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Dividends? Geography? Debt? How to Spot a Well-Designed REIT

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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.

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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.

Geography
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.

Property Type
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.

Management Team
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.

Twitter: @schnageler

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No positions in stocks mentioned.

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