A Look Into Real Estate Investment Trusts
Real estate has always been an attractive asset class. Some of the primary reasons investors are drawn to this asset class is due to the benefits it can provide such as diversification, income generation, inflation hedge and low volatility. There are a myriad of ways to invest in real estate:
There is direct ownership through residential, commercial or other properties, and there is the option of purchasing shares in real estate investment trusts or other securities. Those with smaller portfolios tend to stick to REITs, shares of companies heavily weighted toward real estate, and exchange-traded funds (ETFs) oftentimes based on liquidity needs and preferences. Index funds have become a popular choice due to their ability to achieve diversification, while avoiding the volatility associated with individual shares, by having exposure to a large group of different REITs. In this blog post, we will take a deeper dive into REITs, an investment that was once predominantly considered an “alternative asset class,” but now gaining a foothold in mainstream investing and solidifying its place amongst the core asset classes.
Background of Real Estate Investment Trusts
A “REIT” is a real estate investment trust. An entity that invests in different kinds of real estate or real estate related assets.Examples include office buildings, hotels or condominiums, shopping centers, and mortgages secured by real estate. They come in three forms. The most commonly used is an “Equity REIT,” which invests in or owns real estate and earns income from the rents they collect. The other two variations of REITs are “Mortgage REITs” and “Hybrid REITs.” Mortgage REITs typically lend money to owners and developers and Hybrid REITs are basically the two just described above, combined.
REITs invest in income producing properties and pass on the profit to investors via dividends. REITs must distribute at least 90% of any profit to its shareholders in order to receive preferential tax treatment.
Investors in REITs look at several things when evaluating REITs:
- The level of compensation of management in addition to the credibility and competency of those managers.
- Make sure a REIT’s debt level isn’t too high. A general rule of thumb is that the REIT’s aggregate loan-to-value rate shouldn’t exceed 55 percent.
- Ability to increase earnings in a reliable manner
- Fast and effective reinvestment of available cash flow
- Strong operating characteristics such as strong tenant relationships and accepted accounting practices.
Investors can buy, sell and trade shares of REITs similar to a normal stock. When assessing the value of REIT shares, your analysis may include:
- Anticipated growth in earnings per share
- Corporate structure and management quality
- Comparison of dividend yields as they relate to other investments with high income potential such as bonds or dividend paying stocks
- Comparison of share price to funds from operations (FFO). Achieved by adding back depreciation deductions to earnings.
- Anticipated total return from the stock
- Underlying asset values of the real estate or other assets
Advantages of a REIT
- Income is generated from rent received.
- Access to large commercial real estate projects
- Entry and exit is easy
- The correlation of REITs to the major indices is low compared to other industries. Therefore they may be an attractive addition to a portfolio based on diversification.
- The value of the REIT increases as the value of the real estate increases too therefore the share price will go up.
Disadvantages of a REIT
- Targeted on one particular sector of real estate. If this sector does not perform well it may lead to a substantial decrease in the investor’s money.
- The dividend payments are not guaranteed and the real estate market is subject to cyclical downturns
- Performance can be dependent on demographic/economic factors. An overabundance of construction activity may negatively affect performance of REITs in that area.
- With 90% required to be distributed to holders each year, only 10% of annual profits can be invested back into the business. REITs grow more slowly than the average stock as a result.
A REITs Ideal Environment
REITs and real estate in general can do very well in an environment where interest rates are gradually rising as a result of an improving economy. Their balance sheets are oftentimes shielded from the impact of rising interest rates due to their laddered maturities and limited debt. However, it is important to note that sometimes high-yielding assets are at greater risk of reducing their dividends than ones that already pay lower dividends. The low interest rate environment we have been experiencing has given REITs the ability to enjoy the advantages of long-duration financing, and low interest rates as compared to that of the market. REITs also own hard assets, which is complementary to an inflationary environment and rising economy, which boosts the value of the real estate serving as collateral due to the fact that as prices rise, replacement cost rises.
Source:REIT Growth and Income Monitor- covers 122 REITs with total market cap of $589 billion, as of the end of June, 2013.
REITs can be a great tool to have in a portfolio, but investors should be educated as to the limitations and risks associated with this type of investment. You should consult a registered investment advisor before including a REIT into your investment strategy.