Investing in REITs: Industry Primer

Real Estate Investment Trusts (REITs) allow investment in real estate without the high entry cost, management challenges, and low liquidity associated with the purchase and ownership of properties. This makes them a very appealing way for smaller investors to diversify into real estate.

Let’s take a closer look at how REITs work and at some of the special rules, considerations, and terminology that apply to this asset class.

What are REITs?

REITs are companies that own and operate real estate assets. What makes REITs special is that they are publicly traded on financial markets. This means that investors can buy real estate through the financial markets, without having to deal with any of the day-to-day operations it involves. The same way that markets allow to buy shares in tech companies without having to own and operate an IT business.

This is a very large asset class, with US REITs owning collectively $3.5 trillion worth of assets. In addition to the ease of buying and selling, and the relief of not having to manage the property, Investing in REITs provides diversification. Directly investing in real estate will lead to owning just of just a handful of properties. A diversified REIT will spread out the risk through hundreds or thousands of properties, smoothing out returns and limiting risk.

The Rules of REITs

The US Internal Revenue Code has specific rules defining what can be called a REIT. A REIT must meet these qualifications:

• A REIT must invest at least 75% of its total assets in real estate, US Treasury instruments, or cash.
• At least 75% of a REITs gross income must come from rents, mortgage interest, or real property sales.
• A REIT must pay out 90% of its taxable income to shareholders in the form of dividends each year.
• A REIT must be taxable as a corporation.
• No more than 50% of a REIT’s shares may be held by any five or fewer individuals.
• At least 100 individuals or entities must hold shares after a REIT’s first full year of operation.
• A REIT must be managed by a board of trustees or directors.

The dividend requirement is particularly important in evaluating REITs. It means that while REITs can pay substantial dividends, they do not have much income available to re-invest in operations.

Types of REITs

In this article, we will focus on publicly available REITs investing in properties. Private or non-listed REITs exist as well, but do not offer the same liquidity advantages. There are also mortgage REITs that own mortgages rather than real estate.

The most simple type of REIT is involved in the most basic type of real estate investing: owning and renting residential properties. Residential REITs are the largest part of the market and the easiest to understand.

Other types of REITs are focused on a specific type of commercial property. For example, some will be specialized in office spaces, healthcare facilities, commercial real estate (like malls), or hotels. Some REITs are even more “exotic”, for example with a focus on farmlands, timberlands, data centers, cell phone towers, warehouses, etc.

Some REITs will be more diversified, investing in multiple classes of assets, depending on opportunities and the management’s strategy.

In addition to the type of assets, many REITs will be focused on a specific region. And when evaluating REITs, the old adage of real estate holds true: what matters is “location, location, and location”.

As a result, investing in REITs allows targeted investment far beyond just the general “real estate market”. It can be used to target the growing demand for data centers, farmlands, or a booming economy in one specific state or region.

Choosing a REIT

Because there are so many REITs listed, each with its own specific details, it can be rather overwhelming to find the right ones for your portfolio.

First, you’ll need to decide why you want to invest in real estate in the first place. If it is mostly to provide diversification, a generalist REIT would be best. If it is to invest in a specific sector or region, a more focused REIT will be preferable.

REITs are required to distribute 90% of their profit in dividends. A sustainable dividend yield is really all that matters here, with little capital gain appreciation to be expected.

Once you identify a type of REIT, you’ll need to assess the size and sustainability of the returns and the overall quality of the investment. That requires a set of metrics that is somewhat different from what you’d use to assess stocks.

Assessing a REIT’s Quality

Because REITs are in essence not a company, but a pile of long-duration assets generating a yield, valuation metrics like P/E are not relevant. This can make REITs confusing for investors who are accustomed to evaluating stocks.

Here are a few metrics that you can use to value REITs

Net Asset Value (NAV)

Traditional accounting with depreciation can give a very poor view of a REIT’s real value. This is because many real estate properties will be depreciated over time, while their real value is actually stable or increasing. So instead of using the “value” of assets registered in the balance sheet, investors will need to use the somewhat subjective valuation of the properties owned by the REIT (often, by comparing it to the market price of similar properties).

They then subtract any debt to get the Net Asset Value (NAV). In theory, the NAV/share should not differ widely from the traded share price. In practice, as the NAV is dependent on a subjective value evaluation, it can differ and offer opportunities to cautious investors.

Funds From Operations (FFO)

This metric is somewhat equivalent to operating cash flow, adapted to real estate. It takes earnings and adds back depreciation, amortization, and other “costs” that are probably not accurate for real estate assets. A building is not machinery and is not likely to lose all of its value in 10 or 20 years. A well-maintained building in a good location may even gain value.

Money earned by selling properties is not included in FFO, as this does not reflect the profitability of existing assets.

FFO is useful to evaluate the real profitability of the assets owned and how stable the dividends are.

Fees

Most REITs charge a general fee and a performance fee. Other fees like acquisition fees, divestment fees, and so on are possible. Each fee eats up parts of the profit made from renting the assets. Additional salary for management can come in the form of payment in shares of the REITs.

I would consider fees encouraging buying and selling to boost management income to be a very bad incentive. Good management should be paid well, but overpaying rarely pays off, so fees in the lower range of the industry should be preferred.

Risks

One important risk is possible back-dealing. Reputable firms are unlikely to do this. Some less reputable ones might have building maintenance or service sold to the REIT by firms that the REIT’s management owns or control. This is something to pay attention to, especially for foreign REITs in countries with a weaker rule of law.

Market timing and real estate bubbles are obvious risks when investing in real estate. It is very hard in practice to time markets, but it is possible to watch out for periods and markets where real estate values are highly inflated. As a rule of thumb, REITs with manageable debt loads will be much safer, and buying after a decline in price provides more chance for the REIT’s income to rise over time.

Conclusion

REITs are a great tool to invest in real estate without getting involved with the operational side of the sector. Way less hassle, and the fees are normally worth it for the diversification and liquidity offered, on top of the possibility to invest much smaller sums than in a classic real estate deal. In addition, specialized REITs offer opportunities to invest in types of assets that would be entirely impossible for individual investors, like data centers or cell phone towers for example.

The key to successfully investing in REITs is to take a cautious approach to valuation. Real estate can provide a stable income stream and stabilize a portfolio performance, especially when you can find a REIT trading at a slight discount. Abnormally high yields should still be a red flag. So are mysterious discounts: if the REIT is persistently trading below NAV, the market may know something you do not.

Industry Primers
The process of analyzing a company varies considerably from industry to industry. Many industries have their own vocabularies and specific concerns that investors need to consider. This series of articles looks at specific industries and at industry-specific factors that affect investments. The goals are to highlight specific risks, clarify confusing terminology and explain industry-specific metrics for valuation. These methods complement the usual evaluation process, they don’t replace it.