Real Estate Investment Trusts REITsInvesting in Real Estate Investment Trusts (REITs) can provide dividend investors with high yields, steadily growing payouts, nice diversification, and an attractive income stream for retirement living.

 

However, REITs have a number of complexities and risks that should be understood before making any investments.

 

Before jumping into the essential information investors need to know about REITs to make better informed decisions, it’s worth highlighting some of the sector’s appeal.

 

For one thing, $100 invested across all REITs in 1971 would have grown to nearly $6,000 in 2015, representing compound annual growth of about 10%:

 

Real Estate Investment Trusts REITs

Source: Simply Safe Dividends, REIT.com

 

When it comes to building wealth few industries are more time tested, or successful, than real estate. In fact, real estate is the third biggest creators of the world’s billionaires:

 

Real Estate Investment Trusts REITs

Source: Forbes

 

This is understandable given that real estate has a several built-in advantages that naturally make it appreciate in value. For example, the growing global population generally leads to both economic growth and higher demand for land and properties involved in housing and industrial development.

 

In addition, the ability to use leverage (i.e. buying real estate properties with debt, such as a mortgage) means that investors can generate substantial returns on investment.

Furthermore, real estate is usually a cash rich business thanks to rent income, which makes this kind of investment highly attractive to long-term investors. And finally we can’t forget the numerous tax benefits of real estate, including the ability to deduct depreciation expenses from earnings, and mortgage interest from taxable income.

 

But for most retail investors, the idea of investing in real estate other than their own homes can be intimidating. After all, owning a rental property can be extremely hands on and time intensive. In addition, there are numerous legal implications, as well as risks that becoming a landlord involves, that most people simply don’t have the time or desire to get involved with.

 

Fortunately, there is a much simpler way for long-term income investors to profit from real estate, one that is no more difficult than buying shares on a stock exchange.

 

What are Real Estate Investment Trusts?

Real Estate Investment Trusts, or REITs, were created in 1960 as a new, tax efficient means of helping America fund the growth of its rapidly increasing demand for all types of real estate.

 

Basically, REITs are pass-through equities in which the company pays no federal income tax as long as it pays out at least 90% of its taxable income as unqualified dividends to investors.

 

The result is a naturally high-yielding class of equities in which the business model is predicated on constantly raising new external growth capital from the debt and equity markets in order for management to grow its portfolio of cash producing properties; thus allowing dividend growth over time.

 

And since market studies show that a good rule of thumb for long-term total returns, which include dividend reinvestment, is yield + dividend growth, rising dividends generally result in share price appreciation.

 

REITs: A Proven Long-term, High-yield, Equity Class

Over the last few decades REITs have proven themselves one of the best long-term ways for investors to build income, and wealth over time. As you can see, REITs have not just held their own nicely against both large cap companies, such as make up the S&P 500, but also small cap stocks. Meanwhile they have handily outperformed bonds, and inflation, as one would hope from equities, which have more built in risk than bonds, and should thus offer an appropriate risk premium.

 

Real Estate Investment Trusts REITs

Source: REIT.com

 

This great long-term performance has resulted in the REIT industry growing over the decades to over $1 trillion in market capitalization, and holding over $2 trillion in total assets. The industry has grown so large in fact, that S&P has recently changed its Global Industry Classification Standard, or CIGs system to make REITs its own sector, rather than grouping REITs into finance.

 

This change represents the growing importance of REITs to the overall stock market, and is likely to result in far more interest from institutional money, thanks to the need to hold prominent REITs as part of increasingly popular index funds. Which means that, going forward REITs should represent a potentially even more popular, liquid, and potentially less volatile asset class.

 

There are Many Different Types of REITs

While all REITs are similar in many ways, investors need to realize that this sector encompasses a vast array of differing real estate assets:

  • Office
  • Industrial
  • Shopping Center
  • Malls
  • Single Family units (rental homes)
  • Apartments
  • Medical
  • Data Centers
  • Student Housing
  • Hotels
  • Triple Net Lease Retail
  • Manufactured Homes
  • Storage
  • Timber
  • Infrastructure

Investors can view a complete list of REITs here.

 

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 higher-yielding class of equities that isn’t suitable for investors seeking steady and growing incomes. That’s because the business model of mREITs is extremely interest rate sensitive.

 

It’s based entirely on buying and selling mortgage backed securities, and involves little or no owned properties. Therefore it should be owned only by the most risk-tolerant investors, who are willing to put in the extra effort to find only the best mREITs, hold throughout periods of falling dividends, extreme volatility, and buy on the corresponding dips, corrections, and crashes.

 

Getting back to traditional property-based REITs, as you can see from the above list there is a vast universe to potentially own, each with its own various nuances that investors need keep in mind. However, all REITs share common characteristics in that they derive the majority of their cash flow, which is what secures and grows the dividend, from real estate properties and rental income from tenants.

 

Important REIT Financial Metrics

Of course, being that REITs are generally owned as high-yield, dividend growth investments, naturally the dividend profile is the first thing that you’ll want to look at when performing your due diligence before investing. This consists of three factors: yield, dividend safety, and potential long-term growth prospects.

 

The most important of these is dividend safety, because nothing can potentially generate permanent losses of investor capital than a dividend cut, which generally sends shares crashing. However, because of the way REITs are structured for tax purposes, traditional methods of measuring dividend safety, particularly the EPS payout ratio, are not good means of knowing whether or not a payout is actually safe.

 

That’s because under generally accepted accounting practices, or 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 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.

 

What you instead want to look at is funds from operations, or FFO. This is the REIT equivalent of operating cash flow. It adds back non-cash expenses such as depreciation and amortization back into net income, and subtracts gains or losses on asset sales; such as any properties that management may have sold over a period of time. The “EPS Payout Ratio” charts in our Stock Analyzer add back depreciation and amortization to net income for REITs.

 

Even more important is Adjusted Funds From Operations, or AFFO. This is the equivalent of a REIT’s free cash flow, or FCF. It subtracts maintenance capital expenditures, or capex, 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.

 

This can be thought of as “Funds available for distribution” or 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 FCF also includes growth capex, or the money the company is investing to grow.

 

Investors can retrieve these figures directly from the company they are interested in. Take a look at one of Realty Income’s (O) quarterly earnings reports here. You can see that AFFO per share was 71 cents versus reported net income per share of 27 cents. The company paid dividends of 59.7 cents per share during the quarter, representing a reasonable AFFO payout ratio near 85%.

 

There are several financial metrics beyond the payout ratio that dividend investors really need to understand. Investors can review the top 10 financial ratios I think are most important for investing here.

 

In addition to the unique non-GAAP figures reported by REITs, investors need to be aware that these companies rely on issuing debt and equity to keep their businesses running.

 

REITs Depend Heavily on Capital Markets for Growth

Because REITs are legally only allowed to retain a maximum of 10% of taxable earnings, they must use debt and sell additional shares to fund growth of their assets, such as acquiring new properties or improving existing ones.

 

This means that 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 nearly triple from 80 million shares in fiscal year 2005 to 236 million shares in fiscal year 2015.

 

Real Estate Investment Trusts REITs

Source: Simply Safe Dividends

 

While a rising share count means that existing investors are getting diluted, unlike regular companies, this isn’t necessarily a bad thing. That’s because, as long as the additional money raised by selling new shares and/or taking on new debt results in AFFO per share growing over time, the capital raise is known as accretive.

 

This means that the increase in AFFO is more than the rise in share count, meaning that AFFO per share rises over time. That not only makes the existing dividend more secure, but also allows for dividend growth, which causes the yield to rise, attracting new investors, who bid the share price up. In this way, quality REITs can grow over many decades, generating exponentially rising income streams, and massive shareholder value.

 

Other Key Differences between REITs and Corporations

There are two other key things to remember about REITs that are slightly different than most other dividend-paying c-Corps.

 

First, due to how they structured for tax purposes, remember that REIT dividends are unqualified, meaning they are taxed as regular income, and thus at your top marginal income tax rate. This means that they make great candidates for tax-sheltered accounts such as IRAs. Investors can learn more about which type of IRA is better for dividend-paying stocks here, and a deeper look at how REITs are taxed can be found here.

 

A second important factor is to know whether or not the REIT is internally or externally managed. Most of the bigger, more popular REITs such as Realty Income (O) or Welltower (HCN) are internally managed, and this is generally preferable to an externally managed structure.

 

That’s for two main reasons. 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, or 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 because the best ones are managed by large asset management firms with massive scale, experience, and an army of high quality employees. Thus 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’s 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

Many dividend investors are conservative by nature. They aren’t worried about trying to beat the market but are instead focused on generating safe, growing income while preserving their capital. For this reason, they like to focus on companies that have reliably grown their dividends over time. Dividend aristocrats are one such group of businesses, and a full list of these stocks can be seen here.

 

The financial crisis decimated many retirement accounts, and it’s important that we never forget the painful lessons it taught us. Many of these lessons are incorporated into our Dividend Safety Scores to help us avoid making the same mistakes.

 

The last recession was filled with surprises. 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’s 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 reliable tenants with fairly predictable demand.

 

Real Estate Investment Trusts REITs

Source: Simply Safe Dividends, REIT.com

 

In addition to the drop in many REITs’ stock prices, dividends also proved to be quite vulnerable during the recession.

 

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 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

A key detail to keep in mind when considering investing in REITs, especially today with global interest rates at the lowest level in human history (see below), is that REITs can be highly sensitive to changes in interest rates.

 

Real Estate Investment Trusts REITs Interest Rates

Source: Business Insider

 

REITs are sensitive to interest rates mainly for two reasons.

 

First, because of their business model, in which most growth capital comes from debt or equity, higher interest rates means higher borrowing costs. That’s either from taking on new loans, or merely rolling over (i.e. refinancing existing debt). This is why you want to carefully watch your REIT’s balance sheet over time to make sure it’s 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.

 

Realty Income (O) is arguably one of the most conservatively-managed REITs. As seen below, the company has kept its long-term debt to capital ratio stable below 50% (my personal preference for an upper limit) for many years:

 

Real Estate Investment Trusts REITs

Source: Simply Safe Dividends

 

However, another reason REITs are interest rate sensitive, especially in today’s interest rate environment, is because many investors are yield-starved by low bond rates. Thus, REITs, especially blue chip names such as National Retail Properties (NNN), or Ventas (VTR), are seen as safe, higher-yielding bond alternatives.

 

This explains why REITs have done so stunningly well over the past few years, as income investors have bid up their prices due to their generous, secure payments and stellar track record of consistent dividend growth over time. This is a problem that is shared with many of today’s most beloved dividend blue chips such as Coke (KO) and Johnson & Johnson (JNJ).

 

However, the thing to remember is that the Federal Reserve is attempting to normalize rates. This means bringing them closer to their historic average of 5.85% between 1971 and 2016; up from the current rate of 0.5%.

 

Now don’t get me wrong, I’m not saying that rates will get that high anytime soon, if ever. In fact, as you can see from the Federal Reserve’s own projections below, the Fed’s short-term Fed fund rate, which sets the prime rates that banks charge their most creditworthy customers, isn’t expected to rise above 3.25% even by 2020. And while short-term and long-term rates aren’t precisely correlated, they generally rise and fall together. That means that if rates do rise by 2.75% over the next three years or so, that yields on 10 and 30 year Treasury bond might rise to as high as 4.35%, and 5.1%, respectively.

 

Real Estate Investment Trusts REITs Interest Rates

Source: Bloomberg

 

Today, high-quality REITs such as W.P Carey (WPC) and Digital Realty Trust (DLR) typically yield between 3%, and 5%. If the risk-free rate of return (i.e. Treasury bond yields) rises high enough, then the same group of investors that have piled into REITs over the last few years could reverse course and send share prices much lower. This intuitively makes sense, because any individual stock is naturally much riskier than US Treasuries, even the highest quality “sleep well at night,” or SWAN, REITs.

 

Thus, investors will demand a risk premium in the form of higher yield to own such stocks, and since yields and share prices are inversely correlated, the rise in yields means a fall in price.

 

Not just 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.

 

Remember that REITs are periodically raising growth capital by selling new shares. So if the share price falls too low, it can become harder to grow because the cost of that capital might get too high. 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. Except one that’s dividend will hopefully rises over time, meaning the yield on that particular bit of capital will too.

 

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 funds. This means more dilution to existing investors, and a higher future dividend cost for the company. That will mean that the AFFO payout ratio will rise, dividend security will fall, and future dividend growth might be harder to come by.

 

In comparison, most c-Corps, such as IBM (IBM) 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, and hopefully smart, acquisitions.

 

I’m not trying to say that rising interest rates will necessarily 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. S&P also published a study analyzing the impact of rising interest rates on REITs. S&P noted that “when expectations about future interest rates change suddenly, REITs have often experienced high volatility and rapid price changes.”

 

However, the firm made the following conclusion:

“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.”

Investors need to be careful to buy REITs with experienced management teams, ones that have a proven track record of generating strong shareholder value, and rising dividends, in higher interest rate environments. Short-term price volatility could ensure across the REIT sector if the Fed begins to raise rates more consistently over the coming years, and investors need to be mentally and financially prepared.

 

How to Analyze a REIT

Let’s go over an example of how to analyze a REIT, using Realty Income, “the monthly dividend company,” as an example. This is one of the oldest and most popular REITs thanks to its exceptional track record of slow but steady dividend growth though all types of economic and interest rate environments. Realty Income has been the definition of a blue-chip dividend stock.

 

Real Estate Investment Trusts REITs

Source: Realty Income Investor Presentation

 

First, looking at the dividend profile we can see that Realty Income’s yield is far more generous than what the S&P 500 is offering. However, note that, while the payout ratio appears very high, for a REIT, especially one with as vast, diversified, and long-term contracted rental income stream as Realty Income, this is actually a safe level.

 

REIT Yield Q2 2016 AFFO Payout Ratio 10 Year Dividend Growth Projection 10 Year Projected Total Return
Realty Income 3.6% 85.4% 4.2% 7.8%
S&P 500 2.0% 39.1% 6.2% 9.1%

Sources: Yahoo Finance, earnings release, Fastgraphs, Factset Research, Mutlipl.com, Money Chimp.com

 

Remember that a REIT must pay out 90% of taxable income as dividends, meaning that its AFFO payout ratio will naturally be high; usually between 70% and 90%. So as long as a REIT is in the 80’s or below, and more importantly, has a long track record of stable payout ratios in this range, investors can remain confident of the safety of the payout under normal economic conditions.

 

Now, in terms of future dividend growth analysts aren’t expecting much, thanks to Realty Income’s already large size, which makes growing the portfolio, and thus AFFO, harder than in the past. That being said, keep in mind that analysts have a tendency to fall victim to “recency bias,” meaning they project the most recent results far into the future.

 

In this case, Realty Income’s most recent AFFO per share growth has been 4.4% in the first half of 2016. However, this has also been a time when Realty Income’s shares have soared to all-time highs, so management has wisely been using its expensive shares as currency to fund property growth, while also strengthening the balance sheet by bringing down its leverage ratio.

 

In other words, management has been purposely holding back on borrowing, which would create leverage that allows for less investor dilution to take advantage of the high share price. Even if a big acquisition isn’t in the cards, by raising high amounts of cheap equity capital when the shares are arguably overvalued, Realty Income’s management team will have greater flexibility to continue growing even if the economy takes a downwards turn and a falling market sends the share price crashing.

 

That’s a very wise move, because recessions are the best time for long-term focused REITs to acquire quality properties on the cheap. So deleveraging now, by choosing cheap equity funding over debt leaves Realty better poised to take advantage of future growth opportunities.

 

Why this matters is because the recent rise in share count, which results in slower AFFO per share growth, may turn around in the future, when management takes on more debt to take advantage of undervalued properties, and thus grows its AFFO stream while keeping share count constant. In other words, the recent slow growth in AFFO per share is something that is likely temporary and a choice that management is making to take advantage of current market conditions.

 

Speaking of balance sheets, here is Realty Income’s. As you can see the retail triple net lease REIT space is one where high leverage ratios (Debt/EBITDA) are the order of the day. So it’s important to note, that while Realty Income’s leverage ratio may initially appear very high, in fact it’s better than most of its rivals. In addition, the high interest coverage ratio means that the company should have little problem servicing its debt; the reason that its credit rating is among the highest in its industry.

 

REIT Debt/EBITDA EBITDA/Interest Debt/Equity S&P Credit Rating
Realty Income 5.14 4.12 0.77 BBB+
Industry Average 6.54 NA 1.78 NA

Source: Morningstar, Fastgraphs

 

This combination of strong dividend coverage, and a solid balance sheet is partially why Realty Income will likely be able to maintain long-term dividend growth closer to 5% to 6% per year, similar to this year’s 6.1% payout increase. That would make for a projected total return of 8.6% to 9.6%, which is in line with the market’s historical 9.1% CAGR since 1871.

 

However, keep in mind that basically matching the market in terms of total returns isn’t necessarily a bad thing, especially considering the yield is nearly double that of the market’s and Realty Income is a much less volatile stock than most. Specifically its beta is one of the lowest you can find, at 0.39. This means that Realty Income is 61% less volatile than the S&P 500, making it an ideal, core holding for high-yield portfolios.

 

For more fundamental analysis of Realty Income’s business, please see my whole investment thesis here.

 

Closing Thoughts on Investing in REITs

Despite their unqualified dividend status and interest rate sensitivity, REITs have proven to be an amazing long-term wealth building tool over long periods of time, especially for high-yield investors.

 

As long as you embrace effective investing habits, remember to be 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 great core holding for many dividend portfolios.

 

Many REITs currently look expensive relative to their historical valuation multiples. Record low interest rates around the world have made REITs an especially appealing asset class in recent years.

 

Price volatility seems likely should the Fed actually begin raising interest rates, but this event is more likely an appealing buying opportunity for patient long-term investors. I know I will certainly be watching the sector closely for opportunities for our Conservative Retirees dividend portfolio.

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