Investing in a Real Estate Investment Trust, or REIT, is another method to invest in real estate. Is a REIT investment right for you? Let’s explore the possibilities.
If you are on my blog site, you are obviously interested in investing in the real estate market. However, you may not have the investment capital or experience to invest in real estate on your own. Perhaps, you do not have the time to manage a property. REITs are a potentially good option.
What is a REIT?
A REIT is essentially an entity that either owns, operates, or finances income-producing property. A REIT pools the capital from a group of investors. The investors can reap the benefits of real estate ownership without having to manage the investment themselves.
A brief history of the REIT industry can be found here.
Types of REITs
REITs fall into basically 2 categories;
1. Equity REITs
This type of REIT invests capital and owns income-producing properties. Most are specialized in one type of property, such as apartment buildings, office buildings, or shopping centers. Revenues are generated by rental income and not by the buying and selling of property. As such, income tends to be fairly stable.
2. Mortgage REITs
Mortgage REITS essentially finance income-producing properties. They either finance properties directly or purchase mortgage-backed securities (MBS). See my previous post about MBS.
There are also hybrid REITS which are a combination of the above two types.
Regardless of the type of REIT, all REITs are required to pay out 90% of their taxable income as dividends to their investors, which only allows the REIT to save 10% for reserves or future investments.
How can you invest in a REIT?
A large number of REITS are publicly traded. You can buy shares in a REIT just like you would buy shares in any other publicly-traded company. There are also non-public traded REITS that are open to accredited investors, as well as private REITS that are only sold to institutional investors.
REITs are required to be registered with the SEC. As such, the disclosure requirements are stringent. See my post on Crowdfunding for more details.
Since the REIT is required to pay out 90% of its taxable income, the dividend income is stable and predictable.
Instead of investing all of your cash in one property, investing in a REIT allows you to invest in a number of properties at the same time, thereby minimizing risk.
Since most REITs are publicly traded, they are easy to sell. Selling a traditional property can take time and considerable expense.
No Management Responsibilities
REITs are a passive investment. You invest your cash and wait for the dividend check. All management operations are conducted by the REIT.
The management fees of a REIT can be high which reduces taxable income and dividends.
Lower Rate of Return
Because of the management and transaction fees, the rate of return can be significantly less than the returns on a single property that you own.
All dividends paid out of by the REIT are taxed as ordinary income. The taxable income cannot be reduced by depreciation. There is also no opportunity for capital gains.
Since REITs are publicly traded they are subject to market forces. Depending on the area of investment, the value of REITs can fluctuate significantly.
How To Determine the Best REIT for You
Equity vs. Mortgage REITs
The first step is to decide whether you want to invest in equity or in the financing end of the real estate market. This is largely a function of your risk tolerance. Mortgage REITs usually provide a higher rate of return but have a higher level of risk in that the value of the REIT will fluctuate with the market rate of interest.
Conversely, many equity REITs are not highly leveraged and can withstand fluctuations in the rental market.
The next step in assessing the potential of the investment is to look at the overall economy and which sectors are growing. For example, there is a high demand for rental housing, while at the same time, the market for shopping centers is very weak. Obviously, you do not want to invest in a REIT that is heavily invested in shopping centers.
Once you have decided on which sector of the real estate market you wish to invest, you then want to identify REITs that are invested in that sector. It is important that you verify that every REIT you are considering is registered with the SEC.
You can verify the registration of any REIT using the SEC’s EDGAR system. The SEC maintains files on registrations for the past 20 years.
When you are buying traditional stocks, you often look at the price to earnings or P/E ratio and compare that ratio to other stocks traded on the market. As of this writing, the current P/E ratio is around 23.
Real estate is a different animal in that property can be depreciated over time even though in reality the market value increases over time.
The Income Statement
The following step is to examine the income statement of the REIT.
Gross Rental Income
The most important number on the income statement is the gross rental income. This number indicates what the REIT typically earns on its investments. You should compare the number for the most current year to the previous 3 years.
Fee and Asset Management
The second most important number is the fee and asset management amount. Sometimes, the fee is expressed as a percentage of the gross rental income. You need to compare that percentage to the fee percentage for other REITs in the same sector. The average management fee for the REIT sector is between 0.25% and 0.5% of the value of the assets of the REIT.
Depreciation is a non-cash expense on the income statement. To get a more accurate picture of the actual cash flow, you will want to add the depreciation amount back to the net income.
Gains or (Losses) from the Sale of Property
If a property in the REIT’s portfolio was sold during the reporting year, any gain from that sale needs to be subtracted from the net income. Conversely, if there was a loss on the sale, that loss needs to be added back to the net income.
Funds from Operations (FFO)
When you have completed these adjustments, you will arrive at what is referred to as the funds from operations number or FFO. This number gives you a more accurate assessment of what the REIT actually produces each year.
One item that is not included in the income statement is the capital expenditures number. All property needs to be maintained. Minor repairs are usually expensed in the same year, but major repairs or improvements are capitalized and depreciated. Any capital expenditures need to be accounted for in assessing the value of a REIT.
Adjusted Funds from Operations (AFFO)
The capital expenditure number needs to be subtracted from the FFO number. The net number is referred to as the adjusted funds from operations number or AFFO.
Let’s take a look at the example below:
On its face, REIT ABC has shown stable growth over the previous 4 years of approximately 5% per year. The total asset value is $16,000,000. Based on the income statement, the ROI is only 4.2% That seems rather low when compared to the average market ROI for this sector. Let’s take a closer look at the numbers;
The following are the market statistics at the end of 2019.
The first number that jumps out is the Market cap of the REIT. $10,805,200 is significantly less than the asset value. This would suggest that the market anticipates that asset value is going to decline going forward. The good news is that expectation has already been priced in.
The annual fee and asset management number is $40,000 which represents 0.25% of the asset value. This is at the low end of the range so no concerns there.
Let’s go ahead and calculate the FFO number;
There was no capital gain or loss from the sale of property in 2019 so there is no adjustment required.
When we look at the ROI on the basis of the FFO it has increased to 5.8% which is in line with the dividend rate.
Market Capitalization Rate vs. FFO/AFFO Rate
A very useful exercise is to compare the market cap rate, that is, the rate of return that investors expect when buying an income-producing property, to the FFO or AFFO rate of the assets of the REIT. For example, let’s say the market cap rate at the moment is 8%. That suggests that an investment property valued at $100,000 produces a net income of $8,000 or 8%.
The FFO or AFFO rate should compare favorably to the market rate. However, because of the management fees of the REIT, the FFO or AFFO will likely be slightly less.
Assuming that the market rate is currently 8%, the ROI in the example above is significantly less which may be a further indication of issues and requires further investigation.
It is important to compare the FFO or AFFO ratio for the current reporting year to previous years. If the FFO is growing, it is a strong indication that the investment in that particular REIT is justified.
The Bottom Line
Investing in a REIT is an attractive alternative for the small investor who has neither the means nor the skills to manage a property on his own. However, care must be taken to find the right REIT that satisfies your investment goals.
It is important to monitor not only the REIT itself but the overall market. If market conditions change, you need to be prepared to adjust your REIT investment accordingly, even if that means selling your investment and reinvesting the proceeds in a more market appropriate REIT using the same analysis.