How to Invest in REITs
By: Harry Domash,
Would you like to invest in commercial real estate, such as high rise office buildings or hotel properties? Actually, you don’t have to come up with millions to participate in the booming commercial real estate market. Instead, you could simply buy shares in a real estate investment trust (REIT).
REITs, which are pronounced “REETs,” are a special type of corporation that invests only in real estate. REITs, which trade just like regular (common) stocks, don’t pay federal corporate income taxes as long as they invest primarily in real estate but they do pay out at least 90% of their taxable income to shareholders. Consequently, REITs typically pay dividends equating to higher yields than regular corporations.
REITs come in two flavors; property REITs (sometimes called equity REITs), which own real estate properties, and Finance REITs, which invest in loans backed by real estate.
Property REITs own commercial real estate properties such as apartment complexes, office buildings, or shopping centers. Finance REITs don’t own properties; instead they invest in mortgages or other securities backed by real estate.
Most property REITs specialize in one of these property categories: retail, health care, lodging, industrial, office, mixed industrial/office, self storage, or digital infrastructure. Diversified REITs own properties in multiple categories.
Property REITs provide the customary management services associated with leasing properties such as apartment buildings, shopping centers and office buildings. But they can’t operate properties requiring a high degree of personal service such as hotels and health care facilities. Instead, they must lease those properties out to third-party operators. In some instances, property REITs create affiliated companies that can provide management services in these sectors.
Property REIT Investing Considerations
When calculating profits, accounting rules require that property owners deduct non-cash depreciation expenses, even if the property is, in fact, appreciating in value. For instance, when a new building is constructed, the construction costs must be depreciated over a fixed period, say 30 years. Thus, if construction costs totaled $30 million, the owner must depreciate $1 million annually, even if the building is appreciating in value.
Consequently, for properties with significant depreciation write-offs, the reported incomes do not reflect the actual spendable cash generated by the property. For that reason, the REIT trade association created a measure called funds from operations (FFO). That measure adds back depreciation and other non-cash accounting charges, and thus quantifies the profits generated by a property REIT’s operations. It is the FFO, expressed on a per-share basis, that determines a Property REIT’s ability to pay dividends.
Rising Interest Rates
Rising interest rates generally happen when the overall economy is gaining strength, which usually drives commercial property rents higher. When that happens, because REITs must pay 90% of taxable income to shareholders, dividends rise as well. Consequently, property REIT share prices and dividend payouts typically move up in a rising interest rate environment.
Here’s more detail on Property REIT categories. For each category, I also show my take on the category’s current investment rating, from A to F, where A is best, and a major player in that category. Here are some examples of my rating system at work with actual REITs.
Super Regional Malls: Rating B
Largest shopping centers in major market, mostly featuring high-fashion globally known retailers. Simon Property Group (SPG)
Regional Malls: Rating F
Smaller versions of Super Regionals, typically anchored by Sears, JC Penny, etc. CBL & Associates (CBL)
Neighborhood Centers & Strip Centers: Rating C
Anchored by grocery stores, liquor stores, drug stores, dry cleaners, etc. Kimco Realty (KIM)
Factory Outlets: Rating C
Feature retail discount stores, some owned by manufacturers or major department stores. Tanger Factory Outlet Centers (SKT)
Lifestyle Centers: Rating B
Usually emulate a street setting dominated by restaurants and specialty stores. Federal Realty Investment (FRT)
Nursing Homes: Rating A
Independent living, assisted living senior housing properties and long-term, skilled nursing facilities. Sabra Healthcare REIT (SBRA)
Medical Office: Rating B
Specialized facilities designed to serve needs of medical professionals. Healthcare Trust of America (HTA)
Surgery Centers/Specialty Hospitals: Rating B
Rehabilitation hospitals, acute care facilities, ambulatory surgery centers, cancer centers, etc. Medical Properties Trust (MPW) operates in the sector.
City Center Hotels: Rating B
Facilities capable of hosting large conventions, trade shows, etc. Pebblebrook Hotel Trust (PEB)
Limited Service: Rating C
Discount priced, extended stay hotels that do not offer typical hotel amenities such as room service. Chatham Lodging (CLDT)
Resorts: Rating B
Large-scale resorts capable of hosting conventions and trade shows. Ryman Hospitality Properties (RHP)
Industrial: Rating B
Small industrial facilities, warehouses and distribution centers. ProLogis (PLD)
Office: Rating B
Typically high-rise structures in metro centers. SL Green Realty (SLG)
Suburban: Rating C
Low-rise buildings with less amenities than Class A properties. Franklin Street Properties (FSP)
Mixed Office/Industrial: Rating B
These REITs own a mix of office and industrial properties. Liberty Property Trust (LPT)
Self Storage: Rating A
REITs that own and manage self-storage facilities typically rented to consumers and small businesses. Public Storage (PSA)
Residential: Rating A
Apartment buildings, student housing and single family homes. Camden Property Trust (CPT)
Diversified: Rating C
REITs operating in several different categories. One Liberty Properties (OLP)
Digital Infrastructure: Rating A
Computer data centers and telecomm towers. Digital Realty Trust (DLR)
Finance REITs invest in mortgages or related securities secured by real estate properties. Within that category, Residential Finance REITs primarily hold mortgages secured by single-family residential properties while commercial finance REITs hold paper secured by commercial properties.
Residential Finance REITs: Rating F
Within this category, Agency REITs restrict their holdings to mortgages insured by agencies of the U.S. government, specifically Fannie Mae and Freddie Mac. Because the U.S. government guarantees these mortgages, agency REITs bear no default risk. Orchid Island Capital (ORC)
By contrast, Non-Agency REITs invest in mortgages not insured by Fannie and Freddie, usually because the mortgage amounts exceed government-specified maximums. Chimera Investment Trust (CIM)
Commercial Finance REITs: Rating C
For conventional mortgages, most commercial finance REITs offer mezzanine financing and other relatively short-term debt instruments. Apollo Commercial R. E. Finance (ARI)
For all finance REITs, their profit margins are the difference between the mortgage interest paid by borrowers and the cost to the REIT of borrowing the funds needed to purchase the mortgages, which are generally short-term rates. Thus, finance REIT profit margins vary with the yield curve, which is the difference between the short-term and long-term (mortgage) rates.
Rising Interest Rates
Would you pay the same for an older mortgage paying 5% interest as you would for a newer mortgage paying 6%? I didn’t think so. Instead, you would probably want a discount that would bring the older mortgage’s return on your investment up to 6%.
That’s why rising interest rates depress the value of a mortgage REIT’s existing loan portfolio. The resulting asset write-downs result in EPS shortfalls. Adding to the problem, rising short-term rates reduce a REIT’s profit margins on existing holdings. Consequently, both a finance REIT’s share price and dividend payouts are likely to take hits when interest rates rise.
Property REIT and Finance REIT Investing Considerations
The downside of the non-taxable income status is that, since REITs must pay out most of their earnings to shareholders, they must continuously raise capital to fund expansion by borrowing or selling more shares.
Another caveat that complicates REIT analysis is that the income that defines the amounts that REITs must pay in dividends is the taxable income reported to the Internal Revenue Service (IRS). It is not the same as the net income listed on the financial statements that we see. Thus, you can’t use a REIT’s income statement earnings to predict its dividends.
REIT dividends are mostly taxed at ordinary income tax rates. However, after the year-end, a REIT may designate a portion of its prior year’s payouts as “qualified dividends,” which qualify for the maximum 15%/20% rates. On average, roughly 20% of annual payouts fall into this category. A REIT also may classify portions of its prior year payouts as return of capital. Return of capital payouts reduce your cost basis and are not taxable until you sell your REIT shares, when they are taxed as capital gains.
By Harry Domash
Harry Domash publishes Dividend Detective, www.DividendDetective.com.