We will introduce you to REIT investing. We have invested in REITs for over 20 years. This is what you need to know before you invest in them.
- REITS are a popular investment choice for retirees, income investors and many others. We talk about what they are.
- We talk about REITs from the very beginning and discuss what you need to know about them.
- We also talk about the best REIT sector to invest in if you are starting out.
Real Estate Investment Trusts (REITs) are a relatively new investment sector in the public stock markets. Stocks have been around for more than 100 years in public exchanges, whereas REITs have been generally available at scale for only about 30 years.
REITs have reach critical mass as they have been recently assigned their own sector, separate from general financial service companies in the S&P500 index. This delineation puts REITs out front and center as a potential investment for professionals and individual investors.
As with any investment, you should know the potential risks and rewards of them. REITs are no different. There are investment newsletter writers who focus solely on REITs as well as other writers who offer REIT investing as part of portfolio planning. Before you consider using one of these services or invest on your own, you should get the full story on REITs.
The intent of this article is to introduce you to the REIT sector objectively as well as offer a good starting place to consider for investment.
The Very Beginning
The first thing to understand: what is a REIT?
Under U.S. Federal income tax law, a REIT is “any corporation, trust or association that acts as an investment agent specializing in real estate and real estate mortgages” under Internal Revenue Code section 856. REITs are often found as publicly traded companies, but many more are not.
REITs are creatures of the U.S Federal tax code and are formed not as pure corporations but their own special federal designation with a set of qualifications.
This is the very first point to understand about REITs. They are not the same as other investments you are familiar with such as Apple ($AAPL) or Disney ($DIS). They are similar in that they can be publicly traded investments and can raise money like other equities, either by issuing debt or equity just like common stock companies.
This chart summarizes the differences with REITs versus common stocks.
REIT | Common Stock | |
Publicly traded on stock markets | Yes | Yes |
Raise equity, issue debt | Yes | Yes |
Pay corporate income taxes | No | Yes |
Required to pay profits out to shareholders | Yes | No |
Qualified capital gains | No | Yes |
Qualified business income deduction | Yes | No |
Pay dividends | No | Yes or No |
Pay distributions | Yes, required | No |
Generally, REITs must pay out most of their profits (free cash flow, often referred to as ‘funds from operation’) to shareholders. If the REIT follows all the rules, they are exempt from federal corporate taxes. The tax burden for the profit they earn is the responsibility of the shareholder or unit holder.
Companies that are formed as corporations pay taxes and have no such requirements as to how or if they they pay dividends.
Why Do REITs Exist?
REITS are different entities than other stocks, primary due to the unique corporate structure they hold. This structure is coded into federal law and regulation.
Whenever an entity gets special rules, you should be wary and find out why.
The main reason REITs exist is that business doesn’t want to invest in real estate. The special REIT structure is essentially a carrot to encourage investment into the category, because, hey, somebody has to do it.
REITs exist and more generally real estate investing exists to fill in a need for business. Let’s go back to how businesses are formed. An entrepreneur has a New Great Idea and wants to start a business. Along the way, the entrepreneur may need an office, a manufacturing facility, warehouse or other real estate.
The entrepreneur does not want to raise the capital required to buy the real estate. Real estate is a necessary asset, but tying up money in real estate can take away from much needed capital to run their business. They would want to use all their capital on their actual business — selling the product or service that they are developing.
This is where the real estate investor comes into the picture.
The real estate investor raises the capital to buy real estate. They will then release the property for leasing to businesses who would then pay a monthly lease. The lease is a cost to the business that comes out of their cash flow.
Real estate investing has many different variations depending on how the real estate investor wants to set it up.
It Gets Worse From Here…
The REIT structure has both benefits and downsides. These are the main considerations.
- REITs are exempt from federal corporate taxes.
- REITs are required to payout 90% of their income to unit holders.
- Unitholders (you) are to pay income taxes on distributions.
- Under most circumstances, unit holders qualify for the QBID, which exempts 20% of their distribution income from federal income taxes.
So, there are carrots for both REIT companies and REIT unit holders. That’s the good news.
The second requirement above, paying 90% of income out, is the bad news. Consider that REITs have very high capital requirements to acquire land and in many cases build structures and infrastructure. If the REIT can’t keep most of their profit to expand the business, how will they get the capital do it?
This is unlike most companies that are typical common corporate entities. They can retain all of their earnings and use it as they see fit to expand their business.
If the REIT has lots of capex, they will need to be excellent managers of capital and carefully select properties to insure high lease rates. They will need to increase capital over time and deploy it presently to earn an adequate margin.
Picking good REITs really is about picking good management, their decision making matters.
Picking REITs to Invest In
If it sounds like we are making the case to not invest in REITs, that’s not the complete story. What we are trying to convince you of is that you need to be selective and careful what REITs you invest in.
We have some ideas to share on how to do this.
There are REITS of different quality and there are criteria you can use to determine which ones to pick. Let’s start with the major REIT categories.
REIT Category | Valuation (P/FFO) |
Cell Tower | 17 |
Data Center | 21 |
Health Care | 11 |
Hotel | 10 |
Industrial | 20 |
Large Mall | 12 |
Net Lease | 14 |
Office | 12 |
Storage | 16 |
Strip Mall | 14 |
In the table above are a sampling of REIT categories. We use P/FFO (instead of P/E – price to earnings) because this is the industry standard that values the REIT by cash flow. If you use earnings instead you will get a distorted view because there are large depreciation deductions that skew earnings numbers. The FFO gives you the accurate earnings view.
Some sectors are highly valued by investors: Data Center, Industrial, and Cell Tower. These sectors are in high demand because generally they are involved in powering the modern tech economy as well as the booming online retail business. The industrial sector contains the companies involved in supply warehouses used for online commerce. The buildout for Cell Towers will go on probably for decades, so these locations are in high demand and earn stable income.
On the other side, there are sectors that are in distress, in particular, office REITs. Due to remote work, office REITs are hurting due to lower demand for office space. This will get worked out one way or another, but it could take years or decades.
Malls are another sector in distress due to online commerce. It’s not everywhere, because some malls are doing well, while others are surviving by modernizing their tenant base to other uses.
REIT Criteria to Consider
REIT Category | Summary | |||
Cell Tower | Secular, Low Capex | |||
Data Center | Secular, Low Capex | |||
Health Care | Cyclical, Medium Capex | |||
Hotel | Cyclical, High Capex | |||
Industrial | Secular, Medium Capex | |||
Large Mall | Cyclical, High Capex | |||
Net Lease | Secular, Low Capex | |||
Office | Cyclical, High Capex | |||
Storage | Secular, Medium Capex | |||
Strip Mall | Cyclical, High Capex |
We discussed the major difference between REITs and common stocks is that they must distribute most of their income. This puts the business at a disadvantage because it reduces their capital, which will often require the REIT to continually raise capital to improve the business.
One way you can reduce your risks in REITs is to own REITs that are higher quality businesses that don’t require a lot of capital. In the chart above, we outline at a high level criteria you should consider. To assess quality we specify the REIT as being Cyclical or Secular. A Cyclical business will be sensitive to economic conditions and can affect earnings very quickly (lower quality). A Secular business is stable and not sensitive to economic conditions (higher quality).
Each category is also assessed for its relative level of capital expenditures (Capex). Properties that require a lot of capital will have higher capex, while properties that have lower capital requirements will have lower capex.
The One Sector To Consider…
There are high quality, low quality and everything in between when it comes to REITs. The common denominator is that most REITs need to raise additional capital to build and improve their properties. Consider a mall operator. They own all the infrastructure and must keep it up to date to attract both tenants and customers. It’s a big burden that is not uncommon.
Consider a Cell Tower REIT. These locations are very much in demand and it could be argued the costs overall are relatively lower due to limited set of infrastructure and smaller real estate footprint. Investors offer rich valuations to these companies.
Which sector should you start with? We recommend Net Lease, often it is called Triple Net. These REITs offer relatively attractive valuations and have very low capital requirements. The reason is that the burden of capex is primarily on the lease holder and not the landlord. The reason why capex is on the lease holder is because the company wants to configure the property (typically a retailer) to their own liking to suit their needs/branding.
This is a perfect combination of attractive valuation and low capex.