The SmallCap Informer regularly covers real estate companies that operate as Real Estate Investment Trusts (REITs). REITs are a type of investment security that can provide important diversification elements and other advantages for the portfolios of many investors. However, REITs also require some modified analysis techniques in order to evaluate them successfully.
REITs, as the name suggests, are “trusts,” but they are different from many kinds of trusts in that they are typically operating companies. We focus on publicly-traded REITs that trade on stock exchanges, but they may operate non-publicly. Publicly-traded REITs allow investors the ability to diversify their portfolios into the real estate sector with a higher level of liquidity than would be possible when owning properties outright. They also must report regularly to the SEC, providing a high level of transparency into their operations.
REITs commonly buy, sell, manage, renovate, and develop income-producing real estate, such as apartment complexes, shopping centers, offices, hotels, healthcare facilities, storage units, forests that produce timber, manufactured housing, and warehouses. These are known as Equity REITs, and they may specialize in one or more of the above property types.
Mortgage REITs engage in financing real estate by making and holding loads and other obligations secured by collateral.
Hybrid REITs both own property and mortgages.
Under current U.S. tax law, REITs receive significant tax advantages designed to stimulate large investment in properties. Distributions to shareholders are deducted from corporate taxable income, so most REITs remit more than 100% of their taxable income to shareholders and thus avoid paying corporate income taxes. Paying out more than 100% of net income is possible because REITs regularly write down the value of their property portfolio according to a depreciation schedule; these non-cash charges reduce reported net income but provide the business with enough cash to operate.
To preserve their tax status, REITs must pay out at least 90% of net income to shareholders each year and derive at least 75% of their income from real estate-related business.
For shareholders, distributions from REITs are not considered “qualifying dividends” that are eligible for lower tax rates. Since the distributions come from the company’s non-taxed income, they are fully taxed when received by investors. REIT distributions may include returns of capital or capital gains as well as profits from the company’s operations. Those different categorizations receive different tax treatment on an investor’s tax return at year-end.
Besides the liquidity advantage, REITs offer other benefits to investors. REITs tend to have a low correlation with the performance of the overall stock market, falling less during bear markets but rising less during bull markets.
REITs allow investors to forego the headaches that often come along with being a landlord.
For investors seeking income, REITS tend to be among the highest dividend payers in the stock market. Our preference as stock investors is for total return (generated by capital appreciation as well as income), and REITs tend to shine there as well. According to the National Association of Real Estate Investment Trusts (NAREIT), REITS have a higher pre-tax total return over the past 35 years than the S&P 500, Russell 2000, Nasdaq Composite, or Dow Jones Industrial Average indices.
When analyzing REITS, analysts focus on Funds from Operations (FFO) instead of EPS. FFO is calculated by removing the non-cash expenses of depreciation and amortization from the company’s net income. Since real estate typically does not depreciate in value, including a depreciation cost on property that is appreciating doesn’t provide an accurate snapshot of the company’s finances. As such, we use FFO per share as a substitute for EPS in our stock studies. (ICLUBcentral's EquityResearchService.com, ERS, subscription website provides SSG data for REITs, along with a REIT screener and other analytical information. The data in our stock studies typically comes from ERS.)
When using FFOS in place of EPS, the calculation of the dividend payout ratio on a Stock Selection Guide will commonly exceed 100%. While this would be a red flag for nearly any other kind of company, remember that REITs are paying dividends out of net income, not funds from operations. REITs with a lower payout ratio will still suggest that a REIT may have more opportunity for growth and capital appreciation as opposed to being a current income vehicle.
It is also important to consider a REIT’s capital structure. Since REITs pay out nearly all income, they must rely on capital markets or borrowing in order to expand or develop their property portfolios.
One final note for members of investment clubs: due to the way that REITs classify their distributions only at year-end, they can provide challenges for club treasurers at tax time and may also create unequitable situations for some club members. As a result, it may be prudent to avoid holding REITs in a club portfolio.
Contact the SCI team in the Discussion Forums if you have questions or suggestions about investing in REITs.