Example: Valuing a Real Estate Investment Trust Example

Real estate investment trusts (REITs) were created in the 1960s to allow small investors the opportunity to participate in large-scale real estate investments. The law that created the REIT structure allowed the REIT entities to pass the real estate investment income tax-free to their investors.In exchange for these tax benefits, REITS must distribute virtually all of their earnings (at least 95%) to their investors. Because the REIT entity’s accumulation of earnings is so severely constrained, it must pay dividends constantly, and any dividend growth will, at best, be stable and modest. Because of the dividend growth pattern inherent in the REIT structure, it is a good candidate for application of the Gordon model.

Value Duke Realty Corp. (REIT)

Duke Realty is one of the largest REITs in the country, with over $6.5 billion in total market capitalization. It owns interests in over 106 million square feet of office space and industrial facilities throughout the Southeast and Midwest. In 2001, Duke Realty paid dividends per share of $1.76. Because of present economic conditions, the dividend growth rate for 2002 is expected to be 2.8%. Assume the appropriate cost of equity (discount rate) for REITs is currently 8.16%.

To determine the present value of a share in Duke, we calculate the share value after one period of growth (1.76 times 1 plus the growth rate = $1.80). Next, we divide the per share dividend after one period of growth by the discount rate minus the rate of growth [1.80/(0.0816-0.028)].

This calculation yields a present value of Duke Realty stock of $33.58.

Try investigating the value of Duke Realty shares yourself. All of their financial statements (including dividend payment history) can be found at their website (www.dukereit.com).Perform your calculation with the Gordon model, and then compare your answer to Duke Realty’s current NYSE quotation (symbol: DRE).Is there a substantial difference? If so, why do think that is? Conceptually, how is the valuation reflected in the market price different from that of the DCF/Gordon growth model?

You can learn much more about REITs at the National Association of Real Estate Investment Trusts’ website.