Wednesday, September 21, 2016

What is REIT?

REIT is by far the easiest way for an individual to invest in residential and commercial real estate. A real estate investment trust is a company or financial entity that owns and in many cases operates income producing real estate properties.

Credit: CC0 Public Domain - Pixabay
A REIT is made of a portfolio of properties; therefore, you can think of REIT as a mutual fund of Real Estate. When you buy a share in a given REIT, you are essentially buying a share in a portfolio of rental properties owned and managed (in most cases) by a REIT company. This gives you an instant diversification in real estate while avoiding all the usual headaches of managing a rental property yourself.

Many people like investing in private real estate properties like a rental homes, duplex, or apartment complexes, and don't mind having to manage their properties themselves. I would say that's great for them; however, I believe REITs can still provide value for such investors by giving them the ability to invest in large portfolio of properties including high priced industrial and commercial real estate that they would likely not be able to invest privately unless they have 100s of millions of dollars and a big team to manage such properties.

Personally, I love investing in REITs and I have approximately 25% of my portfolio invested in high quality REITs. The reason I like investing in REITs is because of their ability to return 90-100% of their taxable income to shareholders in the form of higher dividends. REITs also allow me to invest in real estate, an area I wouldn't be normally invested otherwise, mainly due to all the headaches that come with having to manage and maintaining properties while finding and keeping good tenants. It's also capital intensive investment and normally require people to take multiple mortgages to fund their property purchases. Let's just say I am not made up to deal with all the stress of owning and managing my own rental properties besides I hate debt of any kind including mortgages.

Therefore, if you like investing in individual stocks or ETFs and want a low stress way to invest in real estate, REITs can be a good option for you.

Some people look at investing in REITs as high risk. I believe some of this fear may have been instigated by investing in riskier Mortgage REITs which make money by borrowing short-term to buy long-term mortgage-backed securities. I would call out that I do not invest in Mortgage REITs and only invest in Rental REITs that buy tangible income generating rental properties.

Also, just as any other stock or investments, the investor has to make sure they understand risk vs. return and invest according to their tolerance to risk.

Below is some additional information I have gathered to help you get educated on REITs and how you can take advantage of this highly profitable investment vehicle.

History
REITs have been around since 1960. They have been publicly trading on stock market under the Financial Sector. They make up about 20% of Financial Sector and have been a strong and reliable source of dividend income for income seeking investors.

Recent Highlights
  • REITs separated from financials this week
  • Are now a new 11th sector of S&P 500, previously 20% of Financial Sector
  • REITs are 3% of S&P 500
  • Average dividend yield is around 4% as of writing this article, though historically they have been much higher
Performance
REITs benefit from low interest environment and have been posting robust earnings. As of second quarter, the total FFO (Funds-From-Operations) increased 7.1%. FFO is more important for REITs than earnings alone due to the real estate nature of their investments and how amortization and property depreciation can dilute earnings.

Till very recently REITs have outperformed the overall market. However, given the expected increase in interest rates this year, REITs have been under pressure and are expected to lose some pricing ground which may provide a good entry point for new investors.

How are REITs Traded?
There are both Publicly and Privately owned REITs. The publicly owned REITs are traded as common stocks on the stock market where anyone can buy or sell their shares. Similar to any other publicly traded company, REITs have to be registered and abide by the SEC reporting and disclosure filing requirements.

Privately owned REITs are not traded on stock market and even though they are required to register with SEC, they are required to do little in the way of disclosure. There is also a higher upfront cost for investors and redemptions are generally permitted after two to three years of initial investment date.

I only invest in publicly traded REITs due to ease of trade and liquidity provided by the market in addition to the transparency of financial reporting and governance requirements.

REIT Sub-Sectors
There are multiple sub-sectors within the major S&P 500 REIT sector. Each sub-sector focuses on a specific category of properties. There are about 12 different REIT sub-sectors ranging from residential to industrial properties with everything in-between. Here is a short list of these sub-sectors:

Retail REITs - These are REITs that mainly own and operate retail properties such as buildings for big box retail stores and large regional malls.They have been somewhat under pressure due to competition from online retail giant Amazon; nevertheless good source of rental income.

Residential REITs - They buy and manage various forms of residential rental properties. They specialize in apartment buildings, single family manufactured homes. and student housing. For people who want to buy a rental home or property, investing in Residential REITs could be a very good and low overhead option.

Industrial or Infrastructure REITs - They invest in large industrial properties such as warehouses and industrial complexes. There tenants are usually high grade investment grade such as big multi billion dollar corporations. Companies like FedEx, Coca-Cola, Best Buy, and GE lease properties from Industrial REITs. These REITs have very high quality tenants with lease periods ranging from few years to 10+ years.

Healthcare REITs - Invest in senior living and medical properties. This is one of the fastest growing REIT area due to growing demand for senior living properties as well as medical offices, skilled nursing facilities, and hospitals.

There are many additional REIT sub-sectors or categories that own properties and have tenants in highly diversified areas such as technology, data centers, entertainment, self-storage, farming, gaming and leisure. You can see the full list of REIT sub-sectors here: Reit-sectors.

Tax Treatment
By law REITs have to return 90-100% of their taxable profit to share/unit holders. Shareholders are responsible for the taxes. Unlike ordinary dividends, the dividends payed by REITs are taxed as ordinary income unless they are considered to be "qualified dividends" or "Return on Capital". Your broker will normally keep track of what percent of the dividends payed were ordinary dividends vs. capital gains vs. return-on-capital, and then it will be all reported in your 1099 tax form that you receive from your brokerage for each tax year. I know it sounds complicated, but it's quite straight forward as it is all tracked and reported to you by your brokerage. All you need to do is provide that information to your tax accountant or enter yourself in the tax preparation software (which is what I do) at the time of filing your taxes.

Note though that there are different tax treatment for each type of divided I mentioned above. For example, dividends payed as ordinary income are taxed at your normal income marginal tax rate vs. dividends paid as return-on-capital are taxed by lowering your cost basis (price you paid when buying shares/units of a REIT). Dividends payed as "qualified dividends" are taxed at a lower tax rate, currently 15% unless you are in the highest tax bracket.

I have been investing in REITs for many years and in my experience I have seen a big portion of my REIT dividends distributed as ROC (return-on-capital). I like ROC treatment because it allows me to deffer paying taxes till the time I actually sell my shares. This means, I can essential deffer paying taxes on ROC dividends as long as I don't sell my shares, and when I finally sell my shares, the dividends will be taxed as long-term capital gains at a favorable tax rate. Therefore, there are tax benefits for investing in REITs.

Valuation
REITs have been trading at a very high valuation since last year, similar to Utilities. This is mainly due to low interest rate environment and push from investors to seek high yields. Most high quality REITs are currently trading at P/FFO (Price-to-FFO) multiple of 20+ which is historically quite high.

REITs are interest rate sensitive and therefore, I would hold-off buying REITs right now and wait for a good entry point after Feds announce interest rate hike (expect rate increase by December this year).

I would use the current waiting period to do my research and build a watch-list for high quality REITs that I would like to buy at fair or preferably below fair valuation. Normally, a fair valuation would be around Price-to-FFO ratio of 15 or in other words when REIT is trading around 15 times the last year's FFO. Of course, there are always fast growing companies that tend to trade at high FFO multiples. For such a fast growing company, I would look at where the company has been trading for the past 3-5 years and then use it to determine its fair P/FFO.

Therefore, a P/FFO ratio of 15 is typically a fair multiple for an average growth rate company, but likely too low of a valuation for a fast growing company. For this reason, an investor must pay attention to the earnings or FFO growth rate while using such valuation metrics.

Similar to forward PE, for a REIT, I would look at its forward P/FFO ratio to ensure current valuation is inline with the future FFO growth estimates of the company. I would also ensure that all REITs on my watch-list have a long history of growing FFO, BBB or above credit rating, low dividend-to-FFO payout ratio, and dividends are fully covered by FAD (funds-available-for-distribution). Think of FAD as free cash flow which is the left over cash after paying all operation/investment related expenses.

I also like to limit how much I invest within a given sector and would trim my existing overweight/overvalued REIT positions to raise cash and make room for newer positions when next buying opportunity or correction comes.

Where to Start?
One way to start investing in REITs is through ETFs (Exchange Traded Funds). There are numerous ETFs that are currently available including some of the most popular ones such as Vanguard's VNQ (ticker symbol) and IShares IYR (ticker symbol). These are real estate or REIT index funds that invest in a broader REIT industry; thus providing a simple and low cost option for an individual investor to invest in real estate.

By looking at the top 10 holdings of these ETF funds (available through their prospectus) which normally consists of blue-chip REITs, an investor can then either do their own research and decide which ones of those top REITs they would like to own or simply buy the entire ETF. Similar to other low cost Index ETFs, these REIT ETFs provide an excellent and low cost method for anyone to invest in the REIT sector.

From risks perspective, ETFs are not immune to broader market or sector specific risks or in the case of REITs interest rate related risks. Therefore, when investing in such ETFs (or individual REITs), an investor must read and understand ETF's investment profile and risks involved due to pending interest rate hike.

Another great resource for REIT related research is SeekingAlpha.com website. Brad Thomas is one of the resident experts on REITs and has written a treasure trove of research articles covering all types of REITs. I would highly recommend anyone interested in investing in REITs to read some of Brad's articles. To find Brad's articles, just go to seekingalpha website and do a search for his name.

Summary
REITs are a good way to invest in real estate and get the diversification across many sectors of real estate without requiring huge amount of capital and management infrastructure. However, just like with any other stock or investments, there are risks involved and an investor must do their due diligence and/or seek professional advising before investing.

Disclaimer: Author of this article is not a licensed/registered financial or investment advisor and does not provide investment advice. This article is for informational purpose only. Please use your own judgment or seek a licensed financial advisor before investing. You, the reader, bear responsibility for your own investment and financial decisions.  

8 comments:

  1. I LOVE REITs! Especially the commercial real estate REITs. For the most part, they're relatively safe (although equities are always so risky) and their dividend payout, I can't complain about the yield. VNQ pays out a 3.82% yield (as of close yesterday), which is a really hefty amount. I wish my 401k provider had VNQ as one of their investment options but sadly it does not. I do have a lot of room for it in my post-tax account, however.

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  2. That's the downside of 401Ks. They limit our investment choices and some don't even offer low cost index funds. My 401K is full of target date funds and expensive managed funds. Luckily it does offer a S&P 500 Index Fund (VIIIX) which is where I invest.

    REITs are awesome, a year or two ago they were yielding upward of 6%. Right now they are overvalued and the average yield has come down to around 4%. I would wait for interest rates to go up before buying any new shares in REITs.

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  3. Thanks for providing an in depth look at REITs. I thought I knew a lot already but really learned a lot.

    I too am a big fan of REITs. Personally, I hold my REITs in my Roth IRA where it can grow tax free so that I don't have to pay ordinary income taxes on the distributions each year.

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  4. You welcome and thank you for reading. Yes tax deferred/protected accounts such as IRA/Roth-IRA are a great place for buying REITs.

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  5. Which specific REITs are you invested in?

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  6. I am long O, DLR, HCN, WPC to name a few.

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  7. REITs are a great performer lately but the specter of interest rate hikes may send investors scurrying a bit in the near/long term since their performance is so dependent on the search for yield. I do aim for a 10% allocation to REITs so I'll just buy more if they under perform in the short term. I also recommend just having them all in your tax-advantaged accounts so they can grow tax free since so much of their performance is dividend driven.

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  8. Yes good point regarding keeping REITs in tax-advantaged accounts; especially, if you don't need their dividends for current income.

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