Instead of buying physical real estate, some people choose to buy something called a REIT, or real estate investment trust. A REIT is a real estate holding company in the form of a stock so you can share in the benefits of commercial or residential real estate without having to pony up the big bucks to buy shopping malls with cold hard cash.
A real estate company has certain requirements or guidelines that it needs to follow before it can qualify for REIT status. Why become a REIT? Well, you don’t have to pay taxes. What’s the catch though? One of the requirements is that REIT’s must pay out at least 90% of profits in the form of dividends, or cash distributions to shareholders. Typically, REITS have pretty solid dividends, upwards of 3-5% annually. Also, REITs must have at least 75% of their income come from real estate so they cannot diversify too widely away from their core competency.
Another point, there are two kinds of REITS, equity and mortgage. Equity REITS buy real estate and get income from rentals. On the other hand, mortgage REITS finance loans for real estate purchase and receive income in the form of interest.
Competitive Advantage
Scale is key for REITS. The name of the game is smart leverage. In other words, the company that can use debt the smartest will win. Since real estate requires huge upfront investment, loans are important. There is a delicate balance between boosting returns with the use of leverage and taking on too much debt. Look for operators who have been at this game for a while, who have weathered multiple business cycles. If the CEO has only been in the real estate game since after 2008, it is probably unwise to trust them fully.
Scale also benefits REITS because, generally, the more you borrow, the better rate you get. So if you borrow huge sums, your interest rate will be lower. This is a huge competitive advantage.
Another advantage of some REITS is geography. For instance, public storage providers can qualify for REIT status. If a company like Public Storage owns two self-storages in a city, it is unlikely there is room for another player since land is most likely limited and people already have all their stuff stored with Public Storage. This creates another way REITS can have a competitive advantage.
Financials and Valuation
Financials of a REIT can be quite tricky. Typically they trade for pretty high P/E ratios because they are valued by another means. It is called funds from operations or FFO. It is pretty much like operating cash flow for other businesses. You take the net income, add back depreciation, factor out the gains and losses on assets and then subtract interest income. Think about it from the point of view of following the cash. If you have to pay interest, you need to subtract it because you are losing cash. But you add back depreciation because it is a non-cash expense.
Another metric is adjusted funds from operations, or AFFO. This is the just FFO but you subtract capital expenditures. So it is just like free cash flow. Typically you can value the companies by taking the market cap and dividing it by the FFO or AFFO per share. This will give you a multiple that you can compare to other REITs. However, just like the PE ratio, it is not black and white and there are a lot of other factors that go into the philosophy rather than just a number.
These companies can be uber-profitable though. For example, it is not rare for a self-storage company to have 50% operating margins, a very high number. This is similar to Visa’s profitability, one of the most profitable out there. Why? Besides building, the only real expense is a property manager and upkeep of the buildings. Otherwise, these companies just sit back and let the money roll in.
One thing to watch out for though is rising interest rates. Think about it. If it becomes more expensive to borrow money, REITs will be less profitable because that is a serious input to the business. So watch out for a rising interest rate environment because it will likely affect REITs over the long term.
So remember, watch out for too much debt, rising interest rates and inexperienced operators. But look for strong FFO numbers, scale and a decent valuation. Happy real estate investing!