A real estate investment trust (REIT) is a company that owns, operates, or finances income-producing properties. By law, 90% of a REIT's profits must be distributed as dividends to shareholders. Here, we take a look at REITs, their characteristics, and how to evaluate a REIT.
- REITs are required to pay out at least 90% of income as shareholder dividends.
- Book value ratios are useless for REITs, instead, calculations such as net asset value are better metrics.
- Top-down and bottom-up analyses should be used for REITs, where top-down factors include population and job growth, while bottom-up aspects include rental income and funds from operations.
What Qualifies as a REIT?
Most REITs lease space and collect rents, and then distribute that income as dividends to shareholders. Mortgage REITs (also called mREITs) don't own real estate, and instead finance real estate. These REITs earn income from the interest on their investments, which include mortgages, mortgage-backed securities, and other related assets.
To qualify as a REIT, a company must comply with certain Internal Revenue Code (IRC) provisions. Specifically, a company must meet the following requirements to qualify as a REIT:
- Invest at least 75% of total assets in real estate, cash, or U.S. Treasuries
- Earn at least 75% of gross income from rents, interest on mortgages that finance real property, or real estate sales
- Pay a minimum of 90% of taxable income in the form of shareholder dividends each year
- Be an entity that's taxable as a corporation
- Be managed by a board of directors or trustees
- Have at least 100 shareholders after its first year of existence
- Have no more than 50% of its shares held by five or fewer individuals
By having REIT status, a company avoids corporate income tax. A regular corporation makes a profit and pays taxes on its entire profit, then decides how to allocate its after-tax profits between dividends and reinvestment. A REIT simply distributes all or almost all of its profits and gets to skip the taxation.
Types of REITs
There are a number of different types of REITs. Equity REITs tend to specialize in owning certain building types such as apartments, regional malls, office building,s or lodging/resort facilities. Some are diversified and some defy classification—for example, a REIT that invests only in golf courses.
The other main type of REIT is a mortgage REIT. These REITs make loans secured by real estate, but they do not generally own or operate real estate. Mortgage REITs require special analysis. They are finance companies that use several hedging instruments to manage their interest rate exposure.
While a handful of hybrid REITs run both real estate operations and transact in mortgage loans, most REITs are the equity type—the REITs that focus on the "hard asset" business of real estate operations. When you read about REITs, you are usually reading about equity REITs. As such, we'll focus our analysis on equity REITs.
How to Analyze REITs
REITs are dividend-paying stocks that focus on real estate. If you seek income, you would consider them along with high-yield bond funds and dividend-paying stocks. As dividend-paying stocks, REITs are analyzed much like other stocks. But there are some big differences due to the accounting treatment of property.
Traditional metrics like earnings-per-share (EPS) and P/E aren't reliable ways to evaluate REITs. FFO and AFFO are better metrics.
Let's illustrate with a simplified example. Suppose that a REIT buys a building for $1 million. Accounting requires our REIT to charge depreciation against the asset. Let's assume that we spread the depreciation over 20 years in a straight line. Each year we 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 (i.e. the book value), which is the original 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 the 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 (AFFO).
Net Asset Value
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 the book value of a 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 on 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 equal 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.
Top-Down vs. Bottom-Up Analysis
When picking stocks, you sometimes hear of top-down versus bottom-up analysis. Top-down starts with an economic perspective and bets on themes or sectors (for example, an aging demographic may favor drug companies). Bottom-up focuses on the fundamentals of specific companies. REIT stocks clearly require both top-down and bottom-up analysis.
From a top-down perspective, REITs can be affected by anything that impacts the supply of, and demand for, property. Population and job growth tend to be favorable for all REIT types. Interest rates are, in brief, a mixed bag.
A rise in interest rates usually signifies an improving economy, which is good for REITs as people are spending and businesses are renting more space. Rising interest rates tend to be good for apartment REITs as people prefer to remain renters, rather than purchase new homes. On the other hand, REITs can often take advantage of lower interest rates by reducing their interest expenses and thereby increasing their profitability.
Since REITs buy real estate, you may see higher levels of debt than for other types of companies. Be sure to compare a REIT's debt level to industry averages or debt ratios for competitors.
Capital market conditions are also important, namely the institutional demand for REIT equities. In the short run, this demand can overwhelm fundamentals. For example, REIT stocks did quite well in 2001 and the first half of 2002 despite lackluster fundamentals, because money was flowing into the entire asset class.
At the individual REIT level, you want to see strong prospects for growth in revenue, such as rental income, related service income, and FFO. You want to see if the REIT has a unique strategy for improving occupancy and raising its rents.
Economies of Scale
REITs typically seek growth through acquisitions and further aim to realize economies of scale by assimilating inefficiently run properties. Economies of scale would be realized by a reduction in operating expenses as a percentage of revenue. But acquisitions are a double-edged sword. If a REIT cannot improve occupancy rates and/or raise rents, it may be forced into ill-considered acquisitions in order to fuel growth.
As mortgage debt plays a big role in equity value, it is worth looking at the balance sheet. Some recommend looking at leverage, such as the debt-to-equity ratio. But in practice, it is difficult to tell when leverage has become excessive. It is more important to weigh the proportion of fixed versus floating-rate debt. In the current low-interest-rate environment, a REIT that uses only floating-rate debt will be hurt if interest rates rise.
Most REIT dividends aren't what the IRS considers qualified dividends, so they are generally taxed at a higher rate. Depending on your tax bracket, qualified dividends are taxed at 0%, 15%, or 20%. However, with REITs, most dividends are taxed as ordinary income—up to 37% for 2020.
In general, REIT dividends are taxed as ordinary income. As such, it's recommended that you hold REITs in a tax-advantaged account such as an IRA or a 401(k).
However, there may be some good news here. Since REITs are pass-through businesses, any dividends that don't count as qualified dividends may be eligible for the 20% qualified business income (QBI) deduction. For example, if you have $1,000 in ordinary REIT dividends, you might owe taxes on only $800 of that.
The Bottom Line
REITs are real estate companies that must pay out high dividends in order to enjoy the tax benefits of REIT status. Stable income that can exceed Treasury yields combines with price volatility to offer a total return potential that rivals small-capitalization stocks. Analyzing a REIT requires investors to understand the accounting distortions caused by depreciation and pay careful attention to macroeconomic influences.