Before jumping into the essential information investors need to know about REITs to make better informed decisions, it is worth highlighting some of the sector’s appeal.
What are Real Estate Investment Trusts?
REITs: A Proven Long-term, High-yield, Equity Class
"The main reason to own REITs isn't to improve your portfolio's return, though sometimes that will happen. The bigger reason is to reduce volatility, increase diversification and provide a source of income."
And REITs have certainly done just that over the years. In about one out of eveyr four calendar years since 1975, REITs' returns varied by at least 25 percentage points from those of the S&P 500 Index, according to MarketWatch. In most of those years, REITs earned a higher return.
Furthermore, per Andrew Rubin, a portfolio manager at Fidelity, the growth rate of REIT dividends has outpaced inflation in 18 of the last 20 years, demonstrating their inflation-hedging qualities.
There are Many Different Types of REITs
- Shopping Center
- Single Family units (rental homes)
- Data Centers
- Student Housing
- Triple Net Lease Retail
- Manufactured Homes
Note that there is also a separate class of REITs known as mortgage REITs, or mREITs. These are a far more complex, volatile, and challenging class of stocks that are unsuitable for conservative investors seeking steady and growing incomes. That’s because the business model of mREITs is extremely sensitive to interest rate fluctuations (rather than steady contractual rental income).
Important REIT Financial Metrics
That’s because under generally accepted accounting practices (GAAP) a company must include depreciation and amortization of its assets into its earnings calculations. However, the unique nature of real estate assets, particularly that well-maintained properties tend to appreciate in value rather than depreciate over time, means that GAAP earnings don’t actually represent a REIT’s ability to cover its dividend or grow it over time.
Even more important is Adjusted Funds From Operations (AFFO). This is similar to free cash flow for a REIT. AFFO subtracts maintenance capital expenditures from FFO to show how much cash the company is generating after running its operations and investing enough capital to preserve what it already owns.
AFFO can be thought of as “Funds available for distribution” (FAD), and indeed some REITs actually call it that. The difference between AFFO and true free cash flow, as reported by regular corporations, is that free cash flow also includes growth capex, or the money the company is investing to expand its operations.
Investors can retrieve these figures from the company they are interested in, and they are also directly available on our website. You can see Realty Income's (O) historical AFFO and AFFO payout ratios below.
REITs Depend Heavily on Capital Markets for Growth
As a result, the balance sheet of REITs will naturally show higher debt levels than most other sectors of the market. In addition, the share count will tend to rise over time as management sells new shares to fund the company’s growth.
For example, Realty Income (O) has seen its diluted shares outstanding more than triple from 80 million shares in 2005 to 274 million shares in 2017.
In this way, quality REITs can grow over many decades, generating rising income streams and creating substantial shareholder value along the way.
Other Key Differences between REITs and Corporations
First, externally managed REITs, in which management doesn’t work for the REIT directly but is an external adviser that operates and manages the REIT’s assets, have higher operating costs. Typically the manager charges a fixed fee, a percentage of assets, for its services. There is also a performance incentive based on the growth of net asset value (NAV) above a certain hurdle rate. In other words, externally managed REITs are the real estate version of a private equity firm, and high fees can eat into long-term investor returns.
Not only does that lead to higher operating costs, and thus lower profitability, (which can make dividend growth harder), but it can also result in conflicts of interest between shareholders and management. That’s because if management is paid based on the size of a REIT’s assets, then it has an incentive to grow the REIT as large as possible, in order to maximize its own pay.
This can result in a REIT chasing after “growth at any price”, meaning buying poorer quality properties at inflated prices, funded by excessive shareholder dilution. You can see this with some of the lower quality REITs in which the share count rises high enough over time to make the NAV per share (the equivalent of tangible book value per share) stagnate or even decline.
That being said, some externally managed REITs can make good investments, but you have to be very selective and make sure that management’s interests are aligned with shareholders.
Why would anyone take the added risks of owning an externally managed REIT? Well, the best ones are managed by large asset management firms with massive scale, experience, and an army of high quality employees. They are able to make deals that smaller, internally managed REITs might not know about or be able to go after.
Regardless of whether an investor is buying shares of a corporation or a REIT, it is important to remain aware of an asset’s sensitivity to the economy. Let’s take a look at how REITs fared during the Great Recession.
Best Types of REITs for Recessions
The financial crisis decimated many retirement accounts and was filled with shocks. Many iconic dividend growth stocks proved to be vulnerable. From General Electric to Bank of America, there was no shortage of surprises.
During recessions, some businesses perform much worse than others because demand for their products and services is primarily driven by the health of the economy. Unfortunately, many economy-sensitive businesses happen to be major tenants for certain REITs.
Real estate took a big hit during the financial crisis, and many REITs were clobbered. However, some performed better than others and nicely preserved investors’ capital while continuing to provide safe dividends.
The chart below shows the total return of each REIT group in 2007, 2008, and 2009. REITs with more cyclical tenants, such as hotels, experienced a 22% loss in 2007 and a whopping 60% drawdown in 2008. While they did rebound 67% in 2009, this type of volatility isn’t exactly what every retired income investor dreams of.
Mortgage REITs were also walloped with losses in excess of 30% in 2007 and 2008, and industrial and retail REITs weren’t much better.
Fortunately, several types of REITs were not as impacted by the recession. Health care REITs were up 2% in 2007 and recorded a more modest loss of 12% in 2008. They also participated in the market’s rebound in 2009 with a 25% return. People continue to need many health care services regardless of how the economy is doing, which can make for more stable occupancy levels and rental rates for these REITs.
Self storage REITs lost 25% in 2007 but held their ground very well in 2008 with a 5% return. It is a pain to move things in and out of storage. Items are usually stored for a reason, and storage companies usually have an easier time raising prices on their customers. This, in turn, makes them more reliable businesses with fairly predictable demand.
From May 2008 through March 2009, approximately 30% of all REITs suspended, cut, or switched to paying part of their dividend in company stock, according to The Wall Street Journal.
REITs’ relatively high payout ratios and dependence on raising equity and debt to fund their business needs got them into trouble during the credit crisis when affordable capital was hard to come by.
While no one can predict when the next recession will occur, many investors are feeling cautious about another risk – rising interest rates.
Interest Rates Can Impact Real Estate Investment Trusts
This is why investors need to carefully watch a REIT’s balance sheet over time to make sure its leverage ratios don’t get too high. Typically the best REITs are run by conservative management teams that avoid overextending themselves when it comes to debt.
Rising rates can affect property values as well. Fortunately, cap rates (net operating income / the cost of a property) remain well above the 10-year Treasury yield. This healthy spread provides some cushion for commercial real estate prices if interest rates continue rising.
Not only does a potentially falling share price represent a risk that investors need to keep in mind (especially if you will need to sell shares to finance medium-term goals such as retirement living expenses), but share prices can have a direct impact on how quickly a REIT can grow.
Think of it this way. If a REIT is currently selling at X and yields 4%, then any new shares it sells also yield 4% and act as a kind of perpetual bond given the ongoing dividend payments required. And that dividend will hopefully rise over time.
If the share price then falls to 0.5X, and the yield rises to 8%, then management will need to sell twice as many shares to raise the same amount of funds. This means more dilution to existing investors and a higher future dividend cost for the company. As a result, the AFFO payout ratio will rise, dividend security will fall, and future dividend growth might be harder to come by.
In comparison, most corporations, such as Pepsico (PEP) or 3M (MMM), generate sufficient cash flow to fund their growth internally. They only issue more shares in the form of stock-based compensation to employees or to make large acquisitions.
But rising interest rates will not spell doom for the industry, far from it. After all, REITs have been around since 1960, and the industry has managed to thrive under interest rates as high as 21%.
Indeed, REIT.com noted that REITs outperformed the S&P 500 with a total cumulative return of approximately 80% while the Fed raised rates from 2004-2006. Nareit's John Worth also noted that REITs have recorded positive total returns in 87% of prior periods of rising interest rates, outperforming the S&P 500 in more than half of those times.
Standard and Poor's published a study analyzing the impact of rising interest rates on REITs as well. The company noted that “when expectations about future interest rates change suddenly, REITs have often experienced high volatility and rapid price changes.”
“Ultimately, whether interest rates are rising or falling does not seem to be the key driver of REIT performance over medium- and long-term periods. Rather, the more important dynamics to address are the underlying factors that drive rates higher. If interest rates are rising due to strength in the underlying economy and inflationary activity, stronger REIT fundamentals may very well outweigh any negative impact caused by rising rates.”
REIT management teams have had years to prepare for their businesses for the prospect of higher interest rates. As of the fourth quarter of 2017, REITs have clearly taken a number of actions to shore up their balance sheets and lower their exposure to interest rates. Compared to the pre-financial crisis period, they appear to be in great shape.
With that said, base rates have never been this low for this long. Unusually strong price volatility could ripple across the REIT sector if the Fed continues raising rates at a brisk pace over the coming years, and investors need to be mentally and financially prepared.
Focusing on REITs with experienced management teams, ones that have a proven track record of generating strong shareholder value and rising dividends, is all the more important in higher interest rate environments.
Closing Thoughts on Investing in REITs
However, as with all investments, moderation is key to long-term success. The Real Estate sector only accounts for around 3% of the S&P 500 Index, and REITs possess a number of unique risk factors: interest rate sensitivity (especially given the unprecedented era of low rates we have been living in), a need to access debt and equity markets to raise capital, high payout ratios, unique tax treatment, etc.
Therefore, it seems most prudent to limit a portfolio's REIT exposure to no more than 15% to 20% of its overall value. If you are selective in which REITs you invest in, focus on the most important industry-specific metrics such as AFFO, and remain properly diversified, this sector can make a solid addition for many dividend portfolios.