|Dividends? Geography? Debt? How to Spot a Well-Designed REIT|
By Andrew Jeffery DEC 08, 2011 1:30 PM
Like investing in regular stocks, picking a good REIT requires a lot more effort than just perusing a few key metrics and glancing at a chart.
Just because you know what REIT stands for, doesn't mean you can pick a good one.
In Are REITs Right for Your Investment Type, we discussed some of the positive and negative aspects of REIT ownership, along with the specific rules REITs must follow to retain their favorable tax status. We also learned that REITs may own real estate, mortgages, or some combination of the two and carry several tax benefits for investors, along with a few drawbacks.
So now that you've decided REITs are at least intriguing enough to dig into further, let's examine how best to analyze them to find the ones best suited for your investment goals. Like investing in regular stocks, picking a good REIT requires a lot more effort than just perusing a few key metrics and glancing at a chart. Keep in mind there are professional investors who literally spend their entire day combing through REIT financial statements looking for mis-priced assets and good investments.
In other words, don't expect to beat the market. The best you can hope for is that your thesis, whatever that may be, combined with close examination of different REITs will lead you to the best investment decisions possible. In this piece, we will review at a high level some key metrics and other considerations that are essential to evaluating REITs, and in will subsequent pieces dive deeper into the most important and complex concepts.
Dividends and Yield
REIT investors are often attracted by dividends, which when combined with the possibility for equity growth, make REITs an appealing middle-ground between stocks and bonds. Like bonds, REIT share prices move inversely with yields. That is, a REIT with a $10 share price that pays a $1 dividend per year results in a 10% dividend yield for investors. If the REIT's assets perform well and the share price doubles but dividends stay the same, the yield would be 5% ($1 returned for a $20 share price). This is an extreme example of course, since we know that REITs are required to pay out at least 90% of their net income as dividends. As income grows, dividends tend to grow as well, so yields remain relatively steady over time.
That said, if you buy a REIT share for $10 and the market stumbles, expect dividends to fall on a nominal basis, so not only will your shares be worth less, but that smaller dividend looks even worse when compared to the high share price you bought in at.
Dividend yields vary depending on a host of factors. But like all investments, a good rule of thumb is that a higher yield typically carries higher risk. For example, Simon Properties Group (SPG), one of the largest mall owners in the country, currently yields 2.9% ($3.60 dividend on a $124 share price). Meanwhile, National Retail Properties Inc (NNN), which also operates in the retail space, carries a much higher 6.1% yield. Better, right? Perhaps not.
Simon Properties carries an A- rating from Standard and Poor's, whereas National Retail carries a lower, BBB rating. And while the argument over the validity of these ratings should be saved for a separate piece, by looking further into the two firms financial statements it's easy to see why National Retail could be seen as a riskier bet than Simon Properties. For example, over the past three years National Retail has seen asset values contract, while Simon Properties has seen them expand. During that time period National Retail has seen an 80% rise in its stock price, which isn't half bad. But when compared to Simon Properties' 150% gain, it's clear to see that chasing yield doesn't always pay off.
Leverage is an essential aspect of any real estate investment. When employed properly, leverage can be an incredibly powerful tool to enhance returns. It cuts both ways, however, as we found out all to well during the housing meltdown of 2007-2009, as leverage can push equity losses well above 100%.
Three primary aspects of real estate debt for REIT analysis are: overall debt level, cost of debt and maturities.
Overall debt levels, debt to equity ratios and other metrics are readily available for publicly traded REITs. In the example above, a quick glance at Simon Properties and National Retail yields interesting findings when looking exclusively at outstanding debt. Simon Properties, which the market believes is a lower risk investment with better equity returns than National Retail, carries debt on its balance sheet that is more than three times the amount of its equity. National Retail, on the other hand has more equity than debt. The lesson here is that more debt is not always bad.
Equally as important as debt levels is the cost of that leverage. Cheap debt can greatly enhance returns, but that same amount of debt at a higher interest rate can not only cut into returns, but in some situations create a negative cash flow situation. Real estate loans carry terms that range from the simple-to-understand to the insanely complex, so in certain situations even knowing the current interest rate isn't enough to fully know a REIT's debt expenses.
Another term of any loan is the date of maturity. That is, the time at which the REIT must repay the loan, either via a property sale or refinance. Maturities are particularly important during tough times, because weak cash flow and expensive debt can be managed for a time, but when the loan comes due, real estate owners may have few choices to get out from under the loan. If the property's value has fallen below the amount of the loan (as is the case with many commercial real estate loans currently), when the loan matures the owner must choose between ponying up the difference between the loan amount and the property value, or walk away and hand the keys over to the bank.
Debt, as one may expect, as an absolutely critical aspect of REITs to understand, and will be explained in more detail in another piece.
Funds From Operation (FFO)
Funds from Operations, or FFO, is the most widely watched financial metric when evaluating REITs. Whereas most companies are measured on earnings, earnings in the traditionally sense may be misleading when looking at REITs. FFO is of course not without its shortcomings, but as long as you understand what FFO actually measures, it is an essential part of REIT analysis.
NAREIT, a real estate trade group and lobbying organization, defines FFO as "The most commonly accepted and reported measure of REIT operating performance. Equal to a REIT's net income, excluding gains or losses from sales of property, and adding back real estate depreciation." Essentially, FFO tries to boil down how the REIT's regular operations are faring, or as the name would suggest, how much cash the properties (or mortgages) are kicking off.
Importantly, FFO excludes property sales and depreciation. This makes sense, since selling a building at a loss or gain in a given year is more representative of the owner's relative success with that individual investment, rather than how operations are faring at a given moment in time.
Why we add back in depreciation to calculate FFO is a bit trickier to understand. Generally Accepted Accounting Principals, or GAAP, assume that properties depreciate, or decline in value over time. Beancounters, in their infinite wisdom, live in a world wear properties wear out; roofs start leaking, wood rots away and buildings generally decay. Accountants have even gone so far as to have determined that properties will actually depreciate to a zero value in 27.5 years. As a result, property owners can take a non-cash loss of 1/27.5th of their property's value (within certain parameters) each tax year. This loss does not impact cash flow, but does impact taxable income, and therefore traditional earnings measurements. So to get down to how a REIT is actually performing on a cash flow basis, depreciation, which is a completely allowable non-cash loss item, is added back to arrive at FFO.
So by stripping out property sales and depreciation, FFO can turn earnings into a much more meaningful method for evaluating REIT performance on an operating basis. As one would imagine, there are critiques of the widespread use of FFO, not the least of which is that in years when properties are actually falling in value, stripping our deprecation can artificially inflate REIT shares and mask underlying problems.
Understanding FFO is essential to understanding REITs, so our next piece will cover FFO in far more detail.
Real estate, as the saying goes, is local. Thus, it is absolutely essential to know where REITs own properties. As we have discussed, overhead and administrative costs are high for REITs, so you are not likely to find a REIT that owns properties exclusively in your neighborhood, or perhaps even just in your city. Most REITs are large operations that own real estate in several metro areas, and many own properties across the entire country.
For example, contrary to what its name implies, Boston Properties (BXP), is not a REIT focused exclusively on real estate in the greater Boston area. Boston Properties is one the country's largest owners of Class A office buildings, operating 146 buildings totaling 53.6 million rental square feet, according to Standard and Poors. And while 28% of its assets are indeed located in Boston, another 25% are in New York City, 26% are located in Washington DC and 14% are across the country in San Francisco. Some 97% of the company's operating income comes from these core markets, so an investment in Boston Properties is a bet that big US companies will continue to demand high quality office space in major metropolitan areas. If you think the suburban strip mall is the next big thing in real estate, Boston Properties may not be the REIT for you.
In contrast, AvalonBay Communities (AVB), a large owner of multi-family apartment buildings is a bit more geographically diversified. According to Standard and Poors, AvalonBay owns property in New York City (23%), San Francisco (19%), Washington DC (17%), Boston (13%), Los Angeles (9%) and Seattle (6%).
If it's starting to sound like REITs only own properties in major metro areas, in some ways that is actually correct. Because of their sheer size, many REITs really only look to own large buildings. And since most large buildings are concentrated in large cities, big REITs will more often than not have their highest concentration of properties in the country's largest cities.
As noted previously, REITs typically specialize in a single or perhaps two related property types. The most common property types include residential (apartments), retail, office, industrial, health care, self-storage, hotel, and resort. This specialization offers perhaps the easiest way for investors to buy REITs to capitalize on a specific investment thesis. For example, in today's market everyone loves apartments. Rents are way up and demographics favor a strong rental market for the foreseeable future. As a result, apartment REITs like AvalonBay have seen fantastic share price appreciation in the past two years.
Combine property type with geography and you're really getting somewhere. Since small businesses and start-ups typically rebound sooner from a recession than large, slow-moving multinational corporations, office space in and around Silicon Valley and Boston is often snatched up earlier in a cycle than in, say, Bismark. So finding a REIT that owns office space in Mountain View or Cambridge may be a good way to go if you think our nascent economic recovery is just beginning to heat up.
Lumped in with property type is understanding the assets themselves. We'll get into that more later, because it goes without saying that successfully investing in real estate, whether on the individual asset level or in REITs, is heavily dependent on an ability to determine the true value of said real estate.
Lastly, no assessment of REITs could be complete without knowing who is actually calling the shots. REIT management is, unsurprisingly, extremely important in determining which REITs perform well. In good times, a bunch of monkeys could successfully own and manage real estate (no, really, it's not that hard) but when times get rough, good management will shine and investors will be glad they did their homework on the key decisionmakers within the REIT.
If it seems like a we just blew through a ton of material, we did. But don't worry, over the next several weeks we'll break down the key items discussed above and get deeper into how one can actually take these concepts and turn them into real, actionable investment decisions.