Real estate investment trusts (REITs) tend to elicit differing opinions in this current market environment. Many bears believe that the combination of a lack of cheap capital and falling vacancies spells trouble for REITs in the near future. Others believe that the steady stream of rental incomes from various sources should tide the industry over until the recovery.

Regardless of opinion, REITs are often recommended as both appreciation and cash flow plays in an average investor’s portfolio. What is a REIT and how does one analyze a REIT properly?

For our purposes, I will only be looking at equity REITs which purchase or develop income producing real estate. Mortgage REITs are REITs which pay out distributions from the proceeds of mortgages; in Canada, these are often organized as Mortgage Investment Corporations rather than mortgage REITs.  Hybrid REITs contain a portfolio of cash flow producing properties and mortgages.

REITs- What are they?

A REIT is actually a tax designated term for a type of tax structure/security. Depending on the jurisdiction, the trust either not taxed or taxed at a very nominal rate to allow for a greater pool of income to be distributed to the individual unit-holders, who bears the tax burden. In some jurisdictions, a very high percentage of profits has to be distributed to unit-holder. Thus, they are designed by tax laws to take in income and distribute most of it to its investors.

In order to qualify for such advantages, an equity REIT generally has to be engaged in the ownership, administration and development of real estate. The proceeds of this business (i.e. rental income) forms the pool of capital to be distributed to the individual unit-holders.

Equity REITs tend to develop, own and operate residential, commercial or industrial real estate or a combination of all three types of properties.

REITs- Why invest in a REIT?

Before the real estate bubble, REITs were considered generally to be unsexy widow and orphan stocks given their ability to pay distributions to investors from plain old rental income. Given the tax advantage of a REIT, a large distribution per unit could be paid for a relatively stable asset class.

Industry studies have also shown that REIT tend to provide asset diversification from the general equity indexes when measured over long period of times.

There is some short-term uncertainty about these two advantages which, over time, should revert to the mean.

REITs- What are important factors to consider?

There are several quantitative factors to consider when looking at any REIT. I will focus on three in particular:

1. Adjusted funds from operations. This factor speaks to the substaniability of distributions. Traditional dividend analysis of dividend payout ratios is not applicable for REITs. The reason is that GAAP tends to punish real estate stocks. For example, since depreciation is booked as an expense for accounting purposes which does not directly affect cash flow, it is difficult to determine a true sense of earnings to run a dividend payout ratio. Instead, one has to use a non-GAAP measure, adjusted funds from operations, to truly determine how safe a REITs distributions are. I have previously blogged at length about REITs and adjusted funds from operations. Most REITs publish their adjusted funds from operations in their financial statements but do remember it is a non-GAAP measure.
2. Net Asset Value (NAV). This factor speaks to a REITs valuation. Again, GAAP tends to punish real estate since a real estate company books their assets at acquisition price and not at current market value. Thus, on a preliminiary analysis of the financial statements, a real estate company with a lot of older properties may not have a very good looking balance sheet with lots of expenses required to upkeep older capital assets but assets booked at book value. Accordingly, many REITs will value their business on a net asset value basis which is simply the assessed value of the real estate portfolio minus liabilities.  NAV is typically quoted on a per unit basis which gives to the investor the equivalent of price to book valuation in non-real estate stock.  Setting aside what a true valuation of property is, the question for most investors is whether the premium or discount of NAV to the trading price is above or below industry averages. Obviously, a REIT that is trading at many times the normal industry premium of NAV may trigger some concerns about it being over-valued whereas a REIT trading below an industry premium to NAV or at a discount is either a REIT in trouble or a value play. NAV is published by most REITs in their discussion to financial statements.
3. Debt Loads/loan to value ratios. This factor generally speaks to long term prospects. The Globe and Mail ran an interesting story about how the commercial real estate market, which includes REITs with properties in this sector, maybe have a difficult future ahead. Quite simply, commercial REITs are over-leveraged and their assets are falling in valuation. When the short to medium term loans become mature, IF a REIT can obtain financing, it may not have as much capital to utilize which means it either has to: (i) divest of assets; or (ii) cut distributions. There are several things to watch out for: (i) what is the current loan to value ratio of a REITs entire portfolio of real estate (a research report will probably provide this)- the lower the ratio, the better the chances are of obtaining financing since the REIT can cross-collateralize assets to decrease lender’s risk; (ii) how much cash is on balance sheet, since increasing cost of capital may have to be paid partially through revenue and partially through cash on hand;  and (iii) how much short term debt is maturing before 2012? The less the better.

REITs- the common sense approach

I work near a commercial district that seemingly is owned entirely by Allied Properties REIT. On one particular stretch of King Street West, they own 14 properties- in other words, the entire block. All the buildings are all well-maintained and look occupied (i.e. no vacancy signs outside). Not surprisingly, analysts also like this REIT.

Real estate is a very touchable class of investment so if you are interested in investing in REITs, the simple thing to do is to find out what properties they own and visit their locations. Is the site well-maintained? Is it occupied? Are the businesses busy? Would you rent there? On a fundamental basis these types of real world observations tend to reflect upwards into the financial statements.

I’ll be looking at how to invest in insurance companies in my next post in this series.