Understanding and Analyzing REITs (Real Estate Investment Trusts)
Updated: Dec 24, 2022
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Why Choose a REIT over Rental Properties?
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What is a REIT? How do you invest in a REIT? If you’ve been looking at dividend stocks you might have ran across a few of these companies already. One of the most popular, Realty Income ($O), is known as the monthly dividend company.
Other good options include Stag Industrial ($STAG) and Duke Realty Corp ($DRE). REITs are a good choice if you‘re interested in real estate but don’t want to own the property yourself. REITs invest in real estate assets where they manage or own properties or the mortgages on the properties themselves. There are basic requirements that a company must meet to be classified as a REIT. The following are highlights of the requirements:
Invest at least 75% of its total assets in real estate.
Derive at least 75% of its gross income from rents on real properties, mortgage interest, or from real estate sales.
Pay at least 90% of taxable income to shareholders as dividends (This is why REITs typically have higher than average dividend yield)
No more than 50% of shares can be held by fewer than five people
Why choose a REIT over rental properties?
REITs offer simplicity when compared to owning actual property. You don't have to worry about finding tenants or hiring a company to manage your property. No calls at 1am because the toilet broke either. All of this and more are handled by the REIT. REITs are also great for new investors because you can invest for the cost of a single share (or maybe a fractional share if your broker offers it) vice having to invest the normal amount of 20%~ down + closing costs on a property. Another advantage of a REIT is it's liquidity, or your ability to exit the investment quickly. If you choose to sell a rental property it won't be as quick, especially when compared to selling shares which can could be completed in seconds. The downside of choosing a REIT is you miss out on the appreciation of an asset you own. REITs are required to pay 90% of their income as dividends. That only leaves 10% for growing the REITs assets. A portfolio of multiple individual rental properties will become more profitable over time as you pay down the mortgage on your rental properties. The choice is up to the investor. For example, there are no rules about owning rental property AND REITs if you chose to. Understanding the risks, rewards, pros, and cons of an investment are all important factors before allocating your money.
Types of REITs
There are multiple categories a REIT can fall under. Normally the are categorized by the type of assets the REIT invests in.
Retail REITs - These REITs are invested in
shopping malls, grocery stores, home improvement stores, or other freestanding retail. These REITs make money by collecting rent. As such, Retail REITs are at risk if the mall or retail entity is struggling to make its' payments.
Residential REITs - These REITs invest in
manufactured homes and multi-family apartment complexes. These REITs do best in markets where rent is stable or rising. If the rent falls then that will effect to profitability of the underlying REIT.
Healthcare REITs - These REITs invest in hospitals, nursing homes, medical centers, and other retirement facilities. They rely on Medicare, Medicaid, and private payers to earn money. Policies that effect these programs could effect the REIT.
Office REITs - These REITs invest in office buildings. A benefit of this type of REITs is its' typical tenants favor longer term leases. A longer lease provides predictability for the REIT. It's also important to understand if the industry or employment in a particular geographic region is growing or shrinking.
Mortgage REITs (mREIT) - These REITs invest in mortgages instead of owning physical assets. Interest rates can effect the return that these REITs receive.
How to analyze a REIT?
Analyzing a REIT is different from a typical dividend paying stock. Unlike analyzing a dividend stock like our article here, you won't be able to apply principles such as Earnings-Per-Share to a REIT. There a several different valuation metrics you can use to understand a REITs dividend safety, financial flexibility, and overall long-term viability. The hardest aspect of REIT analysis is that the reporting format for financials isn't standardized. REITs report quarterly on Form 10-Q and annually on a Form 10-K. These forms summarize earnings and financial performance. The REITs can also submit additional supplemental information via Form 8-K. Below we detail common assessments used to understand REIT performance:
Net Operating Income (NOI)
Net operating income is how much each individual property is making in profit based on current costs. The NOI is calculated using rental revenues and tenant reimbursement revenue - operating costs. The formula is listed below.
(Rental Revenue + Tenant Reimbursement Revenue) - Operating Expense (Property Management Fees + Taxes + Insurance) = Net Operating Income
The goal is to have a positive Net Operating Income per property. This ensures the underlying assets are profitable for the REIT.
Same Store Earnings
Same-store generally refers to revenues, operating expenses, and net operating income from assets the REIT has owned and operated for 12 or more months. This gives investors an idea of how well the REIT's management is at building profitability internally with assets it currently owns. This is considered internal growth, where acquiring new properties would be considered external growth. Increasing rent, occupancy rates, or changes to vacancy time can increase the Net-operating income of a REITs "same store" portfolio.
Funds from Operations (FFO) Growth (REIT Earnings Growth)
Normal companies use EPS or Earnings per share as metric to evaluate the underlying company. REITs track growth through year-over-year Funds from Operations (FFO). FFO is increased by combining same-store growth with external growth derived from properties the REIT acquired or developed minus the FFO from any properties sold. General and administrative costs of running the REIT are also calculated into FFO. As an investor you want to look for REITs that are growing their earnings or FFO on a consistent basis.
Adjusted Funds from Operations (AFFO)
Adjusted funds from operating (AFFO) is calculated by adding amortization expenses to FFO then subtracting recurring capital expenditures, and adjusting for straight line rents. Recurring Capital expenditures are property improvements to facilitate leasing and structural improvements and upgrades. "Straight Line" rent is rental income reported as the average annual rent to be received over the life of a lease instead of the cash received. AFFO is considered more precise than traditional FFO values. AFFO calculations differ amongst REITs so AFFO shouldn't be compared directly. It makes more sense to compare trends amongst REIT's AFFO in the same sector or peer group.
Cash Available for Distribution (CAD)
CAD is the most valuable asset used to determine safety of a REIT's dividends. It represents the amount of cash available to pay dividends. Realty Income calls this number "AFFO available to Shareholders."
Price to FFO (P/FFO) Multiple
Price to FFO is the same evaluation as Price to Earnings (P/E). P/FFO can be used to compare the ratio amongst REITs with similar investment portfolios. Investopedia states: Similar to P/E multiples, interpreting price-to-FFO or price-to-AFFO multiples is not an exact science. Multiples vary with market conditions and specific REIT sub-sectors. And, as with other equity categories, we want to avoid buying into a multiple that is too high.
Debt to EBITDA Ratio
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. A large amount of debt in any company isn't a good sign and REITs are no different. Describing debt in a REIT is done using the Debt to EBITDA ratio. The ratio will vary from REIT to REIT and comparing the ratio across peers is a good indicator of normal debt load. Typically a ratio of 6:1 is acceptable but there is no concrete answer. To calculate the ratio use the formula below.
Net debt / EBITDA = net debt to EBITDA ratio
Another key component to understanding debt is its maturity date. This is the date and timeframe when the debt is going to come due. This tells you how much debt is due to be repaid and when. Is it short term debt, one to five years? Or is it longer term debt, fifteen to twenty years? Debt repayment can slow or hinder growth so it's an important factor to consider.
REITs provide easy exposure to real estate for investors. Understanding the fundamentals behind a REIT is important to ensure you select a quality REIT that meets your expectations. With 100s of REITs on the market under standing FFO, AFFO, CAD and more will help narrow down your choices.