Complete Guide To Investment Companies, Funds And REITs

AAA

Real Estate Investment Trusts (REITs) - Analyzing REITs And REIT Performance

There are a few things to keep in mind when assessing any REIT. They include the following:

  1. REITs are true total-return investments. They provide high dividend yields along with moderate long-term capital appreciation. Look for companies that have done a good job historically at providing both.
  2. Unlike traditional real estate, many REITs are traded on stock exchanges. You get the diversification real estate provides, without being locked in long term. Liquidity matters.
  3. Depreciation tends to overstate an investment's decline in property value. Thus, instead of using the payout ratio (what dividend investors use) to assess a REIT, look at its funds from operations (FFO) instead. This is defined as net income less the sale of any property in a given year and depreciation. Simply take the dividend per share and divide by the FFO per share. The higher the yield the better.
  4. Strong management makes a difference. Look for companies that have been around for a while or at least possess a management team with loads of experience.
  5. Quality counts. Only invest in REITs with great properties and tenants.
  6. Consider buying a mutual fund or ETF that invests in REITs and leave the research and buying to the pros.

Let's illustrate with a simplified example. Suppose that a REIT buys a building for $1 million. Accounting requires that our REIT charge depreciation against the asset. Let's assume that we spread the depreciation over 20 years in a straight line. Each year we will deduct $50,000 in depreciation expense ($50,000 per year x 20 years = $1 million).

Let's look at the simplified balance sheet and income statement above. In year 10, our balance sheet carries the value of the building at $500,000 (a.k.a., the book value) - the original historical cost of $1 million minus $500,000 accumulated depreciation (10 years x $50,000 per year). Our income statement deducts $190,000 of expenses from $200,000 in revenues, but $50,000 of the expense is a depreciation charge.

However, our REIT doesn't actually spend this money in year 10; depreciation is a non-cash charge. Therefore, we add back the depreciation charge to net income in order to produce funds from operations (FFO). The idea is that depreciation unfairly reduces our net income because our building probably didn't lose half its value over the last 10 years. FFO fixes this presumed distortion by excluding the depreciation charge. (FFO includes a few other adjustments, too.)

We should note that FFO gets closer to cash flow than net income, but it does not capture cash flow. Mainly, notice in the example above that we never counted the $1 million spent to acquire the building (the capital expenditure). A more accurate analysis would incorporate capital expenditures. Counting capital expenditures gives a figure known as adjusted FFO, but there is no universal consensus regarding its calculation.

Our hypothetical balance sheet can help us understand the other common REIT metric, net asset value (NAV). In year 10, the book value of our building was only $500,000 because half of the original cost was depreciated. So, book value and related ratios like price-to-book - often dubious in regard to general equities analysis - are pretty much useless for REITs. NAV attempts to replace book value of property with a better estimate of market value.

Calculating NAV requires a somewhat subjective appraisal of the REIT's holdings. In the above example, we see the building generates $100,000 in operating income ($200,000 in revenues minus $100,000 in operating expenses). One method would be to capitalize the operating income based on a market rate. If we think the market's present cap rate for this type of building is 8%, then our estimate of the building's value becomes $1.25 million ($100,000 in operating income / 8% cap rate = $1,250,000). This market value estimate replaces the book value of the building. We then would deduct the mortgage debt (not shown) to get net asset value. Assets minus debt equals equity, where the "net" in NAV means net of debt. The final step is to divide NAV into common shares to get NAV per share, which is an estimate of intrinsic value. In theory, the quoted share price should not stray too far from the NAV per share.

Taxes
Related Articles
  1. Mutual Funds & ETFs

    How Mutual Fund Companies Make Money

    Read about the many different kinds of fees and sales charges mutual fund companies can use to generate revenue from those who invest in their shares.
  2. Investing Basics

    The Lipper Rating System Explained

    Take a closer look at how Lipper Inc., a subsidiary of Thomson Reuters, determines the ratings for mutual funds in its Lipper Rating System.
  3. Fundamental Analysis

    The 3 Best Investments When Bull Markets Slow Down

    Find out why no bull market lasts forever, and why investors should shift their assets away from growth and toward dividends when stocks slow down.
  4. Products and Investments

    There's a Reason They're Called Junk Bonds

    The closing of Third Avenue Managemet's Focused Credit Fund is a warning to investors and advisors. Beware the junk.
  5. Mutual Funds & ETFs

    Top 3 PIMCO Funds for Retirement Diversification in 2016

    Explore analyses of the top three PIMCO funds for 2016 and learn how these funds can be used to create a diversified retirement portfolio.
  6. Mutual Funds & ETFs

    The 3 Best Downside Protection Equity Mutual Funds

    Learn how it is possible to profit in a bear market by owning the correct selection of mutual funds that provide downside protection and opportunity.
  7. Mutual Funds & ETFs

    The 4 Best Lord Abbett Mutual Funds

    Discover the four best mutual funds administered and managed by Lord, Abbett & Co., LLC that offer investors a wide variety of investment strategies.
  8. Investing Basics

    How And Why Do Companies Pay Dividends?

    The arguments for dividends include the idea that a dividend provides certainty about a company’s well being.
  9. Stock Analysis

    Tribune Media: An Activist Investment Analysis (TRCO)

    Learn more about the breakup of Tribune Company, once a powerful newspaper and broadcasting giant, and the role of activist investor Cliff Robbins.
  10. Mutual Funds & ETFs

    The ABCs of Mutual Fund Classes

    There are three main mutual fund classes, and each charges fees in a different way.
RELATED TERMS
  1. PIPE Deal

    Signifying "Private Investment in Public Equity," a PIPE deal ...
  2. Collateralized Mortgage Obligation ...

    A type of mortgage-backed security in which principal repayments ...
  3. Consumer Staples

    Essential products such as food, beverages, tobacco and household ...
  4. Hedge

    Making an investment to reduce the risk of adverse price movements ...
  5. Benchmark

    A standard against which the performance of a security, mutual ...
  6. Private Equity Real Estate

    A Definition of "Private Equity Real Estate" and how it applies ...
RELATED FAQS
  1. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  2. What is securitization?

    Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming ... Read Full Answer >>
  3. Are target-date retirement funds good investments?

    The main benefit of target-date retirement funds is convenience. If you really don't want to bother with your retirement ... Read Full Answer >>
  4. Do mutual funds require a demat account?

    A dematerialized account enables electronic transfer of funds. The account is used so an investor does not need to hold the ... Read Full Answer >>
  5. Can hedge funds trade penny stocks?

    Hedge funds can trade penny stocks. In fact, hedge funds can trade in just about any type of security, including medium- ... Read Full Answer >>
  6. How liquid are Vanguard mutual funds?

    The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
Hot Definitions
  1. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  2. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  3. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  4. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
  5. Dark Pool Liquidity

    The trading volume created by institutional orders that are unavailable to the public. The bulk of dark pool liquidity is ...
Trading Center