Real Estate Investment Trusts (REITs) can be a great way for investors to gain exposure to the real estate market. These investments tend to attract attention because of their high yields which can often be attributed to the requirement REITs have to pay out 90% of their taxable income to shareholders. Because of this requirement the payout ratio can be safely ignored when evaluating REITs. The SEC has a lot of really good information about what it takes to qualify as a REIT.
Before we get into what to look for in a REIT just a quick note about taxes. Dividends that are paid out from REITs can be treated many different ways. They may be ordinary income, qualified dividends or returned capital. Its important to consult a tax professional before investing in a Real Estate Investment Trust to understand how distributions will be taxed.
Types of REITs
Mortgage REITs are focused on providing financing to real estate owners. This is done by directly lending to real estate owners and operators or by buying mortgage-backed securities. Mortgage REITs can be heavily leveraged and carry exposure to interest rates.
Equity REITs own physical real estate that produces income. They can very focused and only invest or own properties that fall into a specific category. Some of these categories include tech (think data centers), healthcare facilities, apartment buildings or traditional housing.
Hybrid REITs are companies that are a combination of equity REITs and mortgage REITs.
What to look for
There are five major items I use to evaluate a REIT. While historical numbers are important it is equally important to consider the future when evaluating investments.
Yield, it’s why we are here in the first place. The higher the yield the shorter the payback period and REITs often have very short payback periods (the time it takes to regain your initial investment through yield).
Not all REIT yields are created equally because each type of trust is exposed to different factors. For example a trust that owns property and receives most of its income from rent has very different risks than a trust that lends money for property and is exposed to interest rates.
When it comes to yield and REITs its obvious that more is better, as long as its safe.
Dividend growth drives total return and capital appreciation. It is funded by increasing earnings and it is the fabric of solid upside charts that make investors smile. Without it a stock price is likely to be stagnant. That is true for almost all investment types. Our HPR rating gives special preference to stocks that have a dividend growth rate of 7% or more. Growing companies raise dividends, which increases yield and essentially pushes stock prices higher.
Funds From Operations
The FFO data point was created by the NAREIT to better measure the true performance of a Real Estate Investment Trust. Unfortunately its not an easy metric to find and its very difficult to incorporate it into a list but it is still better to measure this investment type by FFO rather than net income. FFO is found by adding depreciation and amortization to net income and then reducing that amount by realized gains or losses from property sales. It’s important to point out that these factors can be easily manipulated through shady accounting practices.
1 Year Return
Stock price appreciation is important, even with stocks that have high yields. We look at 12 month returns but smaller metrics are also important to consider before taking a new position.
And finally the most important question – Where are we headed? Here are just a few items to consider:
-Residential rental prices
-Commercial rental prices
-Real Estate Valuation
Consider the demand for the services that rent these properties. Residential rental demand is driven by home interest rates, unemployment, home ownership and rental prices. Healthcare REITs rent out healthcare facilities to service providers and tech REITs usually rent out datacenter space. Its important to determine if the demand is sustainable for each of those commercial sector types. Interest rates impact everyone and everything in our economy but they have a distinct impact on Mortgage REITs. Trusts that buy Mortgage backed Securities benefit from lower rates.