSherman Burns, Managing Director & Trading Managersburns@greenst.comLaurie Hauck, Vice President, Tradinglhauck@greenst.comCarol Parker, Vice President, Tradingcparker@greenst.comDavid Alexander, Vice President, Tradingdalexander@greenst.comDavid Auerbach, Vice President, Tradingdauerbach@greenst.comAnthony Scalia, Vice President & Institutional Sales Managerascalia@greenst.comTim Joy, Vice President, Institutional Salestjoy@greenst.comScott Bell, Vice President, Institutional Salessbell@greenst.comMurrie Holland, Institutional Salesmholland@greenst.comSeth Laughlin, Institutional Salesslaughlin@greenst.comConsulting (Newport Beach) +1 (949) 640-8780Adam Markman, Managing Directoramarkman@greenst.comBrad Soltis, Associatebsoltis@greenst.comPaul Harmeling, Associatepharmeling@greenst.comAdministration (Newport Beach) +1 (949) 640-8780Warner Griswold, CFA, Chief Operating Officerwgriswold@greenst.comMichael Kao, Director, Technologymkao@greenst.comDamon Scott, Director, Marketingdscott@greenst.comDan Malloy, Manager, Marketingdmalloy@greenst.comRobyn Francis, Manager, Compliancerfrancis@greenst.comKathy Chamberlain, Human Resourceskchamberlain@greenst.comHeadquarters/Research Trading & Institutional Sales Europe - Research & Trading567 San Nicolas Drive, Suite 200 600 North Pearl Street, Suite 2310 22 Grosvenor Square, 3rd FloorNewport Beach, CA 92660 Dallas, TX 75201 London, W1K 6LF, UK+1 (949) 640-8780 Trading: 1 (800) 263-1388 Main: +44 (0) 20 7290 6540Sales: +1 (214) 855-5905 Trading: +44 (0) 20 7290 6555www.greenstreetadvisors.com* This page contains a roster of most Green Street employees. However, only those listed in the "Research" section without anasterisk (*) are registered representatives / research analysts.** These research employees operate in a support capacity and are not yet registered representatives / research analysts.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.