The Ultimate Guide to Investing in REIT Stocks

Investing in reit stocks

The total market cap of US real estate investment trusts (REITs) currently stands at just over $1.7 trillion. REITs (pronounced ree-eets) is clearly not your average acronym. In this ultimate guide, we look to uncover what REIT stocks are, its unique structure and it can be useful to your investment portfolio.

In addition, we explore the key valuation metrics used to value REIT and its investable universe. Finally, we conclude by highlighting the key things you should be looking before investing in REIT stocks.

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    What is REIT?

    In broad terms, real estate investment trust is a company that owns and operates income-producing real estate. For this reason, it has historically provided investors dividend-based income.

    REIT offers the exposure in real estate with the ease of investing through publicly traded stocks. Perhaps the most attractive part about REITs is that they do NOT pay taxes on a corporate level. This allows companies to fund and finance real estate more cheaply than a non-REIT company can do. On a comparable basis, a REIT company almost certainly can pay out larger dividends relative to a non-REIT company.

    There are, however, a few criteria to attain such tax status (skippable 😊)

    • Be structured as a taxable corporation
    • Be managed by a board of directors or trustees
    • Distribute at least 90% of taxable net income as distributions to shareholders
    • Have at least 75% of assets in real estate (real property or loans secured by property)
    • Derive at least 75% of gross income from real estate income (rents or interest from mortgages)
    • Have a minimum of 100 shareholders
    • Have no more than 50% of shares held by five or fewer individuals
    • Have no more than 25% of assets invested in stocks of taxable REIT subsidiaries (TRS)
    REIT infographic
    An overview of REITs. Source: FINRA.

    Why are REITs a popular investment?

    Liquidity

    REITs provide a quick-access into real estate without the need of an enormous upfront cost. More importantly, REIT is a liquid and publicly traded.

    Taxes

    REITs are generally exempt from taxation at the trust level as long as >90% of their income and distributed to shareholders. Consequently, leading to improved after-tax returns for shareholders.

    Distribution per unit (DPU)

    DPU is REIT's lingo for dividends. DPU are relatively stable for two reasons. First, REITs are obliged to pay >90% of its income as dividends. Secondly, most REITs have a triple net lease (see below). Such lease structure generally have long term leases and fixed and stable rent increments.

    Inflation hedge

    Real estates are typically considered as a good inflation hedge. For this reason, REITs are a particular popular option due to its liquidity profile and accessibility.

    The real estate life cycle

    No two cycles are ever the same! Acknowledging where we are in the cycle is paramount when investing in REIT stocks. Here's an illustration of the general real estate life cycle.

    REITs life cycle
    An illustration of the real estate / REITs life cycle.

    Equity & mortgage REITs

    REITs can be either publicly traded or non-traded REIT. For the purpose of this guide, we focus exclusively on publicly traded REITs.

    Within publicly traded REITs, the key types you will encounter are Equity REITS and Mortgage REITs (mREITs). A third type, which is less common, called Hybrid REIT is a mixture of both equity and mortgage REIT.

    An equity REIT is one that owns and operate income-generating assets such as apartments, office buildings, warehouses, shopping malls etc. Majority of such REITs’ portfolio are concentrated in a specific area. For instance, apartment, hotel and retail REITs. Equity REITs are the single largest type of REITs consisting for >90% of all publicly traded REITs.

    A mREIT is one that lends money to owners of the real estate and does not have direct ownership of the asset.

    Types of equity REITs

    Before we dig deeper into the various types of equity REITs, it’s important to understand what a triple net lease (NNN) is as this applies to various types of REITs as you will see. Leases are called triple net because the agreements are structure so that tenants are responsible for all operating expenses (insurance, taxes and capex), and the landlord collects a net rent.

    In NNN, landlords do not have direct exposure to the performance of the property. In other words, rents are fixed and typically increase at fixed amounts over the lifetime of the lease.

    In general, such leases have relatively long leases terms and lower rent increments. REITs that employs a triple net lease structure are generally considered less risky and produces stable and fairly predictable cash flows, and hence, dividends.

    Data center REITs

    Data center REITs involves owning and operating communication technology infrastructure. This consist of servers, fiber option communications, routers etc. Interestingly, data center REITs generally price their space to tenants based on its power usage rather than its square footage. Despite this, they do report on a per square foot basis for comparison purposes.

    The key drivers in this sector are demand of IT outsourcing, increased traffic growth and the demand for cloud-based solutions.

    Healthcare REITs

    These are REITs that invest in healthcare facilities such as hospitals, medical office buildings, nursing facilities and care housings. The lease structures across this sector are generally triple net (NNN). Consequently, it benefits from the relatively stable and consist cash flows.

    Industrial REITs

    Industrial REIT assets typically consist of warehouses, factories, distribution centers and R&D facilities. In recent years, the growth of on-demand economy meant that delivery speed is increasingly important. For this reason, warehouse and factory assets that are in the vicinity of larges cities are highly sought after. We see no reason why this trend should not continue.

    Infrastructure REITs

    This type of REITs involves owning and operating various types of infrastructure. This includes telecommunications, small cell tech, fiber cables/connectivity, data center platforms etc. The primary goal is to provide and improve digital accessibility to the energy, health and telecoms industry.

    Consequently, the two largest REITs globally, American Tower (AMT) and Crown Castle International (CCI) are infrastructure REITs that own wireless and telecommunications towers. See investable universe for the full list of REITs.

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    Lodging REITs

    Portfolio of lodging REITs consist of hotel properties generally managed by a third party. The short-term nature of their leases in the sector can potential lead to highly volatile occupancy and room rates. This sector is often associated with its high cyclicality of the markets.

    Office REITs

    Traditionally, office REITs are split into two key categories, central business district (CBD) and suburban. CBD refers to high-rise buildings, whereas suburban may refer to office buildings outside the urban areas.

    One clear differences between CBD and suburban REITs is the latter has a lower operating costs, which also translates to a lower rent. Importantly, the barriers to entry for suburban REITs are also lower, potentially decreasing its margins.

    Residential REITs

    These group of REITs includes apartments, manufactured housing, single-family rental and student-housing REITs. Since the 2008 financial crisis, we have seen a significant shift in the US from owning to renting. Broadly speaking, the key drivers in this sector are interest rates, supply-side constraints and unemployment rate. See below for more details.

    Retail REITs

    Retail REITs own and manage retail properties and derive its income through renting to tenants. This includes shopping malls, retail shops, outlets centers, grocery shops etc.

    Demographics, location and level of consumer spending are the three key drivers in determining the portfolio quality of a retail REIT. Naturally, a stronger demographics would likely to imply higher consumer spending, which increases the chances of pushing through higher rent.

    Self-storage REITs

    These are REITs that own and manage storage facilities. Majority of self-storage that are developed today are specifically designed for consumer/business storage. Demand for self-storage differs across different locations.

    The role of interest rates in REITs

    One of the most important driver for REITs is the prevailing interest rate. In general, one would expect REITs to thrive in a low interest rate environment.

    As we know REITs are highly levered, a lower interest rate can implies a lower refinancing costs. This translates to higher earnings for REITs, hence, shareholders.

    In addition, low interest rates can spur greater consumer spending, possibility boosting economic growth. Consequently, it can lead to further job creation, increasing GDP per capita. Finally, this in turn may mean a higher occupancy across the sector, leading to increased earnings for REITs.

    The opposite is true for higher interest rates.

    While in theory this makes perfect sense, the reality tend to paint a different picture due to time lag. In short, there is a time lag between interest rates movements and its impact on the REIT sector. In today's world, it gets even more challenging for such theory to hold given the sub-zero interest rates globally.

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    Key drivers of REITs

    There are two key components of REITs. Namely, the income it produces and the value of the property itself.

    Firstly, the rental income. REITs’ income is largely dependent on the economy. Population growth, unemployment rate, demographics, GDP growth / per capita are key drivers of this.

    Secondly, the value of the real estate largely depends on supply and demand. These includes affordability, location, accessibility to labour forces, population and demographic of the area etc.

    Alternatively, REITs can also grow its earnings through acquisition of new development / real estate projects. This remains one of the key drivers in the market today. The need to pay out >90% of its income as dividends implies there are limited cash at hand to acquire / invest in new projects. To a certain extent, this can be alleviated via borrowing. This explains why REITs are the highest levered sector among the GICS classification.

    REITs leverage ratio by sector
    REITs leverage ratio by sector, 2018 vs 2008.

    Setbacks of REITs

    So far we’ve discussed the pros of REITs – what about its cons? Here are a few setbacks we think you should consider before investing in REITs.

    • It usually exhibit low growth due to the fact that REITs must pay out most of its earnings.
    • For this reason, REITs are generally highly leverage in order to pursue growth. In fact, REIT is the most highly levered industry in the market!
    • Fees could erode returns. REIT managers usually charge a base fee and a performance fee, akin to a hedge fund structure. In addition, an acquisition and divestment fee are also levied upon transactions.
    • On an individual level, REIT dividends may be taxed differently relative to conventional stock dividends.

    Key valuation metrics

    To some extent, we can draw similarities between REITs’ and preferred stocks' return profile. The nature of its NNN lease implies rental income stability (bonds), while the ownership of the real estate allows it to participate in the upside/downside (equity). Here are some of the key valuation metrics we look at when evaluating REITs.

    Price to funds from operations (FFO)

    Funds from operations is just another term for cash flow generated from a REIT. FFO is crucial in analysing future dividends as REITs are obligated to pay bulk of its cash flow as dividends. Essentially, price to FFO simply means how much you are paying per unit of cash flow.

    You may also come across a modified measure called price to adjusted funds from operations (AFFO). This is FFO less the recurring capital expense such as maintenance cost etc. Arguably, this is a more accurate measure as it shows the true dividend paying capability of a REIT.

    Price to net asset value (P/NAV)

    Net asset value (NAV) is calculated as the value of total assets less total liabilities. In other words, this is the market value of real estate properties held by a REIT. A price to net asset value (P/NAV) of >1 implies the market is placing a premium over its NAV and vice-versa.

    Net debt/EBITDA

    Net debt / EBITDA is one of the leverage ratio we consider for REITs. REITs are notoriously highly levered animals, so it make sense to monitor leverage ratios, while understanding where we are in the current market cycle.

    REITs leverage ratio by types
    2018 REITs leverage ratio by types.

    Things to look for before investing in REIT stocks

    In addition to the above, we highlight a few key points that can help you fine tune your process when it comes to investing in REIT stocks.

    • Distribution per unit (DPU): Can use this as a benchmark relative to other assets.
    • Track record of growing dividends: Look for sustainable growth in earnings. For example, increased occupancy rates.
    • Lease structure: Income investors should seek for REITs that have long term leases and rents with fixed increments.
    • Choosing a REIT sector: Picking a REIT sector is as important as investing in a REIT itself. Structural trends always underpins the growth of a REIT stock.
    • Asset quality. Location, location, location! Accessibility and up-to-date infrastructure is key in meeting today's demand.
    • Leverage: Traditionally, REITs with above average leverage ratio tend to underperformed those of who have lower leverage.

    REIT stocks investable universe

    Here's a list of REIT stocks investable universe.

    All in all, REITs can be a great addition to your portfolio if you’re looking for passive income. With more countries gradually pushing through REIT legislation, we expect to see a more crowded REIT market in the medium term.

    Finally, the current macro-economic poses a “this time is different” typed scenario. Central banks continued quantitative easing measures are accentuating lower for longer rate environment.

    Optically, this may be good for REITs. But, what if the world is heading a Japan-like scenario, where despite the low interest rate environment, consumer growth has yet to pick up?

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