Want a stake in real estate without the headaches of hands-on property management? Invest in real estate investment trusts (REITs).
For a portfolio stuffed with stocks and bonds, real estate investment trusts (REITs) are a nearly perfect diversification tool. REITs invest in different types of real estate, in which the earnings of the REIT often have more to do with rental and occupancy rates than the interest rates that affect stocks and bonds. Financial planners recommend investing up to 10 percent of your portfolio in REITs as part of a disciplined asset allocation strategy [Hack #74] . By buying shares in a REIT, you can invest in real estate without forking over a bundle of cash—and without the low liquidity because of the time it takes to sell real estate that you own directly. Although analyzing REITs requires a few more financial measures, you can easily expand your studies to include REITs in your portfolio.
Originally created in 1960 by an act of Congress, REITs enable individual investors to easily participate in the commercial real estate market. In structure, REITs are pooled asset vehicles similar to mutual funds, but they invest in properties rather than stocks and bonds. REITs are required by tax law to distribute 90 percent of their taxable income to shareholders. Although the generous dividends that result are a boon for dividend-hungry investors, REITs also offer the potential for stock price appreciation.
Tip
The Tax Relief Act of 2003 eliminated the double taxation of dividends and reduced taxes on long-term capital gains. However, because of the way REITs operate, their dividends aren’t taxed twice, so you still have to pay taxes on the dividends you receive from them. For that reason, tax advisers recommend that investors hold REITs in tax-deferred accounts such as IRAs or 401(k)s.
Publicly held REITs trade on the major stock exchanges and some belong to major stock indexes, such as the S&P 500 index. Although some REITs invest in all types of property all over the country, others specialize by type of property, region of the country, or both. Types of property typically owned by REITs include shopping malls, strip malls, apartment buildings, office buildings, resorts, hotels, storage facilities, industrial complexes, health-related facilities, and residential real estate. REITs come in three flavors:
Real estate is a highly cyclical industry, going through cycles of boom and bust. At the top of the cycle, demand for real estate is high and supplies are lean, so that rental rates and real estate sale prices climb, pulling REIT profits up as well. Then, developers rush in and construct more buildings to satisfy the demand, which eventually results in an oversupply. Sale prices fall, and property managers must cut rental rates in order to lease space, which results in fewer profits for REITs. When rents fall, there’s less incentive to build, which eventually brings the commercial real estate market full circle.
Diversification in real estate is just as important as in other areas of investing. Geographic location, interest rates, disposable income, and business staffing levels all affect REITs to some extent. For example, equity REITs are less affected by swings in interest rates than mortgage REITs. In addition, the cycles for different sectors of the REIT market peak and hit bottom at different times.
Similar to the evaluation of traditional growth stocks, good REITs produce consistent growth in sales and earnings, despite the cyclical nature of the real estate market. However, REITs do differ from other types of companies in the way they operate, so you must analyze a few additional financial measures not found in manufacturing or service companies.
The National Association of Real Estate Investment Trusts (NAREIT) recommends that investors look for REITs that employ their cash flow effectively by reinvesting money in new opportunities. REITs can increase earnings by raising rents and lease rates as building occupancy increases. However, like any other business, REITs must set competitive rates to maintain building occupancy, and also balance the costs and benefits of property maintenance and improvements. Many REITS grow by acquiring new properties or developing new buildings. In 2001, Congress passed the REIT Modernization Act, which enables REITs to create subsidiaries to provide cutting-edge services to their tenants, such as wiring buildings for broadband Internet service. For REITs that construct buildings, avoid those that have trouble completing projects on time and within budget. Construction delays and budget overruns can both make deep cuts into profits.
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Look for the status of ongoing development activities in REIT annual reports and 10-K and 10-Q filings.
One major difference between analyzing REITs and other types of companies is the handling of depreciation of assets. Because other types of companies often own assets comprised of equipment, which lose value over time, depreciation attempts to show the reduction in usefulness and value over time. However, REITs own large quantities of real estate assets, which typically increase in value over time. Therefore, earnings per share, which is reduced by depreciation and amortization, is not a good measure of REIT performance. Instead, analysts typically use the following measures to evaluate REIT performance, also shown in the income statement in Figure 4-44.
Figure 4-44. The income statement for the Washington REIT includes additional categories of income and expense
- Funds from operations (FFO)
Also called income from continuing operations, FFO excludes property depreciation and gains or losses from sales of property.
- Adjusted funds from operations (AFFO)
Some analysts further refine FFO by using adjusted funds from operations (AFFO), which measures the cash flow generated by a REIT’s operations. According to NAREIT, AFFO is calculated by straight-lining rents and subtracting the normalized recurring expenditures (such as installing new carpeting) that REITs usually capitalize and amortize. Straight-lining rents represents the use of the average of a tenant’s rent payments over the lifetime of a lease and is required by generally accepted accounting principles (GAAP).
- Earnings per share (EPS)
You can use EPS if it is adjusted to reflect earnings from continuing operations, which exclude revenue gains from extraordinary and special items.
- Operating net income per share
To further muddy the waters, some REIT analysts focus on operating net income per share as a better reflection of the scope of a REIT’s operations and its worth.
Unlike the measures you use to study other types of stocks, the measures for analyzing REITs require some digging. Value Line (http://www.valueline.com) provides annual data for FFO but doesn’t provide quarterly FFO results. In addition, Value Line doesn’t provide REIT revenue numbers. EdgarScan [Hack #18] (http://edgarscan.pwcglobal.com/servlets/edgarscan) doesn’t provide FFO or AFFO numbers, but does provide operating net income. You can divide operating net income by the total shares outstanding to calculate the operating net income per share.
Many REITs include FFO and AFFO data in their quarterly reports, annual reports, and SEC filings, which you can access from their web sites. NAREIT provides links to the web pages for member REITs (http://www.nareit.com/aboutreits/linkstext.cfm). If a REIT doesn’t provide FFO in its income statement, calculate FFO using the equation shown in Example 4-55.
Example 4-55. Calculate FFO using other numbers from a REIT income statement
FFO = Income before gain on sale of real estate + Depreciation + Amortization
Tip
If you’re not interested in analyzing individual REITs, but still want to take advantage of this type of investment, consider REIT mutual funds. You can choose from actively managed REIT funds, closed-end REIT funds, or REIT index funds. Morningstar is a good place to start (http://www.morningstar.com).
The National Association of Real Estate Investment Trusts (NAREIT) web site (http://www.nareit.com) is full of helpful information, including FAQs about REITs, a 16-page .pdf file “Investor’s Guide to REITs,” detailed information about REIT accounting, and an extensive glossary of REIT investing terms.
—Amy Crane
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