A real property investment trust (REIT) is a company that invests in, manages, or finances income-producing assets. A REIT's profits must be divided dividends among shareholders. We will be discussing the characteristics of REITs and how to assess them.

What Is A REIT?

REITs lease space, collect rents, and distribute the income to shareholders. Mortgage REITs, also known as mREITs, don't have real estate and finance it. Instead, these REITs make income from interest earned on their investments. This includes mortgage-backed securities and other assets.

Must meet certain Internal Revenue Code (IRC) requirements to qualify as a REIT. To be a REIT, a company must fulfill the following requirements:

• At least 75% of your total assets should be invested in real estate, cash, or U.S. Treasuries

• At least 75% of your gross income must come from rents, interest paid on mortgages that finance real property or sales.

• Divide your taxable income each year by paying at least 90% in shareholder dividends

• You can be a corporate entity.

• Managed by a board or trustees

• At least 100 shareholders in its first year of existence

• Five or fewer people cannot hold more than 50% of the shares

A company can avoid corporate income taxes by having REIT status. First, regular corporations make a profit and pay taxes on that amount. Then, they decide how to divide their after-tax profits between dividends or reinvestment. REITs simply give away all or nearly all their profits and get to avoid taxation.

Types Of REITs

There are many types of REITs. For example, equity REITs are more likely to own specific types of buildings such as apartments or regional malls, office buildings, and lodging/resort facilities. Some REITs are diversified, and others defy classification, such as investing in only golf courses.

A mortgage REIT is the other major type of REIT. These REITs can make loans secured by real property, but they don't usually own or operate it. Therefore, a special analysis is required for mortgage REITs. These are financial companies that use multiple hedging instruments to manage their interest rates exposure.

A few hybrid REITs transact in mortgage loans and real estate operations, but most REITs are equity REITs. These REITs focus on real estate operations. You are most likely reading about equity REITs when you read about REITs. We will therefore focus our analysis on equity-related REITs.

How To Analyze REITs

REITs pay dividends and are focused on real estate. Therefore, you should consider REITs if you are looking for income. REITs can be analyzed in the same way as other stocks. However, there are significant differences in the accounting treatment of REITs.

FFO

Our REIT does not actually spend the money in year 10. Depreciation is a cash charge. We add the depreciation fee to the net income to produce funds out of operations (FFO). Depreciation is unfairly reducing our net income since our building didn't lose 50% of its value in the past ten years. FFO eliminates the depreciation fee to correct this distortion. FFO also includes some other adjustments.

AFFO

FFO is closer to net income than it is to cash flow but does not capture cash flow. In the above example, you will notice that we did not include the $1 million spent on the acquisition of the building (the capital expense). An analysis would include capital expenses. The adjusted FFO (AFFO) is the sum of capital expenditures.

Net Asset Value

The net asset valuation (NAV) is another common REIT metric. This hypothetical balance sheet can be used to help us understand it. For example, the book value of our building in year 10 was $500,000, as half of its initial cost had been depreciated. Book value and other related ratios, such as price-to-book, often unsure in general equities analysis, are useless for REITs. NAV attempts to replace the property's book value with a more accurate estimate of market value.

The holdings of the REIT are subject to subjective evaluation in order to calculate NAV. The above example shows that the building generates $100,000. This is $200,000 in operating revenue (minus $100,000 in operating costs). One way to capitalize the operating income using a market rate is to do so. We can estimate the building's worth at $1.25million if we assume that the current cap rate for this building type is 8%. This would equal $1,250,000 in operating income and an 8% cap rate.

This market value estimate replaces book value. We would subtract the mortgage debt (not illustrated)—assets less debt equal equity to calculate net asset value. The 'net' part of NAV refers to the net amount of debt. To get NAV per share, divide NAV into common stock. This is an estimation of intrinsic worth. The quoted share price shouldn't be too far off the NAV per share.

Bottom-Up vs. Top-Down Analysis

You may hear the top-down approach to stock picking. Top-down is based on an economic perspective. It emphasizes themes and sectors (e.g., drug companies may be favored by an aging population). Bottom-up analyzes the fundamentals of specific companies. Both top-down, as well as bottom-up analysis is required for REIT stocks.

If you look at REITs from a top-down view, they can be affected by any factor that affects the demand and supply of property. All REIT types are favored by job growth and population. In short, interest rates are mixed.

An increase in interest rates is usually a sign of an improving economy. This is good news for REITs because people are spending more, and businesses rent more space. Apartment REITs benefit from rising interest rates because people are more inclined to rent than to buy new homes. However, REITs may be able to take advantage of lower interest rates by decreasing their interest costs and increasing their profitability.

Important are also capital market conditions, such as institutional demand for REIT equities. This demand can outweigh fundamentals in the short run. For example, REIT stocks performed well in 2001 and 2002, despite weak fundamentals. This was because money was flowing into all of the assets.

You want strong prospects of growth at the REIT level. This includes rental income and related income. Therefore, it is important to determine if the REIT has an innovative strategy for increasing occupancy and rising rents.

Economies of Scale

REITs are known for their ability to grow through acquisitions. They also seek to realize economies of scale by integrating inefficiently managed properties. A reduction in operating costs would result in economies of scale. This is a percentage of the revenue. Acquisitions can be a double-edged sword. A REIT that cannot improve occupancy or raise rents may make unwise acquisitions to fuel growth.

It is important to look at the balance sheet, as mortgage debt significantly impacts equity value. Many recommend that you look at leverage, such as the ratio of debt to equity. In practice, however, it can be difficult to determine when leverage is excessive. It is important to consider the ratio of fixed and floating-rate debt. RISING INTEREST RATES WILL AFFECT a REIT that only uses floating-rate debt in the current low interest-rate environment.

REIT Taxes

Many REIT dividends don't qualify as qualified dividends by the IRS, so they are generally subject to a higher tax rate. Qualified dividends can be taxed at one of three rates, depending on whether you are in the 15%, 15%, or 20% bracket. REITs have the advantage of being able to tax most dividends as ordinary income, up to 37% in 2021.

There may be good news. Because REITs can be passed through businesses, dividends that aren't qualified may qualify for the 20% QBI deduction. So if you have $1,000 in ordinary REIT dividends, you may owe taxes only on $800.

The Summary

REITs are real estate companies that have to pay high dividends in order for them to receive the tax advantages of being REITs. A combination of price volatility and stable income that exceeds Treasury yields creates a total returns potential comparable to small-capitalization stocks. Investors must understand the accounting distortions caused by depreciation and be aware of macroeconomic influences when analyzing a REIT.