Investopedia REITs

Simple Ways To Invest In Real Estate by Andrew Beattie (Contact Author | Biography)Filed Under: Bonds, Personal Finance, Real Estate

Buying real estate is about more than just finding a place to call home. Investing in real estate has become increasingly popular over the last fifty years and has become a common investment vehicle. Although the real estate market has plenty of opportunities for making big gains, buying and owning real estate is a lot more complicated than investing in stocks and bonds. In this article, we'll go beyond buying a home and introduce you to real estate as an investment.

Basic Rental PropertiesThis is an investment as old as the practice of landownership. A person will buy a property and rent it out to a tenant. The owner, the landlord, is responsible for paying the mortgage, taxes and costs of maintaining the property. Ideally, the landlord charges enough rent to cover all of the aforementioned costs. A landlord may also charge more in order to produce a monthly profit, but the most common strategy is to be patient and only charge enough rent to cover expenses until the mortgage has been paid, at which time the majority of the rent becomes profit. Furthermore, the property may also have appreciated in value over the course of the mortgage (according to the U.S. Census Bureau, real estate has consistently increased in value since 1940), leaving the landlord with a more valuable asset. (To learn more, read Paying Off Your Mortgage and Understanding Your Mortgage.)

There are, of course, blemishes on the face of what seems like an ideal investment. You can end up with a bad tenant who damages the property or, worse still, end up having no tenant at all. This leaves you with a negative monthly cash flow, meaning that you might have to scramble to cover your mortgage payments. There is also the matter of finding the right property - you will want to pick an area where vacancy rates are low (due to demand) and choose a place that people will want to rent.

Perhaps the biggest difference between a rental property and other investments is the amount time and work you have to devote to maintaining your investment. When you buy a stock, it simply sits in your brokerage account and (hopefully) increases in value. If you invest in a rental property, there are many responsibilities that come along with being a landlord. When the furnace stops working in the middle of the night, it's you who gets the phone call. If you don't mind handyman work, this may not bother you; otherwise, a professional property manager would be glad to take the problem off your hands - for a price, of course. (For further reading, see Tips For The Prospective Landlord.)

Real Estate Investment GroupsReal estate investment groups are sort of like small mutual funds for rental properties. If you want to own a rental property, but don't want the hassle of being a landlord, a real estate investment group may be the solution for you. A company will buy or build a set of apartment blocks or condos and then allow investors to buy them through the company (thus joining the group). A single investor can own one or multiple units (self-contained living space), but the company operating the investment group collectively manages all the units - taking care of maintenance, advertising vacant units and interviewing tenants. In exchange for this management, the company takes a percentage of the monthly rent.

There are several versions of investment groups, but in the standard version, the lease is in the investor's name and all of the units pool a portion of the rent to guard against occasional vacancies, meaning that you will receive enough to pay the mortgage even if your unit is empty. The quality of an investment group depends entirely on the company offering it. In theory, it is a safe way to get into real estate investment, but groups are vulnerable to the same fees that haunt the mutual fund industry. Once again, research is the key.

Real Estate TradingThis is the wild side of real estate investment. Like the day traders who are leagues away from a buy-and-hold investor, the real estate traders are an entirely different breed from the buy-and-rent landlords. Real

estate traders buy properties with the intention of holding them for a short period of time (often no more than three to four months), whereupon they hope to sell them for a profit. This technique is also called flipping properties and is based on buying properties that are either significantly undervalued or are in a very hot market.

Pure property flippers will not put any money into a house for improvements - the investment has to have the intrinsic value to turn a profit without alteration or they won't consider it. Flipping in this manner is a short-term cash investment. If a property flipper gets caught in a situation where he or she can't unload a property, it can be devastating because these investors generally don't keep enough ready cash to pay the mortgage on a property for the long term. This can lead to continued losses for a real estate trader who is unable to offload the property in a bad market.

A second class of property flipper also exists. These investors make their money by buying reasonably priced properties and adding value by renovating them. This can be a longer-term investment depending on the extent of the improvements. The limiting feature of this investment is that it is time intensive and often only allows investors to take on one property at a time.

REITsReal estate has been around since our cave-dwelling ancestors started chasing strangers out of their space, so it's not surprising that Wall Street has found a way to turn real estate into a publicly-traded instrument. A real estate investment trust (REIT) is created when a corporation (or trust) uses investors' money to purchase and operate income properties. REITs are bought and sold on the major exchanges just like any other stock. A corporation must pay out 90% of its taxable profits in the form of dividends to keep its status as an REIT. By doing this, REITs avoid paying corporate income tax, whereas a regular company would be taxed its profits and then have to decide whether or not to distribute its after-tax profits as dividends.

Much like regular dividend-paying stocks, REITs are a solid investment for stock market investors that want regular income. In comparison to the aforementioned types of real estate investment, REITs allow investors into non-residential investments (malls, office buildings, etc.) and are highly liquid - in other words, you won't need a realtor to help you cash out your investment. (For further reading, check out What Are REITs?, Basic Valuation Of A Real Estate Investment Trust (REIT) and The REIT Way.)

LeverageWith the exception of REITs, investing in real estate gives an investor one tool that is not available to stock market investors: leverage. If you want to buy a stock, you have to pay the full value of the stock at the time you place the buy order. Even if you are buying on margin, the amount you can borrow is still much less than with real estate. Most "conventional" mortgages require 25% down. However, depending on where you live, there are many types of mortgages that require as little as 5%. This means that you can control the whole property and the equity it holds by only paying a fraction of the total value. Of course, your mortgage will eventually pay the total value of the house at the time you purchased it, but you control it the minute the papers are signed.

This is what emboldens real estate flippers and landlords alike. They can take out a second mortgage on their homes and put down payments on two or three other properties. Whether they rent these out so that tenants pay the mortgage or they wait for an opportunity to sell for a profit, they control these assets despite having only paid for a small part of the total value. (For more on taking out a second mortgage, read The Home-Equity Loan: What It Is And How It Works and Home-Equity Loans: The Costs.)

ConclusionWe have looked at several types of real estate investment. However, as you might have guessed, we have only scratched the surface. Within these examples there are countless variations of real estate investments. As with any investment, there is much potential with real estate, but this does not mean that it is an assured gain. As with any investment, make careful choices and weigh out the costs and benefits of your actions before diving in. by Andrew Beattie (Contact Author | Biography)

How To Assess A Real Estate Investment Trust (REIT) by David Harper,CFA, FRM (Contact Author | Biography)Filed Under: Fundamental Analysis, Real Estate, Stocks

If you try to estimate the value of a real estate investment trust (REIT), you will quickly find that traditional metrics like the earnings-per-share (EPS) ratio, growth, and the price-to-earnings (P/E) multiple do not apply. In this article, we will show you how to estimate the value of an REIT. (For background reading on REIT investing, see The REIT Way.)

Funds from Operations (FFO) Is Better than Earnings Let's start by looking at a summary income statement from one of the largest residential REITs, Equity Residential (NYSE:EQR):

Source: 10KWizard www.10kwizard.com

From 2002 to 2003, Equity Residential's net income, or the "bottom line," grew by almost 30% (+$122,500 to $543,847). These net income numbers, however, include depreciation expenses, which are significant line items. For most businesses, depreciation is an acceptable non-cash charge that allocates the cost of an investment made in a prior period. But real estate is different than most fixed-plant or equipment investments: property rarely loses value and often appreciates. Net income, a measure reduced by depreciation, is therefore an inferior gauge of performance. Therefore, REITs are instead judged by funds from operations (FFO), which excludes depreciation.

FFO is reported in the footnotes, and companies are required to reconcile FFO and net income. The general calculation involves adding depreciation back to net income (since depreciation is not a real use of cash, as discussed in the above paragraph) and subtracting the gains on the sales of depreciable property. These gains are subtracted because we assume that they are not recurring and therefore do not contribute to the sustainable dividend-paying capacity of the REIT. Below we show this reconciliation of

net income to FFO (with a few minor items removed for the sake of clarity) for 2002 and 2003:

Source: 10KWizard www.10kwizard.com.

It is clear that, after depreciation is added back and property gains are subtracted, funds from operations (FFO) equals about $838,390 in 2002 and almost $758,000 in 2003.

FFO must be reported, and it is widely used, but it contains a weakness: it does not deduct for capital expenditures required to maintain the existing portfolio of properties. Shareholders' real estate holdings must be maintained (for example, apartments must be painted), so FFO is not quite the true residual cash flow remaining after all expenses and expenditures.

In estimating the value of an REIT, professional analysts therefore use a measure called "adjusted funds from operations" (AFFO). Although FFO is commonly used, professionals tend to focus on AFFO for two reasons. One, it is a more precise measure of residual cash flow available to shareholders and therefore a better "base number" for estimating value (for example, applying a multiple or discounting a future stream of AFFO). Two, because it is true residual cash flow, it is a better predictor of the REIT's future capacity to pay dividends.

AFFO does not have a uniform definition. However, the most important adjustment made to calculate it is the subtraction of capital expenditures, as mentioned above. In the case of Equity Residential, almost $182,000 is subtracted from FFO to get AFFO for the year 2003. This number was taken directly from the cash flow statement. We use it as an estimate of the cash required to maintain existing properties, although we could try to make a better estimate by going to the trouble of looking at the specific properties in the REIT. (To learn about how to read financial statements, check out Advanced Financial Statement Analysis.)

Look for Growth in FFO and/or AFFO Once we have the FFO and the AFFO, we can try to estimate the value of the REIT. The key assumption here is the expected growth in FFO or AFFO. This involves taking a careful look at the underlying prospects of the REIT and its sector. The specifics of evaluating an REIT's growth prospects are beyond the scope of this article, but, in general, these are the sources to consider:

Prospects for rent increases Prospects to improve/maintain occupancy rates A specific plan to upgrade/upscale properties - A popular and successful tactic is to acquire "low-

end" properties and upgrade them to attract a higher quality tenant. Often a virtuous cycle ensues. Better tenants lead to higher occupancy rates (fewer evictions) and higher rents.

External growth prospects - Many REITs favor fostering FFO growth through acquisition, but it's easier said than done. An REIT must distribute most of its profits and therefore does not have a

lot of excess capital to deploy. Many REITs, however, successfully prune their portfolios: they sell underperforming properties to finance the acquisition of undervalued properties.

Apply a Multiple to FFO/AFFO The total return on an REIT investment comes from two sources: (1) dividends paid and (2) price appreciation. We can break down the expected price appreciation into two components: 1. Growth in FFO/AFFO 2. Expansion in the price-to-FFO or price-to-AFFO multiple

Let's look at the multiples for EQR below. Note that we are showing price divided by FFO, which is really market capitalization divided by FFO. EQR's market capitalization (number of shares multiplied by price per share) in this example is about $8 billion.

Aside from making a direct comparison to industry peers, how can we interpret these multiples? Like interpreting P/E multiples, interpreting price-to-FFO or price-to-AFFO multiples is not an exact science, and the multiples will vary with market conditions and specific REIT sub-sectors (for example, apartments, offices, industrial). As with other stocks, we want to avoid buying into a multiple that is too high.

But remember that, aside from the important dividends paid, any price appreciation breaks down into two sources: growth in FFO/AFFO and/or expansion in the valuation multiple (price-to-FFO or price-to-AFFO ratio). If we are looking at an REIT with favorable FFO growth prospects, we should consider both sources together. If FFO grows at 10%, for example, and the multiple of 10.55x is maintained, then the price will grow 10%. But if the multiple expands about 5% to 11x, then our price appreciation will be approximately 15% (10% FFO growth + 5% multiple expansion)!

A useful exercise is to take the reciprocal of the price-to-AFFO multiple: 1 ÷ [Price/AFFO] = AFFO/Price. In the case of EQR, this equals about 7.2% ($575.7 ÷ 8,000). This is called the "AFFO yield." To evaluate the price of the REIT, we can then compare the AFFO yield to (1) the market's going capitalization rate, or "cap rate," and (2) our estimate for the REIT's growth in FFO/AFFO. The cap rate is a general market-based number that tells you how much the market is currently paying for real estate. For example, 8% implies that investors are generally paying about 12.5 times (1 ÷ 8%) the net operating income (NOI) of each individual real estate property.

Let's assume that we determine the market's cap rate is about 7% and that, further, our growth expectation for EQR's FFO/AFFO is a heady 5%. Given a calculated AFFO yield of 7.2%, we are probably looking at a good investment: our price is reasonable when compared to the market's cap rate (it's even a little higher, which is better), and, even more promising, the growth we are expecting should translate into both higher dividends and price in the future. In fact, if all other investors already agreed with us, the price of EQR would be higher because it would need a higher multiple to impound these growth expectations.

One final note: we ignored debt in this illustration. Essentially, we assumed that EQR's debt burden is modest and "in line" with the industry peers. If EQR's leverage (debt-to-equity or debt-to-total capital) were above average, we would need to consider the extra risk implied by the additional debt.

Summary When evaluating REITs, you will get a clearer picture by looking at funds from operations (FFO) rather

than looking at net income. If you are seriously considering the investment, try to calculate adjusted funds from operations (AFFO), which deducts the likely expenditures necessary to maintain the real estate portfolio. AFFO is also a good measure of the REIT's dividend-paying capacity. Finally, the ratio price-to-AFFO and the AFFO yield (AFFO/price) are tools for analyzing an REIT: look for a reasonable multiple combined with good prospects for growth in the underlying AFFO.

by David Harper,CFA, FRM (Contact Author | Biography)

In addition to writing for Investopedia, David Harper, CFA, FRM, is the founder of The Bionic Turtle, a site that trains professionals in advanced and career-related finance, including financial certification. David was a founding co-editor of the Investopedia Advisor, where his original portfolios (core, growth and technology value) led to superior outperformance (+35% in the first year) with minimal risk and helped to successfully launch Advisor.

He is the principal of Investor Alternatives, a firm that conducts quantitative research, consulting (derivatives valuation), litigation support and financial education.Filed Under: Fundamental Analysis, Real Estate, Stocks

The Basics Of REIT Taxation by Mark P. Cussen,CFP®, CMFC (Contact Author | Biography)Filed Under: Taxes

Real estate investment trusts (REITs) have established themselves as a means for the smaller investor to directly participate in the higher returns generated by real estate properties. In the past, these trusts were considered to be minor offshoots of unit investment trusts, in the same category as energy or other sector-related trusts that had been created, but when the Global Industry Classification Standard granted REITs the status of being a separate asset class the rules changed and their popularity soared.

In this article, we will explain how REITs work and then examine the unique tax implications and savings they offer to regular investors. (To begin with an overview of these assets and what they can do for your portfolio, see The REIT Way.)

Basic Characteristics of REITsREITs are a pool of properties and mortgages bundled together and offered as a security in the form of unit investment trusts. Each unit in an REIT represents a proportionate fraction of ownership in each of the underlying properties. These investment vehicles constitute approximately 10% of the financial sector and nearly one-quarter of the domestic equity sector. In 2007, nearly 200 REITs were traded actively on the New York Stock Exchange and other markets.

Typically, REITs tend to be more value than growth-oriented, and are chiefly composed of small and mid cap holdings.

The IRS requires REITs to pay out at least 90% of their incomes to unitholders (the equivalent of shareholders). This is similar to corporations, and means REITs provide higher yields than those typically found in the traditional fixed-income markets. They also tend to be less volatile than traditional stocks because they swing with the real estate market. (To learn about REIT valuation, see Basic Valuation Of A Real Estate Investment Trust.)

Three Types of REITsREITs can be broken down into three categories: equity REITs, mortgage REITs and hybrid REITs.

Equity REITs - These trusts own and/or rent properties and collect the rental income, dividends and capital gains from property sales. The triple source of income makes this type very popular.

Mortgage REITs - These trusts carry a greater risk because of their exposure to interest rates. If interest rates rise, then the value of mortgage REITs can drop substantially. (To learn more, see The Impact Of Interest Rates On Real Estate Investment Trusts and Behind The Scenes Of Your Mortgage.)

Hybrid REITs - These instruments combine the first two categories. They can be either open- or closed-ended (similar to open- and closed-ended mutual funds), have a finite or indefinite life and invest in either a single group of projects or multiple groups.

Taxation at the Trust LevelREITs must follow the same rules as all other unit investment trusts. This means that REITs must be taxed first at the trust level, then to beneficiaries. But they must follow the same method of self assessment as corporations. So, REITs have the same valuation and accounting rules as corporations, but instead of passing through profits, they pass cash flow directly to unitholders.

There are a few extra rules for REITs beyond the rules for other unit investment trusts. They are:

1. Rental income is treated as business income to REITs because the government considers rent to be the business of REITs. This means that all expenses related to rental activities can be deducted the same as business expenses can be written off by a corporation.

2. Furthermore, current income that is distributed to unitholders is not taxed to the REIT, but if the income is distributed to a non-resident beneficiary, then that income must be subject to a 30% withholding tax for ordinary dividends and a 35% rate for capital gains, unless the rate is lower by treaty.

For all practical purposes, REITs are generally exempt from taxation at the trust level as long they distribute at least 90% of their income to their unit holders. However, even REITs that adhere to this rule still face corporate taxation on any retained income.

Taxation to UnitholdersThe dividend payments made out by the REIT are taxed to the unitholder as ordinary income - unless they are considered to be "qualified dividends", which are taxed as capital gains. Otherwise, the dividend will be taxed at the unitholder's top marginal tax rate.

Also, a portion of the dividends paid by REITs may constitute a nontaxable return of capital, which not only reduces the unit holder's taxable income in the year the dividend is received, but also defers taxes on that portion until the capital asset is sold. These payments also reduce the cost basis for the unitholder. The nontaxable portions are then taxed as either long- or short-term capital gains/losses.

Because REITs are seldom taxed at the trust level, they can offer relatively higher yields than stocks, whose issuers must pay taxes at the corporate level before computing dividend payout.

Example - Unitholder Tax Calculation

Jennifer decides to invest in an REIT that is currently trading at $20 per unit. The REIT has funds from operations of $2 per unit and distributes 90%, or $1.80, of this to the unitholders. However, $0.60 per unit of this dividend comes from depreciation and other expenses and is considered a nontaxable return of capital. Therefore, only $1.20 ($1.80 - $0.60) of this dividend comes from actual earnings.

This amount will be taxable to Jennifer as ordinary income, with her cost basis reduced by $0.60 to $19.40 per unit. As stated previously, this reduction in basis will be taxed as either a long- or short-term gain/loss when the units are sold.

ConclusionThe unique tax advantages offered by REITs can translate into superior yields for investors seeking higher returns with relative stability. Theoretically, it is possible for a unitholder to achieve a negative cost basis if the units are held for a long enough period of time. While this is hardly common, the potential for realizing a possible gain or loss in this manner should be clearly understood by investors.

by Mark P. Cussen,CFP®, CMFC (Contact Author | Biography)

Add Some Real Estate To Your Portfolio by Robert Stammers,CFA (Contact Author | Biography)

With real estate gaining a greater foothold in the capital allocation decisions of both institution and retail investors, there has been increasing development in real estate funds. Due to the capital intensity of real estate investing, its requirement for active management and the rise in global real estate opportunities, institutions are gradually moving to real estate funds of funds to allow for appropriate asset management.

The same is true for retail investors, who now have a much larger selection of real estate mutual funds, allowing for efficient capital allocation and diversification. Like any other investment sector, real estate has its benefits and its disadvantages. However, real estate should be considered for most investment portfolios, and real estate investment trusts (REITs) and real estate mutual funds may be the best methods to fill that allocation. (To learn more, check out What are REITs?)

Real Estate for Institutional InvestorsReal estate investment has long been dominated by large investors, such as pension funds, insurance companies and other large financial institutions. Thanks to the globalization of real estate investing and new offshore opportunities, both of which allow for greater diversification and return potential, there is an increasing trend toward finding a permanent place for real estate in institutional portfolio allocations.

The permanent allocation of real estate capital comes with some hurdles. First and foremost, it is capital intensive. Unlike stocks that can be purchased in small increments, commercial real estate investments require relatively large sums and direct investment often results in lumpy portfolios and inordinate risks in either location or by property type. Real estate also requires active management, which is labor intensive. Managing a real estate allocation requires significant resources relative to traditional investments. As a result of these issues, institutions tend to gravitate toward real estate funds and funds of funds, in order to increase management efficiency and capital distribution. The same advantages that institutions gain from real estate funds can be achieved by retail investors through REITs, REIT exchange-traded funds (ETFs) and real estate mutual funds. (To learn more about ETFs, check out Advantages of Exchange-Traded Funds.)

Retail InvestorsThe following are several ways that retail investors can access the return potential of real estate and obtain exposure to the asset class.

Direct Investment

This strategy relates to investors directly selecting specific properties. The great advantage in this strategy is control. Direct ownership in property allows for the development and execution of strategy and direct influence over return. However, direct investment makes it very difficult to create a well diversified real estate portfolio. The real estate allocation for most retail investors is not large enough to purchase enough properties to diversify and will increase exposure to local property market and property type risks. (For more insight, see Investing In Real Estate.)

Real Estate Investment Trusts (REIT)REIT shares are private and public equity stock in companies structured as trusts that invest in real estate, mortgages or other real estate collateralized investments. REITs typically own and operate real estate properties. These may include multifamily residential properties, grocery-anchored shopping centers, local retail properties and strip centers, malls, commercial office space and hotels.

Real estate investment trusts are run by a board of directors that conducts investment management decisions on behalf of the trust. REITs pay little or no federal income tax as long as they distribute 90% of taxable income as dividends to shareholders. Even though the tax advantage increases after-tax cash flows, the inability for REITs to retain cash can significantly hamper growth and long-term appreciation. Apart from the tax advantage, REITS provide many of the same advantages and disadvantages as equities.

Because REIT managers provide the strategic vision and make the investment and property decisions, they reduce management issues for investors. For retail investors, the greatest disadvantage is the difficulty in investing in them with limited capital and the significant amount of asset-specific knowledge and analysis required in selecting them and forecasting their performance. (To learn more, read The REIT Way.)

REIT investments have a much higher correlation to the overall stock market than direct real estate investments, which leads some to downplay their diversification abilities. Volatility in the REIT market has also been higher than direct real estate. Explanations for this is due to the influence of macroeconomic forces on REIT values and the fact that REIT stocks are continuously valued, while direct real estate is influenced more by local property markets and is valued using the appraisal method, which tends to smooth investment returns

Real Estate Mutual FundsReal estate mutual funds invest primarily in REIT stocks and real estate operating companies. They provide the ability to gain diversified exposure to real estate with a relatively small amount of capital. Depending on their strategy and diversification goals, they provide investors with much broader asset selection than can be achieved in buying REIT stocks alone and also provide the flexibility of easily moving from one fund into another. Flexibility is also advantageous to the mutual fund investor due to the comparative ease in acquiring and disposing of assets on a systematic and regulated exchange, as opposed to direct investing which is arduous and expensive. More speculative investors can tactically overweight certain property or regional exposures to maximize return.

Creating an exposure to a broad base of mutual funds can also reduce transaction costs and commission relative to buying individual REIT stocks. Another significant advantage to retail investors is the analytical and research information provided by the funds on acquired assets and management's perspective on the viability and performance of specific real estate investments and as an asset class.

Real estate funds allow investors who do not have the desire, knowledge or capital to buy land or property on their own to participate in the income and long-term growth potential of real estate. Although real estate mutual funds bring liquidity to a traditionally illiquid asset class, naysayers on the use of these funds believe they are not akin to direct investment in real estate. (For more insight, see The Risks of Real Estate Sector Funds.)

Home OwnershipMany retail investors who have not considered real estate allocations for their investment portfolios fail to

realize that they may already be investing in real estate by owning a home. Not only do they already have real estate exposure, most are also taking additional financial risk by having a home mortgage. For the most part, this exposure has been beneficial and has helped many people amass the capital required for retirement.

ConclusionAlthough retail investors can and should take into account home ownership when conducting their portfolio allocations, additional, more liquid investments in real estate might also be considered. For those with the requisite trading skills and capital, REIT investing provides access to some of the benefits of real estate investing without the need for direct ownership. For others considering a smaller allocation or for those that do not want to be saddled by asset selection but require maximum diversification, real estate mutual funds would be an appropriate choice.

For more insight, read Investing in Real Estate. by Robert Stammers,CFA (Contact Author | Biography)

The Impact Of Interest Rates On Real Estate Investment Trusts by David Harper,CFA, FRM (Contact Author | Biography)

A real estate investment trust (REIT) must pay out at least 90% of its taxable profit as a dividend to shareholders. REITs are relatively high-yield instruments. From the perspective of total return, dividends plus price appreciation, REITs behave like a typical small-cap stock. Unlike a small-cap stock, most of the expected return of a REIT comes not from price appreciation but from dividends. In fact, on average, about two thirds of a REIT's return comes from dividends. As a high-yield investment, a REIT can be expected to exhibit sensitivity to interest rate changes. In this article, we explore this relationship. (For more on this, see What Are REITs?)

Relatively High Yields In Figure 1, we show the median yield for each REIT sector as of September 2004. The top of each bar is in the 75% yield; the bottom is in the 25% yield; and the break from green to blue in the middle is the median yield.

Figure 1Copyright 2009 Investopedia.com

You can see that yields vary by sector. As of September 2004, the median yield among all REITs (the bar furthest on the right) was about 5.5%, but the yields were dispersed: the 25% yield (the bottom of the blue portion) was about 4% and the 75% yield was more than 6.5% (the top of the green portion). This means only half of the REIT yields were between 4% and 6.5% while the other half of REIT yields was outside this range. At the same time, the yield on long-term U.S. government treasuries was less than 5%. Therefore, if your goal is income, you might do better with a REIT, but you would assume additional risk.

REIT Total Returns Compared to Interest Rates Conventional wisdom says that higher rates are generally bad for REITs. The most popular REIT index is the NAREIT Equity REIT Index. Figure 2 compares the value of the NAREIT Index to the 10-year Treasury bond (T-bond) from the beginning of 1972 to almost the end of 2004:


Keep in mind that the chart of the NAREIT Index shown above includes both income and price gains. The blue line starts at an indexed value of 100 and is plotted against the vertical axis on the right. The green line is charted against the left vertical axis.

Although we have over 30 years of data, it is hard to draw conclusions because most of the period was dominated by a secular (i.e. long-term) decline in interest rates. The strong negative 66% correlation between the two instruments suggests an inverse relationship. However, such implications would be more compelling if the few periods of sustained rate increases were met with declines in the NAREIT Index. Instead, increases occurred simultaneously: during the five-year period from December 1976 to October 1981, 10-year Treasury rates leaped from 6.87% to 15.15% (the peak of the green line), and the value of the NAREIT Index gained an impressive 15.8% during the same period.

REITs did even better in later years as interest rates declined. Table 1 shows the annualized return for the NAREIT Index. REITs had a good run over the five years preceding 2004:

NAREIT Index

Annualized Return for Period Ending September 2004

1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year

25.6% 26% 20.4% 18.6% 18.8% 13.7% 9.2%

Table 1

Unfortunately, we can probably assume that past returns such as these cannot be replicated into the

future over the long run for the industry as a whole. There will be exceptions in the short-term.

REIT Price Returns Compared to Interest Rates Let's focus on just the price component of REIT stocks. In Figure 3 below, we compare the same 10-year Treasury bond rates to a price-only index. In other words, we exclude dividends and isolate only on price changes to see what would happen to $100 if it were invested in 1972.


Although the overall correlation is weaker, there is a strong inverse pattern over the last 15 years in the period shown above. In fact, from the 1989 point, Figure 3 shows a virtual mirror-image relationship between the price component of the REIT index and the medium-term interest rate. For those considering a REIT investment as of late 2004, this would be a "red flag" for two reasons. First, in the five years preceding 2004, the index produced an annualized gain of 18.8%, including a steep annualized gain of 26% over the two preceding years. During that period, therefore, price gains (as a percentage) exceeded fundamental gains, as measured by earnings, cash flow, or funds from operations (FFO). While such gains could be replicated going forward, it is unlikely. Further, it is entirely possible that prices could revert to prior multiples (for example, price as a multiple of FFO).

Second, the medium-term interest rate is low by historical standards. It is entirely likely that this interest rate will edge upward. If the 15 years of inverse correlation between rates and REIT prices shown above continued, then REIT prices would suffer.

Summary The 15-year period examined above shows there is a strong inverse relationship between REIT prices and interest rates. On average, it would be safe to assume that interest rate increases are likely to be met by REIT price declines. Of course, reaction by sectors will vary. For example, some argue that in the case of residential and office REITs rising interest rates would drive up REIT prices because increasing rates correspond to economic growth and more demand. But you will need to be selective in such an

environment. The good news about REITs is that high yields are a sort of hedge against price declines: if you buy a high-yield REIT, any price decline will be mitigated by high income in the meantime.

To learn more about REITs, see Basic Valuation Of A Real Estate Investment Trust (REIT) and The REIT Way.


What Are REITs? by David Harper,CFA, FRM (Contact Author | Biography)Filed Under: Bonds

A real estate investment trust (REIT) is a real estate company that offers common shares to the public. In this way, an REIT stock is similar to any other stock that represents ownership in an operating business. But an REIT has two unique features: its primary business is managing groups of income-producing properties and it must distribute most of its profits as dividends. Here we take a look at REITs, their characteristics and how they are analyzed.

The REIT StatusTo qualify as an REIT with the IRS, a real estate company must agree to pay out in dividends at least 90% of its taxable profit (and fulfill additional but less important requirements). By having REIT status, a company avoids corporate income tax. A regular corporation makes a profit and pays taxes on the entire profits, and then decides how to allocate its after-tax profits between dividends and reinvestment; an REIT simply distributes all or almost all of its profits and gets to skip the taxation.

Types of REITsFewer than 10% of REITs fall into a special class called mortgage REITs. 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. We will not consider them here.

While a handful of hybrid REITs run both real estate operations and transact in mortgage loans, most REITs focus on the "hard asset" business of real estate operations. These are called equity REITs. When you read about REITs, you are usually reading about equity REITs. Equity REITs tend to specialize in owning certain building types such as apartments, regional malls, office buildings or lodging facilities. Some are diversified and some are specialized, meaning they defy classification - such as, for example, an REIT that owns golf courses.

What Kind of Asset Is an REIT Stock?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. Consider 20 years of returns for the NAREIT Equity REIT Index (an index of about 150 traded REITs) between 1984 through 2003, shown below. The red bars represent annual returns solely from dividends; they have averaged about 8% and never once fallen below 4.8%. The blue bars add price changes for each year - they represent total return, price change plus income return. You can see that stable dividends combine with price volatility to create a total return that is often promising, but volatile nonetheless.

Analyzing REITsAs dividend-paying stocks, REITs are analyzed much like other stocks. But there are some large differences due to the accounting treatment of property.

Let's illustrate with a simplified example. Suppose that an 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.

Top Down Vs. Bottom UpWhen 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.

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 and related service income, and FFO. You want to see if the REIT has a unique strategy for improving occupancy and raising its rents. 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 an 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 ration. 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, an REIT that uses only floating-rate debt will be hurt if interest rates rise.

ConclusionREITs 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 an REIT requires understanding the accounting distortions caused by depreciation and paying careful attention to macroeconomic influences.


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