One of the most important investing struggle is related to buying. A lot of investors will tell you that you don’t make money when you sell a stock. You really make your money when you buy. Buying the right asset at the right price and at the right time has been known for years to really be the key to a successful investment. I, in turn, believe that a solid buying process combined with discipline will pay off. Today, I will give you guidelines to increase your confidence with REITs, and hopefully your success, when clicking on the “buy” button.
REITS often look attractive for income-seeking investors because they offer good yields. Since REITs are a different type of corporate structure, they deserve to be addressed differently too. Usually, I like to start with the dividend triangle to analyse a stock. This methodology covers all “regular companies”, but not REITs and other businesses that use non-conventional metrics instead of EPS.
First, Let’s Recap What’s a REIT
REITs are like MLPs in the sense that they are tax-advantaged investments. They pay no corporate tax, but in return, they must meet certain guidelines. They must invest primarily in real estate, and must pay out most of their net income as dividends.
REITs can be good investments because they typically offer above-average dividend yields and can give an investor exposure to real estate without the typical difficulties of owning real estate directly (low liquidity, responsibility for maintenance, etc.).
Equity REITs own and invest in property. They may own a diversified set of properties, and they generate income primarily in rent payments from leasing their properties.
Mortgage REITs finance property. They generate income from interest on loans they make to finance property.
Hybrid REITs do a bit of both, as they own property and finance property.
REITs Valuation Metrics
Valuing a REIT is like valuing any stock. Much like with MLPs, I generally utilize the Dividend Discount Model to value them, since most of their profits are paid as dividends.
There are, however, a few key metrics to know.
Net Asset Value is another estimate of intrinsic value. It’s the estimated market value of the portfolio of properties, and it can be determined by using a capitalization rate on the current income that is fair for those types of properties. This can potentially understate the value of the properties, because properties may appreciate rather than depreciate over time. Compare the NAV to the price of the REIT.
The Funds from Operations (FFO) are far more important than net income for a REIT. Similarly, earnings mean almost nothing for a MLP, and instead it’s all about the cash flow. To determine net income, depreciation is subtracted from revenues, but depreciation is a non-cash item and may not represent a true change in the value of the company’s assets.
So FFO adds back depreciation to net income to provide a better idea of what the cash income is for a REIT.
Adjusted Funds from Operation (AFFO) is arguably the most accurate form of income measurement of all with regard to REITs, since it takes FFO but then subtracts recurring capital expenditures on maintenance and improvements. It’s a non-GAAP measure, but a very good measure for the actual profitability and the actual amount of cash flow that is available to pay out in dividends.
Overall, it’s good to look for REITs that have diversified properties, strong FFO and AFFO, and a good history of consistent dividend growth.
REIT Advantages and Disadvantages
The advantages and disadvantages of REITs are like that of MLPs. They typically have high dividend yields, but their dividend growth rates are generally on the lower side. They rely less on issuing new shares.
-REITs typically have above-average dividend yields.
-REITs serve as good protectors from inflation. If inflation occurs, property values and rents should increase over time, but fixed-interest debt that’s used to help finance the properties will not.
-Real Estate, if managed conservatively, can be a very reliable investment in terms of cash flow and in terms of dealing with recessions – assuming rents are paid by the REIT’s tenants.
-REITs often have low dividend growth.
-REITs generally utilize debt to add to their property portfolio, but they typically make up for larger debt loads by using that debt for conservative, appreciating assets.
-Since REITs must pay out most of their income as dividends, they have little downside protection from recessions. They may have to trim the dividend if their cash flow dips below their distribution levels. There are, however, some REITs that have developed good track records of consistent dividend growth.
Understand the Business Model
Finally, if you don’t understand how a company makes money and how it will grow in the future, just skip to the next one. The point is to be able to explain what a company does (and how it will grow) to a 12 year old. If you can’t put it in simple words, chances are you don’t fully grasp what’s happening. If you can’t, don’t feel bad (it happens to me too!) and just focus on the stocks you can fully grasp.
I believe one should ever invest >20% a single sector. The more you add past 20%, the more volatile your portfolio may be. When the market drops, it affects all sectors. Each crisis will be particularly hurtful for a few industries. We never know which ones will suffer the most. No matter how stable they look, REITs are no exception. The secret really is in your sector allocation. The key is to hold some of the best companies from each industry sector.
Thanks. I found your explanation a very useful overview of REITs.
Nice intro to REITs. One major advantage you missed is taxation. Not having ti pay current taxes on depreciation and deducting a portion of the dividend from income. Also, participating in capital gains when a REIT sells a property that appreciates from a higher price compared to the adjusted cost basis.