A Real Estate Investment (REIT) is a company that acquires, manages, and sells real estate on behalf of investors. This structure enables multiple investors to buy shares in a single company with an entire portfolio of income-producing real estate. REIT shares entitle each investor to their portion of the income, tax benefits, and potential appreciation of the underlying real estate. It is a commonly used tool for investors who are interested in passive income-producing real estate, as it can provide income throughout the hold period and capital appreciation upon sale of the properties. A REIT can be structured in various ways, specialize in a specific asset class or diversify its holdings across multiple classes.
- What are the primary benefits that REITs offer investors?
- What types of REITs are there?
- What should investors look for in a REIT?
What are the primary benefits that REITs offer investors?
Passive Income
Unlike most real estate investments, a REIT is obligated to distribute at least 90% of the taxable income that is produced by the property back to their shareholders. This is paid on a monthly or quarterly basis and provides the investors with income during their hold period. All REIT investments are passive. As a shareholder you are provided with communication from the REIT manager(s), however you are not entitled to any decision making power. As an investor you rely upon the experience of the property manager and asset manager that is appointed by the REIT to make day-to-day decision regarding the acquisition, management, and disposition of the properties in the REIT. As a shareholder you are entitled to review all publicly filed documents and receive a monthly or quarterly distribution of income that is produced by the REIT.
Tax Advantages
REITs are structured to have corporate taxes eliminated or reduced. This structure benefits investors as the income that would have been lost to taxation can be paid to investors as a dividend. The structure also allows investors to use a depreciation tax shelter on the current income of the portfolio. This is due to the ability of the REIT to pass through this depreciation to the investors. REITs are also able to be used as an option for tax deferred investments using a 721 exchange (UPREIT), however a REIT does not qualify for a 1031 exchange.
What types of REITs are there?
The ability of a REIT to structure their portfolio in a variety of ways allows investors to be selective and choose a REIT that suits their needs. Whether the REIT is non-traded or publicly traded as well as the asset class focus and fee structure of the REIT makes each a bit different. It is common for a non-traded REIT to be structured to eventually target a public listing. This strategy is useful for investors who are not concerned with immediate liquidity as they can acquire a non-traded REIT (generally less expensive) and wait until the REIT is listed publicly to realize a gain. Investors who need the ability to liquidate at any time may be forced to choose a publicly traded REIT (generally more expensive). Another strategy that is commonly used is taking advantage of a stock market decline to acquire shares of a REIT on a stock exchange while the prices are depressed. This allows for gain that can be realized immediately in the public exchange should the price increase after an investor acquires the shares.
Publicly Traded vs. Non-Traded
All REITs are required to provide documentation to the SEC. All are publicly registered and must provide shareholders access to their financial reporting documentation, which is provided quarterly and annually. The major difference between a non-traded and publicly traded is that a publicly traded REIT is listed and sold on the stock market, giving them greater access to the public and allowing investors to buy and sell at their convenience.
Non-traded REITs are generally illiquid as there is no secondary market for the purchase and sale of shares. This means that investors must be willing to have their capital tied up in the investment until the portfolio goes full cycle or it is listed as a public REIT on the stock market.
Publicly traded REITs have a liquidity feature as there is ability to buy or sell a position on a public stock exchange. This allows investors the flexibility of realizing gains without needing the portfolio to go full cycle, however it also increases the risk of the investment as the REIT is correlated to the stock market and therefore subject to risk.
What should investors look for in a REIT?
REITs should be carefully analyzed prior to investment. Investors need to know how much of their capital is being put to use immediately as well as the fee structure of the REIT. It is a common practice for investors to gravitate towards publicly traded REITs as they are more liquid and can be tracked more easily. A great strategy to use for publicly traded REITs is to buy during a market downturn. This allows for a decreased cost basis, higher potential appreciation, and downside protection. REITs are currently overvalued in the public market and should be reviewed thoroughly before investing.
It is important to recognize all the potential risks associated with REIT investment before investing. REITs are subject to many risks of commercial real estate investments such as risks on specific asset classes, structure, management, financing, and overall market risk. Some major considerations to take into account are discussed below.
Strong Leadership
A major factor to consider is whether or not the management team is invested personally in the REIT they are managing.
- A manager that is personally invested will be motivated to perform as well as possible to increase their own personal return as well as the return of other investors.
- Is a manager going to receive a large upfront fee or ongoing management fees that will encourage them to maximize their own income even at the expense of the return to investors?
- Knowing these factors can help an investor determine if the management will act in the best interest of the investors or if they will try to increase their personal return while decreasing that of the investors.
- Does the management team have experience with the local area and asset classes that are being sourced for the portfolio? Knowing this will ensure the management team has the best chance for success.
Conservative Loan
A more secure REIT will have a lower leverage or have longer-term debt to elongate their hold period and maximize profits upon sale of the properties.
If a REIT is using variable rate financing, there is an increased risk that the debt may become too expensive. With a fixed rate long term loan, the payments will be known and can be underwritten into projections for the portfolio. Inflation, although it may increase the value of the properties, will also increase interest rates on variable debt. This relationship may not be beneficial to investors.
Covered Yield
Is the dividend paid to investors being fully covered by the net Cash Available for Distributions (CAD)? This is a very important factor to consider and ties directly back to the previous bullet points. A REIT can use its financing and capital raise to pay out its stated dividend to investors. This means that a dividend that is being received by an investor may not come from the property.
Most REITs will not be able to pay distributions from solely property income until they reach about $400 million in assets due to their fees and management structures.
It is also possible that a REIT markets and advertises a high dividend that can never truly be reached due to their fees, management structure, property underperformance, or lack of income. Although a REIT may appear attractive, if the properties do not produce the income, investors may be disappointed with the total return from an underperforming portfolio.
It is essential to know the metrics that are being used by the REIT management. Always look for CAD calculations and avoid looking at Funds from Operations (FFO), Modified Funds from Operations (MFFO) and Adjusted Funds from Operations (AFFO) as these metrics can be engineered to appear more attractive. When it comes down to it, a REIT should produce it’s divided from actual property income. This is a rare occurrence for REITs before the close of their capital raise period as they are using the capital to source property, but you should analyze how the management has used the already raised capital to source property.
Total Return
A REIT return is comprised of the funds that are distributed to shareholders during the hold period of the portfolio and the appreciation that is realized upon the sale and disposition of the portfolio. The distributions are paid to investors on a monthly or quarterly basis and are at a minimum 90% of the income that is generated by the properties in the portfolio. The gain upon sale is based on the difference in value between the purchase and sale of the properties. It is possible for the value to decrease and this would mean that investors do not receive the entirety of their originally invested capital upon disposition.
The Right Stage of the Capital Raise
This is a strategy that is used by investors to gain a better understanding for the structure and strategy of the REIT. It is common for the equity raise period for a REIT to be up to 3 years long. Some investors may choose to place capital as early as possible to receive maximum dividend income. However, some may choose to wait until the end of the raise period as to guarantee there are properties in the portfolio and that the properties are producing income.
A good way to look at the differences in strategy is to utilize IRR. An investor who places capital early may achieve a greater total return on their investment, but during the first few years they may not achieve a high IRR due to property sourcing still occurring and not being able to receive dividend income until the properties are actually producing income. For an investor that chooses to wait, their total return may be decreased a bit compared to an early investor. However, because they are investing into a stabilized portfolio they are receiving an increased dividend amount immediately as well as having a shorter period of time between their purchase and a “full cycle” event which will increase their IRR due to a shorter time horizon.
Assets in the Right Class for the Current Stage of the Macroeconomic Cycle
This is a consideration to take into account for all investments in real estate and not just REIT investments. Looking back 10-15 years, REITs were overvalued due to the strength of the economy at the time. Many investors who chose to buy into a REIT in the period before the Great Recession realized that their timing was wrong. The price drop during the Great Recession created losses for many investors, however it also created an opportunity to capitalize on depressed prices for investors who were able to take advantage. Investors should take caution and recognize trends in the market to execute a well-timed purchase of REIT shares.
Assets in Classes in the Right Stages of Their Valuation Cycles
This is a consideration for asset-specific REITs. Each asset class, like the stock market, goes through periods of inflation as well as deflation. It is important to recognize the cycle of the specific asset class to execute a purchase during an inflationary period for the asset class.
One great example is Multifamily assets. After the Great Recession, there was a large portion of the US population that moved into rental properties rather than deciding to purchase a home. This is also due to the increased portion of the population that is young. Over the past 10 years, multifamily valuation has increased steadily as demand has increased. With prices increasing rapidly due to the demand for multifamily assets, an investor should be aware that the multifamily sector may soon reach a peak. It is possible to find good deals in multifamily assets, but investors should be aware that many properties are overvalued in the current market.
In an asset-class-specific REIT, understanding and analyzing these trends is paramount to a successful investment. For diversified REITs, understanding each asset class cycle is less important, however overall market cycle should be understood to stray away from REITs that are overvalued in their pricing.
We focus on tenants whose businesses perform well through economic prosperity and thrivethrough recessions, because they sell necessities like groceries, medicine, critical medical services, and discount auto supplies.
Assets Acquired at a Good Value
As with any investment, the relationship between the upside and downside should be analyzed. It is especially important to try to achieve downside protection while maximizing upside potential.
Each property that is part of the portfolio is important to the success of the portfolio as a whole. Investors should determine if the properties are well-located, have a valuation that justifies the purchase price, and meets the objectives of the REIT as a whole.
Does the management team of the REIT have experience in the local area of the properties? If not, there could be increased risk due to the market. The same question can be raised about the asset class.
If the properties are purchased opportunistically, it will increase the likelihood that dividends are able to be distributed and are achieved from the property.
It is also important to understand the source of income for the REIT to hedge the investment properly. For example, a multifamily REIT may have varying income month to month due to tenant rollover, expenses, etc. However, a net-leased REIT that only sources investment-grade tenants with a guaranteed lease, will return the same dividend each month as they can underwrite the guaranteed lease payment for the hold period.
Assets With Strong Lease Terms
In a net-leased REIT, it is important to know which tenants and which buildings will be occupied and when their leases are subject for rollover in order to know when you can expect a need to re-tenant.
Assets Leased to Tenants With Investment Grade Credit
Tenants whose creditworthiness has been analyzed by professional rating agencies and determined to be worthy of investment are far more likely to fulfil their lease obligations. These are typically multi-billion dollar companies with proven financial performance and strong balance sheets.
Assets That Are Well-Diversified
All REITs are able to choose the type of portfolio they wish to build. In general, a REIT will either choose to be asset class specific or diversify across multiple asset classes. For example, an asset class specific REIT would only source assets that are multifamily, retail, office, student housing, etc. This focuses their strategy on one class of assets, but decreases the diversification of the REIT.
