Capital Structure in the REIT Sector - Green Street Advisors

Capital Structure in the REIT Sector - Green Street Advisors

Capital Structure in the REIT Sector - Green Street Advisors


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<strong>Capital</strong> <strong>Structure</strong> <strong>in</strong> <strong>the</strong> <strong>REIT</strong> <strong>Sector</strong>July 1, 2009DJIA: 8,504 | RMZ: 435Old Habits are Hard to BreakA Cultural Aff<strong>in</strong>ity for Leverage: Until about twenty years ago, <strong>the</strong> structural make-up of <strong>the</strong> realestate <strong>in</strong>dustry (i.e. small players, fragmented ownership, no outside equity sources, etc.) dictatedthat debt, not equity, serve as <strong>the</strong> primary source of external capital. As a result, market participantsgrew accustomed to operat<strong>in</strong>g with far more leverage than is found <strong>in</strong> virtually any o<strong>the</strong>r <strong>in</strong>dustry.Now that f<strong>in</strong>anc<strong>in</strong>g options for major real estate companies are very similar to what is availableto o<strong>the</strong>r large corporations, <strong>the</strong>re are several reasons to believe that less debt and more equityshould be <strong>the</strong> norm go<strong>in</strong>g forward.F<strong>in</strong>ancial Theory: There is no reason why a non-taxable entity (e.g. a <strong>REIT</strong>) should have any debt,yet <strong>the</strong> costs associated with credit crunches (both <strong>in</strong> <strong>the</strong> 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 <strong>REIT</strong>s likely fall <strong>in</strong> <strong>the</strong> 0-30% (debt/asset value) range.Best Practices <strong>in</strong> Corporate America: Most corporations have a strong <strong>in</strong>centive to utilize debt –<strong>in</strong>terest expense helps m<strong>in</strong>imize <strong>the</strong>ir corporate tax bill – yet it represents less than one-quarter of<strong>the</strong> typical corporation’s capital structure. <strong>REIT</strong>s, by contrast, have no reason to use debt, yet ittypically comprises about half <strong>the</strong> capital structure. There is no justifiable reason why f<strong>in</strong>anc<strong>in</strong>gpractices should differ as much as <strong>the</strong>y do.The Real World Lab Experiment: Higher leverage should be accompanied by higher returns <strong>in</strong> orderto compensate for its added risk. This has not been <strong>the</strong> case, however, <strong>in</strong> <strong>the</strong> <strong>REIT</strong> sector, asmore levered <strong>REIT</strong>s failed to provide mean<strong>in</strong>gfully better returns even <strong>in</strong> <strong>the</strong> ten-year period preced<strong>in</strong>g<strong>the</strong> peak of <strong>the</strong> asset valuation bubble. Lower levered <strong>REIT</strong>s have substantially outperformedover <strong>the</strong> last fifteen years.De-leverag<strong>in</strong>g & Value Creation Ahead: The <strong>REIT</strong> sector has commenced what is likely to be amulti-year de-leverag<strong>in</strong>g process. It should unfold <strong>in</strong> 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 <strong>the</strong> first phase,yet most companies are not yet entirely out of <strong>the</strong> woods. The subsequent stages will entail massiveamounts of equity issuance, as leverage ratios need to decl<strong>in</strong>e by more than 1500 bps to return toprior norms, and a substantial reduction beyond prior targets is appropriate. At a time when o<strong>the</strong>rreal estate market participants lack access to capital, <strong>REIT</strong>s that aggressively de-lever as <strong>the</strong>y articulatethoughtful strategic objectives with regard to <strong>the</strong>ir 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, <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>, Inc.This report conta<strong>in</strong>s copyrighted subject matter and is covered under <strong>the</strong> <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>' Terms of Use.<strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong> reserves all rights not expressly granted.

<strong>Capital</strong> <strong>Structure</strong> <strong>in</strong> <strong>the</strong> <strong>REIT</strong> <strong>Sector</strong> — July 1, 20092"The pizza deliverer says to Yogi Berra: 'Do you want <strong>the</strong> pizza cut <strong>in</strong>to quarters or eighths?'Yogi answers: 'Cut it <strong>in</strong>to eight pieces. I'm feel<strong>in</strong>g hungry tonight.' "Merton MillerI. OverviewThe real estate <strong>in</strong>dustry has historically relied primarily on debt, ra<strong>the</strong>r than equity, to satisfy its f<strong>in</strong>anc<strong>in</strong>gneeds. Key structural differences that have long separated real estate from broad capital markets expla<strong>in</strong>why this has been true, although <strong>in</strong> <strong>the</strong> last 15-20 years, most of those differences have been elim<strong>in</strong>ated.Despite that, <strong>the</strong> <strong>in</strong>dustry has been slow to question whe<strong>the</strong>r adherence to historical practices isappropriate <strong>in</strong> light of how much <strong>the</strong> world has changed. This report explores that question, specificallyas it perta<strong>in</strong>s to <strong>REIT</strong>s, and concludes that <strong>the</strong> capital structure of most <strong>REIT</strong>s typically conta<strong>in</strong>s toomuch debt and too little equity. Three key arguments support this conclusion:1. Well-accepted f<strong>in</strong>ancial <strong>the</strong>ory suggests that <strong>the</strong>re is no reason why non-taxable entities such as<strong>REIT</strong>s need to have any debt. While <strong>the</strong>re is noth<strong>in</strong>g objectionable about <strong>the</strong> use of modest leverage,<strong>the</strong> costs associated with credit crunches have proven to be so high for leveraged operatorsthat optimal leverage ratios for most <strong>REIT</strong>s likely fall <strong>in</strong> <strong>the</strong> 0-30% range. Above those levels, <strong>the</strong>weighted average cost of capital beg<strong>in</strong>s to <strong>in</strong>crease (albeit, slowly at first) and firm value decl<strong>in</strong>es.2. Despite <strong>the</strong> fact that most corporations have a powerful <strong>in</strong>centive to utilize debt (i.e. <strong>in</strong>terest expensehelps m<strong>in</strong>imize <strong>the</strong> double taxation of corporate profits), <strong>the</strong>y typically employ far less leveragethan <strong>REIT</strong>s. The simple fact that real estate can support relatively high debt levels has noth<strong>in</strong>gto do with whe<strong>the</strong>r it should.3. The historic track record from <strong>the</strong> <strong>REIT</strong> <strong>in</strong>dustry shows that leverage is associated with lower returns.Consider<strong>in</strong>g that leverage should enhance returns <strong>in</strong> order to compensate for <strong>the</strong> higherrisk, <strong>the</strong>se results are very surpris<strong>in</strong>g.• Over <strong>the</strong> last fifteen years, more leveraged <strong>REIT</strong>s have substantially underperformed <strong>REIT</strong>swith less leverage.• A similar review of total returns <strong>in</strong> <strong>the</strong> ten years preced<strong>in</strong>g <strong>the</strong> early ’07 peak of <strong>the</strong> asset valuationbubble shows that leverage may have provided a very small boost to total returns, but thisf<strong>in</strong>d<strong>in</strong>g is not statistically significant. Consider<strong>in</strong>g 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 deleverag<strong>in</strong>g process that is now underway <strong>in</strong> <strong>the</strong> <strong>REIT</strong> sector is <strong>in</strong> <strong>the</strong> very early stages, with a lot ofwork to be done before most capital structures resemble <strong>the</strong>ir pre-credit crunch make up. After thatwork is done, well-run <strong>REIT</strong>s will cont<strong>in</strong>ue <strong>the</strong> process, as <strong>the</strong>y <strong>in</strong>creas<strong>in</strong>gly acknowledge that <strong>the</strong>ir priorleverage targets were too high. Those <strong>REIT</strong>s that articulate thoughtful strategic objectives with regard to<strong>the</strong>ir optimal leverage ratios will be well rewarded <strong>in</strong> <strong>the</strong> marketplace, which is why we will ascribehigher warranted share prices to companies that operate at lower leverage levels.WWW.GREENSTREETADVISORS.COM© 2010, <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>, Inc. - Use of this report is subject to <strong>the</strong> Terms of Use listed at <strong>the</strong> end of <strong>the</strong> report.This report conta<strong>in</strong>s copyrighted subject matter and is covered under <strong>the</strong> <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>' Terms of Use.<strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong> reserves all rights not expressly granted.

<strong>Capital</strong> <strong>Structure</strong> <strong>in</strong> <strong>the</strong> <strong>REIT</strong> <strong>Sector</strong> — July 1, 20093II. History of Real Estate F<strong>in</strong>ance – An Aff<strong>in</strong>ity for LeverageReal estate market participants have long employed capital structures that utilize much more leveragethan is typical elsewhere <strong>in</strong> corporate America. Three attributes that have historically differentiated <strong>the</strong>world of real estate help expla<strong>in</strong> why this has been <strong>the</strong> case.• The localized nature of <strong>the</strong> bus<strong>in</strong>ess led to highly fragmented ownership, with <strong>the</strong> vast majority of <strong>the</strong>commercial real estate <strong>in</strong> <strong>the</strong> US owned by small developers/operators.• Traditional external sources of equity capital (e.g. <strong>the</strong> public market & <strong>in</strong>stitutional <strong>in</strong>vestors) havehistorically been very limited <strong>in</strong> size and not well suited to f<strong>in</strong>ance an <strong>in</strong>dustry with such fragmentedownership.• The aversion that small players would normally have aga<strong>in</strong>st high debt levels has been m<strong>in</strong>imizeddue to <strong>the</strong> fact that most mortgage f<strong>in</strong>anc<strong>in</strong>gs are “non recourse”.As a result, <strong>the</strong> vast majority of outside capital utilized by <strong>the</strong> real estate <strong>in</strong>dustry has long come <strong>in</strong> <strong>the</strong>form of debt, not equity, and most of today’s participants <strong>in</strong> <strong>the</strong> real estate <strong>in</strong>dustry grew up amidst a culture<strong>in</strong> which <strong>the</strong> only question anyone asked about leverage was, “how much can I get?”Much has changed s<strong>in</strong>ce that time. The com<strong>in</strong>g of age of public <strong>REIT</strong>s <strong>in</strong>troduced a new source of equitycapital far larger than any that preceded it. Yet ano<strong>the</strong>r source of equity capital came <strong>in</strong> <strong>the</strong> form of muchgreater <strong>in</strong>terest <strong>in</strong> real estate by pension funds, endowments and o<strong>the</strong>r <strong>in</strong>stitutional sources of capital.Meanwhile, <strong>the</strong> development of a large market for securitized mortgages (i.e. CMBS) and <strong>the</strong> rapid expansion<strong>in</strong> <strong>the</strong> ability of <strong>REIT</strong>s to tap corporate (i.e. unsecured) debt markets <strong>in</strong>extricably l<strong>in</strong>ked <strong>the</strong>world of real estate f<strong>in</strong>ance with broad global capital markets. As a result, <strong>the</strong> <strong>in</strong>dustry has become lessfragmented and <strong>the</strong> menu of f<strong>in</strong>anc<strong>in</strong>g 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 <strong>the</strong> powerful arguments that follow as to why <strong>REIT</strong>sshould have less leverage than most companies, even today’s more conservatively levered <strong>REIT</strong>s utilize alot more debt than is common at o<strong>the</strong>r corporations. It is clear that <strong>the</strong> historic culture of <strong>the</strong> real estate<strong>in</strong>dustry cont<strong>in</strong>ues to play a big role when it comes to how real estate companies are f<strong>in</strong>anced, much <strong>in</strong><strong>the</strong> same way that <strong>the</strong> equity-heavy historic culture of <strong>the</strong> Tech <strong>in</strong>dustry cont<strong>in</strong>ues to cause even maturecompanies (e.g. Microsoft, Oracle, Cisco, etc.) with now-predictable <strong>in</strong>come streams to utilize little or nolong-term debt. Cultural norms that no longer make sense can persist for a long time, but ultimately <strong>the</strong>companies that have done <strong>the</strong> best job of react<strong>in</strong>g to <strong>the</strong> changed conditions eclipse <strong>the</strong> firms that arestuck <strong>in</strong> <strong>the</strong> ways of <strong>the</strong> past. “How much debt can I get?” is certa<strong>in</strong>ly <strong>the</strong> wrong question. Companiesthat <strong>in</strong>stead ask, “How much debt should I have?” will be <strong>the</strong> w<strong>in</strong>ners.WWW.GREENSTREETADVISORS.COM© 2010, <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>, Inc. - Use of this report is subject to <strong>the</strong> Terms of Use listed at <strong>the</strong> end of <strong>the</strong> report.This report conta<strong>in</strong>s copyrighted subject matter and is covered under <strong>the</strong> <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>' Terms of Use.<strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong> reserves all rights not expressly granted.

<strong>Capital</strong> <strong>Structure</strong> <strong>in</strong> <strong>the</strong> <strong>REIT</strong> <strong>Sector</strong> — July 1, 20094III. How Does <strong>the</strong> Rest of Corporate America Do It?Whereas real estate execs have historically had to choose from an abbreviated menu of f<strong>in</strong>anc<strong>in</strong>g options(what flavor of secured debt do you prefer?), o<strong>the</strong>r large companies have enjoyed a lengthy list of alacarte options. Now that <strong>REIT</strong>s are allowed to order off <strong>the</strong> adult menu, <strong>the</strong>re is presumably much to belearned by look<strong>in</strong>g to see which items are preferred by <strong>the</strong> long-time d<strong>in</strong>ers.<strong>REIT</strong>s use far more debt than most companies. Tech companies use a lot less. It appears that<strong>the</strong> history of <strong>the</strong> 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 <strong>Capital</strong>izationNet Liabilities/EBITDA8.321%9%1.60.9<strong>REIT</strong>s S&P 500 (ex f<strong>in</strong>ancials) Tech Companies10. Liabilities/EBITDAThe figures shown for <strong>REIT</strong>s and <strong>the</strong> S&P are <strong>the</strong> median value. For tech companies it’s <strong>the</strong> 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 F<strong>in</strong>ancials) that Use MoreLeverage than <strong>REIT</strong>s25%0%18%Net Liabilities % of Tot Mkt Cap2%Net Liabilities/EBITDAThe key takeaway is that, except<strong>in</strong>g companies engaged <strong>in</strong> <strong>the</strong> bus<strong>in</strong>ess of f<strong>in</strong>ance (e.g. banks and <strong>in</strong>surancecompanies), most corporations ma<strong>in</strong>ta<strong>in</strong> a conservative posture with regard to leverage. The medianleverage ratio (net liabilities/total market capitalization) for non-f<strong>in</strong>ancial members of <strong>the</strong> S&P 500is 21%, a figure that is well below <strong>the</strong> 54% median for <strong>the</strong> <strong>REIT</strong>s <strong>in</strong> that <strong>in</strong>dex. Similarly, <strong>the</strong> median NetLiabilities/EBITDA multiple of 1.6X for S&P members stands <strong>in</strong> stark contrast to <strong>the</strong> 8.3X figure for<strong>REIT</strong>s. Only 2% of S&P members have higher Net Liabilities/EBITDA multiples than <strong>the</strong> typical <strong>REIT</strong>!At least as <strong>in</strong>terest<strong>in</strong>g as <strong>the</strong>se averages is <strong>the</strong> 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 <strong>the</strong>se statistics for each of <strong>the</strong> 50 largest US corporations).Consider<strong>in</strong>g that each of <strong>the</strong>se blue-chips, and virtually every member of <strong>the</strong> S&P 500, is a taxablecorporation (and not a pass-through vehicle like a <strong>REIT</strong>), <strong>the</strong> conservative leverage stance stands <strong>in</strong>stark contrast with <strong>the</strong> norms of <strong>the</strong> <strong>REIT</strong> <strong>in</strong>dustry.A common refra<strong>in</strong> heard from real estate <strong>in</strong>dustry participants goes someth<strong>in</strong>g like, “<strong>the</strong> stability of realestate cash flows allows higher debt levels for <strong>REIT</strong>s”, which purportedly expla<strong>in</strong>s why <strong>REIT</strong>s havehigher debt levels than most companies. However, this po<strong>in</strong>t is relevant only when ask<strong>in</strong>g, “How muchdebt can I get”? It has noth<strong>in</strong>g to do with answer<strong>in</strong>g <strong>the</strong> far more important question, “How muchshould I have?”WWW.GREENSTREETADVISORS.COM© 2010, <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>, Inc. - Use of this report is subject to <strong>the</strong> Terms of Use listed at <strong>the</strong> end of <strong>the</strong> report.This report conta<strong>in</strong>s copyrighted subject matter and is covered under <strong>the</strong> <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>' Terms of Use.<strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong> reserves all rights not expressly granted.

<strong>Capital</strong> <strong>Structure</strong> <strong>in</strong> <strong>the</strong> <strong>REIT</strong> <strong>Sector</strong> — July 1, 20095IV. What Would Miller & Modigliani Have to Say?Merton Miller and Franco Modigliani had a profound impact on modern f<strong>in</strong>ance <strong>the</strong>ory, and nowherewas <strong>the</strong>ir work more pioneer<strong>in</strong>g, nor endur<strong>in</strong>g, than <strong>the</strong> <strong>in</strong>sights <strong>the</strong>y provided on leverage. In a paper(which was <strong>in</strong>strumental <strong>in</strong> w<strong>in</strong>n<strong>in</strong>g its authors <strong>the</strong> Nobel Prize <strong>in</strong> Economics) published <strong>in</strong> 1958, Mssrs.Miller and Modigliani (M&M) postulated that, <strong>in</strong> a perfect world, <strong>the</strong> level of debt at a company shouldhave no impact on <strong>the</strong> value of <strong>the</strong> company, i.e. <strong>the</strong> price of <strong>the</strong> stock. Put differently, <strong>the</strong> value of a firmis tied to <strong>the</strong> value of its assets (both tangible and <strong>in</strong>tangible), and how one chooses to divide this valuebetween debt holders and equity holders has no bear<strong>in</strong>g on overall value. Very simply, as debt <strong>in</strong>creases,risk-averse <strong>in</strong>vestors demand a higher return on <strong>the</strong> equity, and any improvement <strong>in</strong> net <strong>in</strong>come pershare generated by tak<strong>in</strong>g on more debt is fully offset by a decl<strong>in</strong>e <strong>in</strong> <strong>the</strong> multiple <strong>the</strong> market will award<strong>the</strong> 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. Multiple$0.000% 10% 20% 30% 40% 50% 60% 70% 80% 90%Leverage as % of Assets0.0In subsequent revisions to <strong>the</strong>ir <strong>in</strong>itial <strong>the</strong>orem, M&M acknowledged that <strong>the</strong>ir “perfect world” assumptionwas not realistic, and that <strong>the</strong>re are two big exceptions that result <strong>in</strong> <strong>the</strong> conclusion that an “optimalleverage ratio” exists for most companies. The two exceptions:1. Taxes: Tax laws <strong>in</strong> most countries allow companies to deduct <strong>in</strong>terest expense but not dividendpayments. This creates an “<strong>in</strong>terest 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 m<strong>in</strong>imize <strong>the</strong> entity’s tax bill.2. Costs of Severe F<strong>in</strong>ancial Distress: The odds that a firm will <strong>in</strong>cur sizable costs associated with severef<strong>in</strong>ancial distress (e.g. bankruptcy) <strong>in</strong>crease as leverage goes higher. This puts a cap on howmuch leverage any firm should have and serves to offset <strong>the</strong> value of <strong>the</strong> <strong>in</strong>terest tax shield athigher leverage ratios.WWW.GREENSTREETADVISORS.COM© 2010, <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>, Inc. - Use of this report is subject to <strong>the</strong> Terms of Use listed at <strong>the</strong> end of <strong>the</strong> report.This report conta<strong>in</strong>s copyrighted subject matter and is covered under <strong>the</strong> <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>' Terms of Use.<strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong> reserves all rights not expressly granted.

<strong>Capital</strong> <strong>Structure</strong> <strong>in</strong> <strong>the</strong> <strong>REIT</strong> <strong>Sector</strong> — July 1, 20096The M&M View of Optimal Leverage for <strong>REIT</strong>sAcross much of <strong>the</strong> leverage spectrum, non-taxable entities (e.g. <strong>REIT</strong>s) should be <strong>in</strong>differentwith regard to debt levels. However, <strong>the</strong> recurr<strong>in</strong>g nature of credit crunches shows that: 1) <strong>the</strong>costs of f<strong>in</strong>ancial distress can beg<strong>in</strong> to kick <strong>in</strong> 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 <strong>REIT</strong>s operat<strong>in</strong>g at leverage ratios <strong>in</strong> <strong>the</strong> 50% ballpark, <strong>the</strong>re is materialvalue <strong>in</strong> hav<strong>in</strong>g 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 <strong>Capital</strong>11%10%Cost of F<strong>in</strong>ancialDistressCost 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 F<strong>in</strong>ancial DistressCost of Missed Opportunities10% 20% 30% 40% 50% 60% 70% 80%Leverage RatioThe optimal capital structure for a taxable corporation is where <strong>the</strong>se two offset each o<strong>the</strong>r, and, as outl<strong>in</strong>edearlier, corporate America currently seems to believe that answer is, on average, somewhere <strong>in</strong> <strong>the</strong>15-25% ballpark.The fact that <strong>REIT</strong>s do not pay corporate <strong>in</strong>come taxes effectively removes one of <strong>the</strong> two participants <strong>in</strong>this tug of war. Just like every o<strong>the</strong>r corporation, <strong>the</strong>re is a ceil<strong>in</strong>g on <strong>REIT</strong> leverage ratios, but unlikeo<strong>the</strong>r corporations, <strong>the</strong>re is no reason why a <strong>REIT</strong> should have any debt 1 . <strong>REIT</strong>s provide a special case <strong>in</strong>an M&M world, one where extremely low leverage ratios make perfect sense.1 While <strong>the</strong> majority of <strong>REIT</strong> <strong>in</strong>come is exempt from corporate <strong>in</strong>come taxes, it is not uncommon for <strong>REIT</strong>s to generate some taxable <strong>in</strong>come.In such <strong>in</strong>stances, a <strong>REIT</strong> could benefit from hav<strong>in</strong>g some debt.WWW.GREENSTREETADVISORS.COM© 2010, <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>, Inc. - Use of this report is subject to <strong>the</strong> Terms of Use listed at <strong>the</strong> end of <strong>the</strong> report.This report conta<strong>in</strong>s copyrighted subject matter and is covered under <strong>the</strong> <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>' Terms of Use.<strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong> reserves all rights not expressly granted.

<strong>Capital</strong> <strong>Structure</strong> <strong>in</strong> <strong>the</strong> <strong>REIT</strong> <strong>Sector</strong> — July 1, 20097While it is clear that acceptable leverage ratios for <strong>REIT</strong>s go all <strong>the</strong> way to zero, determ<strong>in</strong><strong>in</strong>g <strong>the</strong> po<strong>in</strong>t atwhich M&M’s costs of f<strong>in</strong>ancial distress start to put a cap on this number is a tougher task. However, ifwe’ve learned noth<strong>in</strong>g else <strong>in</strong> recent years, we’ve learned that what we used to th<strong>in</strong>k of as 100-year creditcrunches have a nasty habit of occurr<strong>in</strong>g every 15-20 years (‘73/’74, ‘90/’91 & ‘07/’08 all represent timesof extreme turmoil <strong>in</strong> real estate credit markets). In M&M-speak, <strong>the</strong> costs of distress are very high, and<strong>the</strong>y kick <strong>in</strong> at leverage ratios that are probably well below where most have long assumed.To boot, <strong>the</strong>re is yet ano<strong>the</strong>r reason to limit leverage, one which M&M described as “<strong>the</strong> need for preserv<strong>in</strong>gflexibility” which, “will normally imply <strong>the</strong> ma<strong>in</strong>tenance by <strong>the</strong> corporation of a substantial reserveof untapped borrow<strong>in</strong>g power”. Credit crunches have proven to be such disruptive events, that<strong>the</strong>y create wonderful opportunities for companies that keep large amounts of “untapped borrow<strong>in</strong>gpower”. The tendency of markets to transition from bubble to bust and back aga<strong>in</strong> has never been moreobvious, and companies with balance sheets that allow <strong>the</strong>m to play offense amidst <strong>the</strong> worst busts arelikely to create a lot more value for shareholders than companies that are on <strong>the</strong>ir heels <strong>the</strong> whole time.In summary, <strong>the</strong> <strong>the</strong>ories that underp<strong>in</strong> <strong>the</strong> way corporate America addresses capital structure suggestthat leverage ratios for <strong>REIT</strong>s are constra<strong>in</strong>ed by two factors, <strong>the</strong> cost of severe f<strong>in</strong>ancial distress and <strong>the</strong>cost of lost opportunities, whereas <strong>the</strong>re is no factor work<strong>in</strong>g <strong>in</strong> <strong>the</strong> o<strong>the</strong>r direction. In o<strong>the</strong>r words, a<strong>REIT</strong> with no leverage is probably manag<strong>in</strong>g its balance sheet no better or worse than one with, say, 25%leverage.However, at some po<strong>in</strong>t – a po<strong>in</strong>t that we’ve learned is a lot lower than people used to th<strong>in</strong>k – <strong>the</strong> costsof distress and lost opportunities beg<strong>in</strong> to kick <strong>in</strong>, and a leverage ratio above that po<strong>in</strong>t is clearly suboptimal.<strong>REIT</strong>s that operate with leverage <strong>in</strong> excess of that threshold will have higher weighted average costsof capital and lower share prices than <strong>REIT</strong>s with “bulletproof” balance sheets.WWW.GREENSTREETADVISORS.COM© 2010, <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>, Inc. - Use of this report is subject to <strong>the</strong> Terms of Use listed at <strong>the</strong> end of <strong>the</strong> report.This report conta<strong>in</strong>s copyrighted subject matter and is covered under <strong>the</strong> <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>' Terms of Use.<strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong> reserves all rights not expressly granted.

<strong>Capital</strong> <strong>Structure</strong> <strong>in</strong> <strong>the</strong> <strong>REIT</strong> <strong>Sector</strong> — July 1, 20099Over <strong>the</strong> last fifteen years, however, higher leverage has been closely associated withlower returns. Consider<strong>in</strong>g that cap rates today stand at about <strong>the</strong> same level <strong>the</strong>y did at<strong>the</strong> beg<strong>in</strong>n<strong>in</strong>g of this period (i.e. <strong>the</strong> cycle has come full circle), <strong>the</strong> track record suggests<strong>the</strong>re must be powerful reasons why leverage is undesirable.VI. Lessons Learned <strong>in</strong> This DownturnAs recently as 2007, total leverage (<strong>in</strong>clud<strong>in</strong>g preferreds) equated to a conservative-sound<strong>in</strong>g 45% for atypical <strong>REIT</strong>. While this was notably higher than <strong>the</strong> 30-40% levels that prevailed through most of <strong>the</strong>‘90s, it was not high enough to trigger alarm bells. Know<strong>in</strong>g what we now know – that real estate valueswere poised to decl<strong>in</strong>e by 35-40% and that capital markets were about to lock up – it is clear that <strong>the</strong>alarm bells should have sounded. Why <strong>the</strong>y didn’t provides two key lessons that <strong>REIT</strong> <strong>in</strong>vestors 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. Consider<strong>in</strong>g that real estate values plunged by 30% <strong>in</strong> <strong>the</strong> early ‘90s andnearly 40% so far <strong>in</strong> this downturn, it is clear that seem<strong>in</strong>gly safe loan-to-value figures canquickly shoot higher. When <strong>the</strong>y do, companies that were operat<strong>in</strong>g at, say, 50% leverage ratiosare forced to take desperate measures (i.e. sales of properties at distressed prices, issuance ofvery costly debt/equity, etc.) <strong>in</strong> order to repair <strong>the</strong>ir balance sheets. These measures can be veryharmful to shareholder wealth, and <strong>the</strong>y can be avoided by <strong>REIT</strong>s employ<strong>in</strong>g 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. Go<strong>in</strong>g forward,all of our snapshots of balance sheet strength will <strong>in</strong>clude at least two measures of leverage: leverageas a % of asset value and Debt/EBITDA. In most environments, <strong>the</strong>y will send similar signals,but both views are critical at moments when this is not <strong>the</strong> case.What have we learned? First, companies with seem<strong>in</strong>gly conservative leverage ratios (leverage/asset value) can get <strong>in</strong>to a lot of trouble dur<strong>in</strong>g credit crunches. Second, it is important to employa measure of leverage that can’t be fooled by asset valuation bubbles.Average <strong>REIT</strong> Leverage(Debt + Pref)/Asset ValueDebt/NOI (right axis)70%60%50%40%30%The amount of debt outstand<strong>in</strong>grelative to <strong>the</strong> cash flowavailable to support it <strong>in</strong>creasedfrom 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 <strong>in</strong>come. We use thisDebt/NOI metric throughout <strong>the</strong> rema<strong>in</strong>der of this report, as opposed to Debt/EBITDA multiples that were used earlier for comparisons with <strong>the</strong>S&P because we don't have a historical time series of <strong>the</strong> latter.WWW.GREENSTREETADVISORS.COM© 2010, <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>, Inc. - Use of this report is subject to <strong>the</strong> Terms of Use listed at <strong>the</strong> end of <strong>the</strong> report.This report conta<strong>in</strong>s copyrighted subject matter and is covered under <strong>the</strong> <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>' Terms of Use.<strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong> reserves all rights not expressly granted.

<strong>Capital</strong> <strong>Structure</strong> <strong>in</strong> <strong>the</strong> <strong>REIT</strong> <strong>Sector</strong> — July 1, 200910VII. Answers to Commonly Heard Objections from <strong>the</strong> Old SchoolThe <strong>in</strong>dustry’s cultural aff<strong>in</strong>ity 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 <strong>the</strong> old habits. Meanwhile, <strong>the</strong> follow<strong>in</strong>gobjections to <strong>the</strong> arguments posed here<strong>in</strong> will be commonplace.Old School Objection (OSO): Low leverage might be okay for <strong>the</strong> next few years, but eventually<strong>REIT</strong>s will need to <strong>in</strong>crease leverage <strong>in</strong> order to compete with <strong>the</strong> numerous market participants whoemploy leverage <strong>in</strong> pursuit of higher levered returns.Response: Not be<strong>in</strong>g able to buy someth<strong>in</strong>g because someone else wants to overpay for it doesn’t meanyou should f<strong>in</strong>d an excuse to outbid <strong>the</strong>m. If M&M taught us one th<strong>in</strong>g it is that <strong>in</strong>vestors who focus onlevered returns have <strong>the</strong>ir eye on <strong>the</strong> wrong ball. The fallout from <strong>the</strong> leverage-fueled asset valuationbubble serves as a strong validation of this view. When price levels are boosted by <strong>the</strong> use of high leverage,<strong>the</strong> last th<strong>in</strong>g a <strong>REIT</strong> should be do<strong>in</strong>g is buy<strong>in</strong>g assets. An unwaver<strong>in</strong>g focus on unlevered returns,and how those returns stack up with o<strong>the</strong>r capital market alternatives, will lead to superior long-termcapital allocation decisions. <strong>REIT</strong> execs that <strong>in</strong>stead pursue levered earn<strong>in</strong>gs growth objectives are farmore likely to underperform.OSO: <strong>REIT</strong>s employ<strong>in</strong>g lower leverage will not be able to grow <strong>the</strong>ir FFO/AFFO as quickly as <strong>the</strong>irmore 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 th<strong>in</strong>k <strong>the</strong>y are gett<strong>in</strong>g from “Wall <strong>Street</strong>”, <strong>the</strong>y shouldnever compromise <strong>the</strong> goal of value creation <strong>in</strong> <strong>the</strong> name of maximiz<strong>in</strong>g earn<strong>in</strong>gs. These two goals oftenconflict, and companies that utilize earn<strong>in</strong>gs growth targets for any reason, <strong>in</strong>clud<strong>in</strong>g exec comp, shouldtrade at lower valuations.OSO: Because real estate appreciates <strong>in</strong> a fairly reliable fashion over a long period of time, long-termequity returns can be boosted by add<strong>in</strong>g leverage.Response: Actually, <strong>the</strong> long-term evidence suggests that real estate does not appreciate at all. By <strong>the</strong>time this year is up (i.e. appraisers acknowledge what has hit <strong>the</strong>m), <strong>the</strong> 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 com<strong>in</strong>g from <strong>in</strong>come, not appreciation. Participants <strong>in</strong> <strong>the</strong> real estatemarket rout<strong>in</strong>ely overhype <strong>the</strong> returns that <strong>in</strong>vestors can reasonably expect to achieve <strong>in</strong> this asset class,and <strong>the</strong> overly bullish outlook probably has someth<strong>in</strong>g to do with <strong>the</strong> sector’s overly aggressive capitalstructures.OSO: Because cash flows are predictable, real estate can support more leverage than most operat<strong>in</strong>gbus<strong>in</strong>esses.Response: This has everyth<strong>in</strong>g to do with <strong>the</strong>, “how much can I get?” m<strong>in</strong>dset, and noth<strong>in</strong>g to do with,“how much should I have?” If <strong>the</strong>re was an identifiable advantage toward us<strong>in</strong>g debt, this would be avery <strong>in</strong>terest<strong>in</strong>g po<strong>in</strong>t. That <strong>the</strong>re is not renders it moot.WWW.GREENSTREETADVISORS.COM© 2010, <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>, Inc. - Use of this report is subject to <strong>the</strong> Terms of Use listed at <strong>the</strong> end of <strong>the</strong> report.This report conta<strong>in</strong>s copyrighted subject matter and is covered under <strong>the</strong> <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>' Terms of Use.<strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong> reserves all rights not expressly granted.

<strong>Capital</strong> <strong>Structure</strong> <strong>in</strong> <strong>the</strong> <strong>REIT</strong> <strong>Sector</strong> — July 1, 200911OSO: Real estate is a capital-<strong>in</strong>tensive bus<strong>in</strong>ess, 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 seem<strong>in</strong>glyhave plenty of places to <strong>in</strong>vest capital, yet <strong>the</strong>y barely use any debt. Even if it is true, it really doesn’tchange anyth<strong>in</strong>g. The fact that capital is needed does not impact whe<strong>the</strong>r that capital should be debt orequity.OSO: <strong>REIT</strong>s are <strong>in</strong> <strong>the</strong> bus<strong>in</strong>ess of f<strong>in</strong>anc<strong>in</strong>g real estate, and f<strong>in</strong>ancial service firms always employhigh leverage.Response: Equity <strong>REIT</strong>s are engaged primarily <strong>in</strong> <strong>the</strong> bus<strong>in</strong>esses of own<strong>in</strong>g and operat<strong>in</strong>g real estate,not f<strong>in</strong>anc<strong>in</strong>g it. Equity <strong>REIT</strong>s are not f<strong>in</strong>ance companies.OSO: A <strong>REIT</strong> that is 45% levered generates higher FFO/AFFO than one that is 20% levered, yet <strong>in</strong>vestorsdon’t really worry enough at that level to cause <strong>the</strong>m to ascribe a lower P/E multiple.Response: This is <strong>the</strong> “free lunch” that M&M debunked. While costs of severe f<strong>in</strong>ancial distress maynot be excessive (though <strong>the</strong>y are likely present) at a 45% leverage ratio, higher leverage makes <strong>the</strong> cashflow stream more volatile/risky, which will cause <strong>in</strong>vestors to ascribe a lower P/E multiple.OSO: Non-recourse debt affords <strong>the</strong> opportunity to enjoy <strong>the</strong> benefits of leverage without putt<strong>in</strong>g myfirm at risk (or, <strong>in</strong> M&M speak, rais<strong>in</strong>g <strong>the</strong> risk of severe f<strong>in</strong>ancial distress).Response: Non-recourse debt can, <strong>in</strong>deed, lower <strong>the</strong> potential cost/risk of severe f<strong>in</strong>ancial distress,thus allow<strong>in</strong>g a <strong>REIT</strong> to operate with more debt before exceed<strong>in</strong>g <strong>the</strong> maximum end of <strong>the</strong> optimal leveragerange. However, <strong>the</strong>re are a number of reasons why non-recourse debt is not tantamount to somesort of free lunch:• The lack of personal recourse is ak<strong>in</strong> to an <strong>in</strong>surance policy that is implicitly sold by <strong>the</strong> lender to<strong>the</strong> borrower. Lenders charge for this <strong>in</strong>surance and it is presumptuous to believe that it is systematicallymispriced.• Heavy reliance on non-recourse debt precludes <strong>REIT</strong>s from access<strong>in</strong>g o<strong>the</strong>r important sources of<strong>REIT</strong> debt, specifically <strong>the</strong> unsecured corporate debt market. <strong>REIT</strong>s that keep all f<strong>in</strong>anc<strong>in</strong>g optionson <strong>the</strong> menu are better positioned to wea<strong>the</strong>r full cycles, as evidenced by <strong>the</strong> current state of affairswhere<strong>in</strong> unsecured markets are receptive, while secured markets are likely to rema<strong>in</strong> treacherousfor several more years.• Just like every o<strong>the</strong>r type of debt, any boost non-recourse debt provides to earn<strong>in</strong>gs will be entirelyoffset by a reduction <strong>in</strong> <strong>the</strong> P/E multiple.In summary, <strong>the</strong>re are pros and cons associated with non-recourse debt, but its existence does not <strong>in</strong> anyway change <strong>the</strong> fact that <strong>the</strong>re is no compell<strong>in</strong>g reason for <strong>REIT</strong>s to have debt.WWW.GREENSTREETADVISORS.COM© 2010, <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>, Inc. - Use of this report is subject to <strong>the</strong> Terms of Use listed at <strong>the</strong> end of <strong>the</strong> report.This report conta<strong>in</strong>s copyrighted subject matter and is covered under <strong>the</strong> <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>' Terms of Use.<strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong> reserves all rights not expressly granted.

<strong>Capital</strong> <strong>Structure</strong> <strong>in</strong> <strong>the</strong> <strong>REIT</strong> <strong>Sector</strong> — July 1, 200912VIII. Where We Go From HereThe <strong>REIT</strong> <strong>in</strong>dustry is <strong>in</strong> a very early stage of what will prove to be a lengthy deleverag<strong>in</strong>g process. Theprocess is best thought of as tak<strong>in</strong>g place <strong>in</strong> three dist<strong>in</strong>ct stages. While some companies are at differentpo<strong>in</strong>ts than o<strong>the</strong>rs <strong>in</strong> this process, <strong>the</strong> comments below perta<strong>in</strong> to <strong>the</strong> <strong>in</strong>dustry <strong>in</strong> general:• Phase One: This is <strong>the</strong> stage we’re still <strong>in</strong>, and re-equitization at this po<strong>in</strong>t still centers primarilyaround survival. Most <strong>REIT</strong>s have made great strides <strong>in</strong> enhanc<strong>in</strong>g <strong>the</strong>ir own prospects for surviv<strong>in</strong>ga credit crunch that could persist through 2012, but many have unf<strong>in</strong>ished bus<strong>in</strong>ess on thisfront.• Phase Two: From ’97-’02, <strong>REIT</strong>s operated at leverage ratios below 50% and Debt/NOI multiplesbelow 5.0X. Assum<strong>in</strong>g that <strong>REIT</strong>s merely strive to return <strong>the</strong>ir balance sheets to a state of normalcy,massive de-leverag<strong>in</strong>g (a 1700 bp reduction <strong>in</strong> LTV and a 210 bps reduction <strong>in</strong> <strong>the</strong> Debt/NOI multiple) needs to take place just to return to <strong>the</strong> capital structures of yore. This goal shouldserve as <strong>the</strong> absolute m<strong>in</strong>imum amount of deleverag<strong>in</strong>g any management team should strive toachieve. O<strong>the</strong>rwise, <strong>the</strong>y will face <strong>the</strong> challeng<strong>in</strong>g task of expla<strong>in</strong><strong>in</strong>g why leverage ratios of <strong>the</strong> pastwere overly conservative.• Phase Three: Two catalysts are likely to cause <strong>REIT</strong>s to eventually adopt leverage targets that aresubstantially more conservative than what conventional wisdom dictated as appropriate <strong>in</strong> <strong>the</strong> ’97-’02 period. First, <strong>the</strong> <strong>in</strong>dustry will cont<strong>in</strong>ue to learn from <strong>the</strong> best practices of corporate Americaand <strong>the</strong> cultural aff<strong>in</strong>ity for leverage will eventually become an historic relic. Second, <strong>the</strong> pa<strong>in</strong>fullessons learned <strong>in</strong> recent years all po<strong>in</strong>t toward reduced leverage targets go<strong>in</strong>g forward. There is nomagic number that all <strong>REIT</strong>s should adopt as a target, but it is clear that whatever seemed appropriate<strong>in</strong> <strong>the</strong> past was almost certa<strong>in</strong>ly too high.The Phases of <strong>the</strong> 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 <strong>the</strong> phases of <strong>the</strong> de-leverag<strong>in</strong>g process will <strong>in</strong>volve battles on multiple fronts, <strong>in</strong>clud<strong>in</strong>g propertysales and jo<strong>in</strong>t venture formations. However, <strong>the</strong> most effective way to de-lever is to issue equity, and<strong>the</strong> needs of <strong>the</strong> <strong>in</strong>dustry are so large that <strong>the</strong> equity issuance wave is certa<strong>in</strong> to last longer and be larger<strong>in</strong> scale than most observers likely anticipate. The good news, however, is that <strong>REIT</strong>s will <strong>in</strong>creas<strong>in</strong>glygarner a competitive edge <strong>in</strong> <strong>the</strong> real estate market place, as only <strong>the</strong>y have direct access to <strong>the</strong> biggestand cheapest pool of equity capital – <strong>the</strong> public market.Mike KirbyWWW.GREENSTREETADVISORS.COM© 2010, <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>, Inc. - Use of this report is subject to <strong>the</strong> Terms of Use listed at <strong>the</strong> end of <strong>the</strong> report.This report conta<strong>in</strong>s copyrighted subject matter and is covered under <strong>the</strong> <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>' Terms of Use.<strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong> reserves all rights not expressly granted.

<strong>Capital</strong> <strong>Structure</strong> <strong>in</strong> <strong>the</strong> <strong>REIT</strong> <strong>Sector</strong> — July 1, 200913Appendix A: Optimal Leverage Targets are Both <strong>Sector</strong>- and Company-SpecificThe body of this report addresses optimal leverage targets for <strong>the</strong> typical <strong>REIT</strong>, but <strong>the</strong>re are numerousfactors that have an impact on <strong>the</strong> amount that a given <strong>REIT</strong> can prudently borrow. Examples <strong>in</strong>clude:• Operat<strong>in</strong>g Leverage: Real estate with lower operat<strong>in</strong>g leverage (e.g. apartments) can bear more debtthan real estate with high operat<strong>in</strong>g leverage (e.g. hotels).• Lease Terms: Companies with long-lived leases can bear more debt.• Bus<strong>in</strong>ess L<strong>in</strong>es: The bus<strong>in</strong>ess of own<strong>in</strong>g and operat<strong>in</strong>g real estate is safer than develop<strong>in</strong>g.• Non-recourse Debt: Though <strong>the</strong> embedded <strong>in</strong>surance policy comes at a cost, non-recourse debt allowsa <strong>REIT</strong> to operate prudently at higher leverage.To <strong>the</strong> extent a <strong>REIT</strong> stacks up favorably on <strong>the</strong>se variables, it translates <strong>in</strong>to an ability to operate athigher leverage before costs of f<strong>in</strong>ancial distress become an issue. However, <strong>the</strong> fact that a <strong>REIT</strong> can operatewith higher leverage has noth<strong>in</strong>g to do with whe<strong>the</strong>r it should.<strong>REIT</strong>s with access to Fannie Mae/Freddie Mac (primarily owners of apartments) provide <strong>the</strong> only exampleof companies that not only can borrow more than average, but <strong>the</strong>y also should. The government“subsidized” enterprises (GSEs) have proven to be relatively reliable sources of f<strong>in</strong>anc<strong>in</strong>g even at timeswhen o<strong>the</strong>r providers of capital have locked <strong>the</strong>ir doors. This means that <strong>the</strong> odds/costs of severe f<strong>in</strong>ancialdistress are not as problematic for owners <strong>in</strong> sectors with GSE access as is <strong>the</strong> case elsewhere. Thevalue of <strong>the</strong> government subsidy (i.e. below-market <strong>in</strong>terest rates) <strong>in</strong>creases as a <strong>REIT</strong> utilizes more GSEf<strong>in</strong>anc<strong>in</strong>g, a fact that provides strong motivation to have at least moderate levels of debt.The optimal leverage target for apartment <strong>REIT</strong>s is well above zero. It occurs at <strong>the</strong> leverage ratiowhere costs associated with distress and/or missed opportunities beg<strong>in</strong> to outweigh <strong>the</strong>benefits proffered by borrow<strong>in</strong>g at subsidized <strong>in</strong>terest rates.11%The Effect of Leverage on WACC - Apartment <strong>REIT</strong>sWtd Avg Cost of <strong>Capital</strong>10%9%Cost of NotMaximiz<strong>in</strong>g GSESubsidyOptimal LeverageCost of DistressCost of MissedOpportunities8%0% 10% 20% 30% 40% 50% 60% 70% 80%Leverage RatioWWW.GREENSTREETADVISORS.COM© 2010, <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>, Inc. - Use of this report is subject to <strong>the</strong> Terms of Use listed at <strong>the</strong> end of <strong>the</strong> report.This report conta<strong>in</strong>s copyrighted subject matter and is covered under <strong>the</strong> <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>' Terms of Use.<strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong> reserves all rights not expressly granted.

<strong>Capital</strong> <strong>Structure</strong> <strong>in</strong> <strong>the</strong> <strong>REIT</strong> <strong>Sector</strong> — July 1, 200914Appendix B: Leverage Ratios for <strong>the</strong> 50 Largest Companies <strong>in</strong> <strong>the</strong> S&P 500 (ex F<strong>in</strong>ancials)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 Bus<strong>in</strong>ess Mach<strong>in</strong>es 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 Scher<strong>in</strong>g-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 Mart<strong>in</strong> Corp 32 39% 3.350 Boe<strong>in</strong>g Co/The 31 49% 5.4Net Liabilities/EBITDAMedian - Top 50 12% 0.9Median - <strong>REIT</strong>s <strong>in</strong> <strong>the</strong> 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, <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>, Inc. - Use of this report is subject to <strong>the</strong> Terms of Use listed at <strong>the</strong> end of <strong>the</strong> report.This report conta<strong>in</strong>s copyrighted subject matter and is covered under <strong>the</strong> <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>' Terms of Use.<strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong> reserves all rights not expressly granted.

<strong>Capital</strong> <strong>Structure</strong> <strong>in</strong> <strong>the</strong> <strong>REIT</strong> <strong>Sector</strong> — July 1, 200915Appendix C: If Leverage Doesn’t Turbocharge Returns Dur<strong>in</strong>g a Bubble, When Will It?As discussed <strong>in</strong> Section V, <strong>REIT</strong>s with higher leverage have substantially underperformed <strong>the</strong>ir less leveredbrethren over <strong>the</strong> last 15 years. A potential criticism of this f<strong>in</strong>d<strong>in</strong>g is that <strong>REIT</strong> pric<strong>in</strong>g suffered anunprecedented decl<strong>in</strong>e near <strong>the</strong> end of <strong>the</strong> time period studied, thus rais<strong>in</strong>g <strong>the</strong> prospect that results bylevered companies would look a lot better dur<strong>in</strong>g a “normal” time period. While this gripe is not entirelywithout merit, concerns should be m<strong>in</strong>imized by <strong>the</strong> fact that cap rates today are very close to where <strong>the</strong>ywere 15 years ago. Aga<strong>in</strong>st a flat-cap-rate backdrop, leverage should have boosted returns, but it appearsto have impaired <strong>the</strong>m.At least as surpris<strong>in</strong>g is <strong>the</strong> fact that leverage did not significantly enhance returns <strong>in</strong> <strong>the</strong> ten years preced<strong>in</strong>gJanuary ‘07, <strong>the</strong> peak of <strong>the</strong> asset valuation bubble. Consider<strong>in</strong>g that cap rates went from roughly9% to 6% over this time frame, caus<strong>in</strong>g asset values to skyrocket, leverage should have served as a returnturbocharger. As shown below, <strong>the</strong>re is some weak evidence that more levered <strong>REIT</strong>s outperformed dur<strong>in</strong>gthis period, but <strong>the</strong> f<strong>in</strong>d<strong>in</strong>gs are not statistically significant. That leverage failed to clearly boost<strong>REIT</strong> returns dur<strong>in</strong>g a period when it should have provided a huge boost provides yet one more reason toth<strong>in</strong>k that <strong>the</strong> costs associated with debt (at <strong>the</strong> leverage ratios typical for <strong>REIT</strong>s) must be sizable.Leverage and Returns Before <strong>the</strong> BustTotal Return '97-'06 (ann.)25%20%15%10%PSAW RECUZAVBBREVNOKIMSK TFRTR EGCPTEQR PLDLRYDR EW RICLIPPST CODDRCBLM ACSPGUDRELSCL PHIWGGPBest fit l<strong>in</strong>e +/- 2 St.DeviationsR 2 = 0.095%30% 35% 40% 45% 50% 55% 60% 65% 70%Avg Leverage RatioWWW.GREENSTREETADVISORS.COM© 2010, <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>, Inc. - Use of this report is subject to <strong>the</strong> Terms of Use listed at <strong>the</strong> end of <strong>the</strong> report.This report conta<strong>in</strong>s copyrighted subject matter and is covered under <strong>the</strong> <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>' Terms of Use.<strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong> reserves all rights not expressly granted.

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<strong>Green</strong> <strong>Street</strong>’s Disclosure InformationAt any given time, <strong>Green</strong> <strong>Street</strong> publishes roughly <strong>the</strong> same number of “BUY”recommendations that it does “SELL” recommendations.<strong>Green</strong> <strong>Street</strong>’s “BUYs” have historically achieved far higher total returnsthan its ”HOLDs”, which, <strong>in</strong> turn, have outperformed its “SELLs”. 1, 2% of companiesunder coverage<strong>Green</strong> <strong>Street</strong> Recommendation Distribution(as of 5/29/09)50%25%0%31%38%31%BUYs HOLDs SELLsYear Ended December 31:Total Return of <strong>Green</strong> <strong>Street</strong>'s RecommendationsYear Buy Hold Sell NA<strong>REIT</strong> 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 <strong>in</strong>dependently 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 Do<strong>in</strong>g?".2) Company <strong>in</strong>clusion <strong>in</strong> <strong>the</strong> calculation of total return has been based on whe<strong>the</strong>r <strong>the</strong> companies were listed <strong>in</strong> <strong>the</strong> primary exhibit of <strong>Green</strong> <strong>Street</strong>’s "Real Estate Securities Monthly”, pg. 11-14. Beg<strong>in</strong>n<strong>in</strong>g with May 2000, Gam<strong>in</strong>g C-Corpsand Hotel C-Corps, with <strong>the</strong> exception of Starwood Hotels and Homestead Village, are not <strong>in</strong>cluded <strong>in</strong> <strong>the</strong> primary exhibit and <strong>the</strong>refore not <strong>in</strong>cluded <strong>in</strong> <strong>the</strong> calculation of total return. Beg<strong>in</strong>n<strong>in</strong>g with March 2003, all Hotel companies areexcluded.3) Study uses recommendations given <strong>in</strong> <strong>Green</strong> <strong>Street</strong>'s "Real Estate Securities Monthly" from January 29, 1993 through May 29, 2009.4) Not directly comparable to <strong>Green</strong> <strong>Street</strong>'s performance <strong>in</strong>dices because NA<strong>REIT</strong> <strong>in</strong>cludes more companies and uses market-cap weight<strong>in</strong>gs. <strong>Green</strong> <strong>Street</strong>'s returns are equally-weighted averages.This report conta<strong>in</strong>s copyrighted subject matter and is covered under <strong>the</strong> <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>' Terms of Use.<strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong> reserves all rights not expressly granted.

<strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong> - North American Team*Research (Newport Beach) + 1 (949) 640-8780General:Mike Kirby, Director of Researchmkirby@greenst.comCraig Leupold, Presidentcleupold@greenst.comPeter Ro<strong>the</strong>mund, CFA, Senior Associatepro<strong>the</strong>mund@greenst.comKawika Tarayao, Senior Associate**ktarayao@greenst.comMat<strong>the</strong>w 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, Manag<strong>in</strong>g 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.comLodg<strong>in</strong>g:John Arabia, Manag<strong>in</strong>g Directorjarabia@greenst.comBob Grundstrom, Senior Associatebgrundstrom@greenst.comTrad<strong>in</strong>g & Institutional Sales (Dallas) 1 (800) 263-1388Lynn Lewis, Manag<strong>in</strong>g Director of Sales and Trad<strong>in</strong>glynnlewis@greenst.comSherman Burns, Manag<strong>in</strong>g Director & Trad<strong>in</strong>g Managersburns@greenst.comLaurie Hauck, Vice President, Trad<strong>in</strong>glhauck@greenst.comCarol Parker, Vice President, Trad<strong>in</strong>gcparker@greenst.comDavid Alexander, Vice President, Trad<strong>in</strong>gdalexander@greenst.comDavid Auerbach, Vice President, Trad<strong>in</strong>gdauerbach@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 Laughl<strong>in</strong>, Institutional Salesslaughl<strong>in</strong>@greenst.comConsult<strong>in</strong>g (Newport Beach) +1 (949) 640-8780Adam Markman, Manag<strong>in</strong>g Directoramarkman@greenst.comBrad Soltis, Associatebsoltis@greenst.comPaul Harmel<strong>in</strong>g, Associatepharmel<strong>in</strong>g@greenst.comAdm<strong>in</strong>istration (Newport Beach) +1 (949) 640-8780Warner Griswold, CFA, Chief Operat<strong>in</strong>g Officerwgriswold@greenst.comMichael Kao, Director, Technologymkao@greenst.comDamon Scott, Director, Market<strong>in</strong>gdscott@greenst.comDan Malloy, Manager, Market<strong>in</strong>gdmalloy@greenst.comRobyn Francis, Manager, Compliancerfrancis@greenst.comKathy Chamberla<strong>in</strong>, Human Resourceskchamberla<strong>in</strong>@greenst.comHeadquarters/Research Trad<strong>in</strong>g & Institutional Sales Europe - Research & Trad<strong>in</strong>g567 San Nicolas Drive, Suite 200 600 North Pearl <strong>Street</strong>, Suite 2310 22 Grosvenor Square, 3rd FloorNewport Beach, CA 92660 Dallas, TX 75201 London, W1K 6LF, UK+1 (949) 640-8780 Trad<strong>in</strong>g: 1 (800) 263-1388 Ma<strong>in</strong>: +44 (0) 20 7290 6540Sales: +1 (214) 855-5905 Trad<strong>in</strong>g: +44 (0) 20 7290 6555www.greenstreetadvisors.com* This page conta<strong>in</strong>s a roster of most <strong>Green</strong> <strong>Street</strong> employees. However, only those listed <strong>in</strong> <strong>the</strong> "Research" section without anasterisk (*) are registered representatives / research analysts.** These research employees operate <strong>in</strong> a support capacity and are not yet registered representatives / research analysts.This report conta<strong>in</strong>s copyrighted subject matter and is covered under <strong>the</strong> <strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong>' Terms of Use.<strong>Green</strong> <strong>Street</strong> <strong>Advisors</strong> reserves all rights not expressly granted.

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