Simple Ways To Invest In Real Estate

by Andrew Beattie (Contact Author | Biography)
Filed Under: Bonds, Personal Finance, Real Estate

Buying real estate is about more than just finding a place to call home. Investing in real estate has become increasingly popular over the last fifty years and has become a common investment vehicle. Although the real estate market has plenty of opportunities for making big gains, buying and owning real estate is a lot more complicated than investing in stocks and bonds. In this article, we'll go beyond buying a home and introduce you to real estate as an investment. Basic Rental Properties This is an investment as old as the practice of landownership. A person will buy a property and rent it out to a tenant. The owner, the landlord, is responsible for paying the mortgage, taxes and costs of maintaining the property. Ideally, the landlord charges enough rent to cover all of the aforementioned costs. A landlord may also charge more in order to produce a monthly profit, but the most common strategy is to be patient and only charge enough rent to cover expenses until the mortgage has been paid, at which time the majority of the rent becomes profit. Furthermore, the property may also have appreciated in value over the course of the mortgage (according to the U.S. Census Bureau, real estate has consistently increased in value since 1940), leaving the landlord with a more valuable asset. (To learn more, read Paying Off Your Mortgage and Understanding Your Mortgage.) There are, of course, blemishes on the face of what seems like an ideal investment. You can end up with a bad tenant who damages the property or, worse still, end up having no tenant at all. This leaves you with a negative monthly cash flow, meaning that you might have to scramble to cover your mortgage payments. There is also the matter of finding the right property - you will want to pick an area where vacancy rates are low (due to demand) and choose a place that people will want to rent. Perhaps the biggest difference between a rental property and other investments is the amount time and work you have to devote to maintaining your investment. When you buy a stock, it simply sits in your brokerage account and (hopefully) increases in value. If you invest in a rental property, there are many responsibilities that come along with being a landlord. When the furnace stops working in the middle of the night, it's you who gets the phone call. If you don't mind handyman work, this may not bother you; otherwise, a professional property manager would be glad to take the problem off your hands - for a price, of course. (For further reading, see Tips For The Prospective Landlord.) Real Estate Investment Groups Real estate investment groups are sort of like small mutual funds for rental properties. If you want to own a rental property, but don't want the hassle of being a landlord, a real estate investment group may be the solution for you. A company will buy or build a set of apartment blocks or condos and then allow investors to buy them through the company (thus joining the group). A single investor can own one or multiple units (self-contained living space), but the company operating the investment group collectively manages all the units - taking care of maintenance, advertising vacant units and interviewing tenants. In exchange for this management, the company takes a percentage of the monthly rent. There are several versions of investment groups, but in the standard version, the lease is in the investor's name and all of the units pool a portion of the rent to guard against occasional vacancies, meaning that you will receive enough to pay the mortgage even if your unit is empty. The quality of an investment group depends entirely on the company offering it. In theory, it is a safe way to get into real estate investment, but groups are vulnerable to the same fees that haunt the mutual fund industry. Once again, research is the key. Real Estate Trading This is the wild side of real estate investment. Like the day traders who are leagues away from a buy-andhold investor, the real estate traders are an entirely different breed from the buy-and-rent landlords. Real

whereupon they hope to sell them for a profit. A corporation must pay out 90% of its taxable profits in the form of dividends to keep its status as an REIT. check out What Are REITs?. As with any investment. Flipping in this manner is a short-term cash investment. etc. Whether they rent these out so that tenants pay the mortgage or they wait for an opportunity to sell for a profit. As with any investment. Basic Valuation Of A Real Estate Investment Trust (REIT) and The REIT Way. there are many types of mortgages that require as little as 5%. office buildings. depending on where you live. REITs are bought and sold on the major exchanges just like any other stock. investing in real estate gives an investor one tool that is not available to stock market investors: leverage. the amount you can borrow is still much less than with real estate. If a property flipper gets caught in a situation where he or she can't unload a property. The limiting feature of this investment is that it is time intensive and often only allows investors to take on one property at a time. we have only scratched the surface.estate traders buy properties with the intention of holding them for a short period of time (often no more than three to four months). Within these examples there are countless variations of real estate investments. However. Even if you are buying on margin. whereas a regular company would be taxed its profits and then have to decide whether or not to distribute its after-tax profits as dividends. Much like regular dividend-paying stocks. These investors make their money by buying reasonably priced properties and adding value by renovating them. This is what emboldens real estate flippers and landlords alike. This means that you can control the whole property and the equity it holds by only paying a fraction of the total value. They can take out a second mortgage on their homes and put down payments on two or three other properties.) Leverage With the exception of REITs. you won't need a realtor to help you cash out your investment. If you want to buy a stock. REITs avoid paying corporate income tax. by Andrew Beattie (Contact Author | Biography) . A second class of property flipper also exists. make careful choices and weigh out the costs and benefits of your actions before diving in.in other words. they control these assets despite having only paid for a small part of the total value.the investment has to have the intrinsic value to turn a profit without alteration or they won't consider it. REITs Real estate has been around since our cave-dwelling ancestors started chasing strangers out of their space. read The Home-Equity Loan: What It Is And How It Works and Home-Equity Loans: The Costs. This can be a longer-term investment depending on the extent of the improvements. but this does not mean that it is an assured gain. This can lead to continued losses for a real estate trader who is unable to offload the property in a bad market. as you might have guessed. This technique is also called flipping properties and is based on buying properties that are either significantly undervalued or are in a very hot market. Of course. but you control it the minute the papers are signed. By doing this.) and are highly liquid . (For more on taking out a second mortgage. so it's not surprising that Wall Street has found a way to turn real estate into a publicly-traded instrument. Pure property flippers will not put any money into a house for improvements . it can be devastating because these investors generally don't keep enough ready cash to pay the mortgage on a property for the long term.) Conclusion We have looked at several types of real estate investment. your mortgage will eventually pay the total value of the house at the time you purchased it. (For further reading. REITs allow investors into non-residential investments (malls. A real estate investment trust (REIT) is created when a corporation (or trust) uses investors' money to purchase and operate income properties. there is much potential with real estate. In comparison to the aforementioned types of real estate investment. you have to pay the full value of the stock at the time you place the buy order. Most "conventional" mortgages require 25% down. REITs are a solid investment for stock market investors that want regular income. However.

CFA. In this article. a measure reduced by depreciation. For most businesses." grew by almost 30% (+$122. Net income. Below we show this reconciliation of . we will show you how to estimate the value of an REIT. depreciation is an acceptable non-cash charge that allocates the cost of an investment made in a prior period. Stocks How To Assess A Real Estate Investment Trust (REIT) If you try to estimate the value of a real estate investment trust (REIT). which excludes depreciation. FRM (Contact Author | Biography) Filed Under: Fundamental Analysis.by David Harper.) Funds from Operations (FFO) Is Better than Earnings Let's start by looking at a summary income statement from one of the largest residential REITs. you will quickly find that traditional metrics like the earnings-per-share (EPS) ratio. FFO is reported in the footnotes.com From 2002 to 2003. REITs are instead judged by funds from operations (FFO). is therefore an inferior gauge of performance.500 to $543. and the price-to-earnings (P/E) multiple do not apply. see The REIT Way. Real Estate. The general calculation involves adding depreciation back to net income (since depreciation is not a real use of cash. which are significant line items.847). These net income numbers. include depreciation expenses. and companies are required to reconcile FFO and net income. (For background reading on REIT investing. as discussed in the above paragraph) and subtracting the gains on the sales of depreciable property. These gains are subtracted because we assume that they are not recurring and therefore do not contribute to the sustainable dividend-paying capacity of the REIT. growth. Equity Residential's net income. however. or the "bottom line.10kwizard. Equity Residential (NYSE:EQR): Source: 10KWizard www. Therefore. But real estate is different than most fixed-plant or equipment investments: property rarely loses value and often appreciates.

Often a virtuous cycle ensues. The key assumption here is the expected growth in FFO or AFFO. AFFO does not have a uniform definition. and it is widely used. it is a more precise measure of residual cash flow available to shareholders and therefore a better "base number" for estimating value (for example. but it contains a weakness: it does not deduct for capital expenditures required to maintain the existing portfolio of properties.A popular and successful tactic is to acquire "lowend" properties and upgrade them to attract a higher quality tenant.) Look for Growth in FFO and/or AFFO Once we have the FFO and the AFFO. In the case of Equity Residential. in general. External growth prospects . (To learn about how to read financial statements. It is clear that.Many REITs favor fostering FFO growth through acquisition. However. the most important adjustment made to calculate it is the subtraction of capital expenditures. as mentioned above.10kwizard. we can try to estimate the value of the REIT. Although FFO is commonly used.390 in 2002 and almost $758. professional analysts therefore use a measure called "adjusted funds from operations" (AFFO). This number was taken directly from the cash flow statement. apartments must be painted). it is a better predictor of the REIT's future capacity to pay dividends.net income to FFO (with a few minor items removed for the sake of clarity) for 2002 and 2003: Source: 10KWizard www. because it is true residual cash flow. Better tenants lead to higher occupancy rates (fewer evictions) and higher rents.000 in 2003. In estimating the value of an REIT. FFO must be reported. An REIT must distribute most of its profits and therefore does not have a . but it's easier said than done. applying a multiple or discounting a future stream of AFFO). We use it as an estimate of the cash required to maintain existing properties. these are the sources to consider: y y y y Prospects for rent increases Prospects to improve/maintain occupancy rates A specific plan to upgrade/upscale properties . after depreciation is added back and property gains are subtracted. The specifics of evaluating an REIT's growth prospects are beyond the scope of this article. almost $182. One.000 is subtracted from FFO to get AFFO for the year 2003. but. funds from operations (FFO) equals about $838. Shareholders' real estate holdings must be maintained (for example. This involves taking a careful look at the underlying prospects of the REIT and its sector.com. Two. check out Advanced Financial Statement Analysis. professionals tend to focus on AFFO for two reasons. so FFO is not quite the true residual cash flow remaining after all expenses and expenditures. although we could try to make a better estimate by going to the trouble of looking at the specific properties in the REIT.

Essentially. For example. the price of EQR would be higher because it would need a higher multiple to impound these growth expectations. we are probably looking at a good investment: our price is reasonable when compared to the market's cap rate (it's even a little higher. for example. which is really market capitalization divided by FFO. But if the multiple expands about 5% to 11x.000). you will get a clearer picture by looking at funds from operations (FFO) rather .2% ($575. and the multiple of 10. aside from the important dividends paid." To evaluate the price of the REIT. how can we interpret these multiples? Like interpreting P/E multiples. Aside from making a direct comparison to industry peers. we assumed that EQR's debt burden is modest and "in line" with the industry peers. which is better). Expansion in the price-to-FFO or price-to-AFFO multiple Let's look at the multiples for EQR below. In fact. even more promising.7 ÷ 8. As with other stocks. the growth we are expecting should translate into both higher dividends and price in the future. or "cap rate. interpreting price-to-FFO or price-to-AFFO multiples is not an exact science. then our price appreciation will be approximately 15% (10% FFO growth + 5% multiple expansion)! A useful exercise is to take the reciprocal of the price-to-AFFO multiple: 1 ÷ [Price/AFFO] = AFFO/Price. Given a calculated AFFO yield of 7. we would need to consider the extra risk implied by the additional debt. any price appreciation breaks down into two sources: growth in FFO/AFFO and/or expansion in the valuation multiple (price-to-FFO or price-to-AFFO ratio). 8% implies that investors are generally paying about 12. If we are looking at an REIT with favorable FFO growth prospects.5 times (1 ÷ 8%) the net operating income (NOI) of each individual real estate property. But remember that. In the case of EQR. we should consider both sources together. and. If EQR's leverage (debt-to-equity or debt-to-total capital) were above average. If FFO grows at 10%." and (2) our estimate for the REIT's growth in FFO/AFFO. we want to avoid buying into a multiple that is too high. We can break down the expected price appreciation into two components: 1. Apply a Multiple to FFO/AFFO The total return on an REIT investment comes from two sources: (1) dividends paid and (2) price appreciation. Let's assume that we determine the market's cap rate is about 7% and that. This is called the "AFFO yield. if all other investors already agreed with us. this equals about 7. and the multiples will vary with market conditions and specific REIT sub-sectors (for example. then the price will grow 10%. our growth expectation for EQR's FFO/AFFO is a heady 5%. further. Growth in FFO/AFFO 2. The cap rate is a general marketbased number that tells you how much the market is currently paying for real estate.2%.55x is maintained. industrial). however. successfully prune their portfolios: they sell underperforming properties to finance the acquisition of undervalued properties. EQR's market capitalization (number of shares multiplied by price per share) in this example is about $8 billion. we can then compare the AFFO yield to (1) the market's going capitalization rate.lot of excess capital to deploy. apartments. One final note: we ignored debt in this illustration. Many REITs. Summary When evaluating REITs. Note that we are showing price divided by FFO. offices.

Filed Under: Fundamental Analysis. try to calculate adjusted funds from operations (AFFO). y Equity REITs . these trusts were considered to be minor offshoots of unit investment trusts. mortgage REITs and hybrid REITs. (To learn about REIT valuation. In 2007. but when the Global Industry Classification Standard granted REITs the status of being a separate asset class the rules changed and their popularity soared. where his original portfolios (core. REITs tend to be more value than growth-oriented.) Three Types of REITs REITs can be broken down into three categories: equity REITs. and means REITs provide higher yields than those typically found in the traditional fixed-income markets. see The REIT Way. see Basic Valuation Of A Real Estate Investment Trust. Cussen. CFA. The IRS requires REITs to pay out at least 90% of their incomes to unitholders (the equivalent of shareholders). litigation support and financial education. They also tend to be less volatile than traditional stocks because they swing with the real estate market. CMFC (Contact Author | Biography) Filed Under: Taxes Real estate investment trusts (REITs) have established themselves as a means for the smaller investor to directly participate in the higher returns generated by real estate properties. by David Harper. and are chiefly composed of small and mid cap holdings. nearly 200 REITs were traded actively on the New York Stock Exchange and other markets. The triple source of income makes this type very popular. In this article.These trusts own and/or rent properties and collect the rental income. dividends and capital gains from property sales. (To begin with an overview of these assets and what they can do for your portfolio. If you are seriously considering the investment. David Harper. In the past. a firm that conducts quantitative research. Typically.) Basic Characteristics of REITs REITs are a pool of properties and mortgages bundled together and offered as a security in the form of unit investment trusts. Real Estate. growth and technology value) led to superior outperformance (+35% in the first year) with minimal risk and helped to successfully launch Advisor. He is the principal of Investor Alternatives. in the same category as energy or other sector-related trusts that had been created.CFA. Finally. These investment vehicles constitute approximately 10% of the financial sector and nearly one-quarter of the domestic equity sector. David was a founding co-editor of the Investopedia Advisor. FRM (Contact Author | Biography) In addition to writing for Investopedia.CFP®. Stocks The Basics Of REIT Taxation by Mark P. is the founder of The Bionic Turtle. . we will explain how REITs work and then examine the unique tax implications and savings they offer to regular investors. FRM. AFFO is also a good measure of the REIT's dividend-paying capacity. the ratio price-toAFFO and the AFFO yield (AFFO/price) are tools for analyzing an REIT: look for a reasonable multiple combined with good prospects for growth in the underlying AFFO. which deducts the likely expenditures necessary to maintain the real estate portfolio. consulting (derivatives valuation). a site that trains professionals in advanced and career-related finance. Each unit in an REIT represents a proportionate fraction of ownership in each of the underlying properties. including financial certification.than looking at net income. This is similar to corporations.

80.and closed-ended mutual funds). they can offer relatively higher yields than stocks. even REITs that adhere to this rule still face corporate taxation on any retained income. They can be either open.These trusts carry a greater risk because of their exposure to interest rates. y There are a few extra rules for REITs beyond the rules for other unit investment trusts.20 ($1. $0. then to beneficiaries. whose issuers must pay taxes at the corporate level before computing dividend payout. The REIT has funds from operations of $2 per unit and distributes 90%. Because REITs are seldom taxed at the trust level. Furthermore. The nontaxable portions are then taxed as either long.60) of this dividend comes from actual earnings. This means that REITs must be taxed first at the trust level.Mortgage REITs . then that income must be subject to a 30% withholding tax for ordinary dividends and a 35% rate for capital gains. . Rental income is treated as business income to REITs because the government considers rent to be the business of REITs. For all practical purposes.or short-term capital gains/losses. unless the rate is lower by treaty. which are taxed as capital gains. Also. If interest rates rise.) y Hybrid REITs . have a finite or indefinite life and invest in either a single group of projects or multiple groups. which not only reduces the unit holder's taxable income in the year the dividend is received. current income that is distributed to unitholders is not taxed to the REIT. Taxation to Unitholders The dividend payments made out by the REIT are taxed to the unitholder as ordinary income . So. they pass cash flow directly to unitholders. but if the income is distributed to a non-resident beneficiary. (To learn more. REITs are generally exempt from taxation at the trust level as long they distribute at least 90% of their income to their unit holders. 2. then the value of mortgage REITs can drop substantially.or closed-ended (similar to open. These payments also reduce the cost basis for the unitholder. but instead of passing through profits. Example . However.Unitholder Tax Calculation Jennifer decides to invest in an REIT that is currently trading at $20 per unit. Taxation at the Trust Level REITs must follow the same rules as all other unit investment trusts. of this to the unitholders. only $1. This means that all expenses related to rental activities can be deducted the same as business expenses can be written off by a corporation.60 per unit of this dividend comes from depreciation and other expenses and is considered a nontaxable return of capital. the dividend will be taxed at the unitholder's top marginal tax rate. But they must follow the same method of self assessment as corporations. REITs have the same valuation and accounting rules as corporations. Otherwise.These instruments combine the first two categories. Therefore.unless they are considered to be "qualified dividends".80 $0. see The Impact Of Interest Rates On Real Estate Investment Trusts and Behind The Scenes Of Your Mortgage. but also defers taxes on that portion until the capital asset is sold. a portion of the dividends paid by REITs may constitute a nontaxable return of capital. They are: 1. However. or $1.

direct investment makes it very difficult to create a well diversified real estate portfolio. (To learn more. the potential for realizing a possible gain or loss in this manner should be clearly understood by investors. Due to the capital intensity of real estate investing. The permanent allocation of real estate capital comes with some hurdles. Conclusion The unique tax advantages offered by REITs can translate into superior yields for investors seeking higher returns with relative stability. commercial real estate investments require relatively large sums and direct investment often results in lumpy portfolios and inordinate risks in either location or by property type. The great advantage in this strategy is control. check out What are REITs?) Real Estate for Institutional Investors Real estate investment has long been dominated by large investors.or short-term gain/loss when the units are sold. its requirement for active management and the rise in global real estate opportunities. there is an increasing trend toward finding a permanent place for real estate in institutional portfolio allocations. As stated previously.40 per unit. Unlike stocks that can be purchased in small increments. who now have a much larger selection of real estate mutual funds. However. Like any other investment sector. institutions tend to gravitate toward real estate funds and funds of funds. Direct ownership in property allows for the development and execution of strategy and direct influence over return. The real estate allocation for most retail investors is not large enough to purchase . REIT exchange-traded funds (ETFs) and real estate mutual funds. it is capital intensive. which is labor intensive. First and foremost. As a result of these issues. institutions are gradually moving to real estate funds of funds to allow for appropriate asset management. Real estate also requires active management. The same is true for retail investors. insurance companies and other large financial institutions. However. by Mark P. CMFC (Contact Author | Biography) Add Some Real Estate To Your Portfolio by Robert Stammers.60 to $19. allowing for efficient capital allocation and diversification. there has been increasing development in real estate funds. check out Advantages of Exchange-Traded Funds. Cussen.CFA (Contact Author | Biography) With real estate gaining a greater foothold in the capital allocation decisions of both institution and retail investors. in order to increase management efficiency and capital distribution. While this is hardly common. Thanks to the globalization of real estate investing and new offshore opportunities. it is possible for a unitholder to achieve a negative cost basis if the units are held for a long enough period of time. both of which allow for greater diversification and return potential.This amount will be taxable to Jennifer as ordinary income. Theoretically. real estate should be considered for most investment portfolios.CFP®.) Retail Investors The following are several ways that retail investors can access the return potential of real estate and obtain exposure to the asset class. (To learn more about ETFs. Managing a real estate allocation requires significant resources relative to traditional investments. this reduction in basis will be taxed as either a long. such as pension funds. real estate has its benefits and its disadvantages. Direct Investment This strategy relates to investors directly selecting specific properties. The same advantages that institutions gain from real estate funds can be achieved by retail investors through REITs. and real estate investment trusts (REITs) and real estate mutual funds may be the best methods to fill that allocation. with her cost basis reduced by $0.

Another significant advantage to retail investors is the analytical and research information provided by the funds on acquired assets and management's perspective on the viability and performance of specific real estate investments and as an asset class. Flexibility is also advantageous to the mutual fund investor due to the comparative ease in acquiring and disposing of assets on a systematic and regulated exchange. the inability for REITs to retain cash can significantly hamper growth and long-term appreciation. see The Risks of Real Estate Sector Funds. (For more insight.) REIT investments have a much higher correlation to the overall stock market than direct real estate investments. commercial office space and hotels. which leads some to downplay their diversification abilities. For the most part. grocery-anchored shopping centers. Real estate funds allow investors who do not have the desire. mortgages or other real estate collateralized investments. they reduce management issues for investors. Real estate investment trusts are run by a board of directors that conducts investment management decisions on behalf of the trust. this exposure has been beneficial and has helped many people amass the capital required for retirement. the greatest disadvantage is the difficulty in investing in them with limited capital and the significant amount of asset-specific knowledge and analysis required in selecting them and forecasting their performance. local retail properties and strip centers. as opposed to direct investing which is arduous and expensive. see Investing In Real Estate. while direct real estate is influenced more by local property markets and is valued using the appraisal method. knowledge or capital to buy land or property on their own to participate in the income and long-term growth potential of real estate. For retail investors. Because REIT managers provide the strategic vision and make the investment and property decisions. Although real estate mutual funds bring liquidity to a traditionally illiquid asset class. naysayers on the use of these funds believe they are not akin to direct investment in real estate. They provide the ability to gain diversified exposure to real estate with a relatively small amount of capital. These may include multifamily residential properties. most are also taking additional financial risk by having a home mortgage.) Real Estate Investment Trusts (REIT) REIT shares are private and public equity stock in companies structured as trusts that invest in real estate. Not only do they already have real estate exposure. Explanations for this is due to the influence of macroeconomic forces on REIT values and the fact that REIT stocks are continuously valued. REITs typically own and operate real estate properties. .enough properties to diversify and will increase exposure to local property market and property type risks. they provide investors with much broader asset selection than can be achieved in buying REIT stocks alone and also provide the flexibility of easily moving from one fund into another. Even though the tax advantage increases after-tax cash flows. Creating an exposure to a broad base of mutual funds can also reduce transaction costs and commission relative to buying individual REIT stocks. Volatility in the REIT market has also been higher than direct real estate. REITS provide many of the same advantages and disadvantages as equities. Apart from the tax advantage. (To learn more. (For more insight. which tends to smooth investment returns Real Estate Mutual Funds Real estate mutual funds invest primarily in REIT stocks and real estate operating companies. More speculative investors can tactically overweight certain property or regional exposures to maximize return. Depending on their strategy and diversification goals. read The REIT Way.) Home Ownership Many retail investors who have not considered real estate allocations for their investment portfolios fail to realize that they may already be investing in real estate by owning a home. REITs pay little or no federal income tax as long as they distribute 90% of taxable income as dividends to shareholders. malls.

From the perspective of total return.CFA (Contact Author | Biography) The Impact Of Interest Rates On Real Estate Investment Trusts by David Harper. As a high-yield investment. a REIT can be expected to exhibit sensitivity to interest rate changes. see What Are REITs?) Relatively High Yields In Figure 1. we show the median yield for each REIT sector as of September 2004.Conclusion Although retail investors can and should take into account home ownership when conducting their portfolio allocations. Unlike a small-cap stock. on average. the bottom is in the 25% yield. real estate mutual funds would be an appropriate choice. about two thirds of a REIT's return comes from dividends. For those with the requisite trading skills and capital. REITs behave like a typical small-cap stock. more liquid investments in real estate might also be considered. For more insight. we explore this relationship. (For more on this. additional.CFA. FRM (Contact Author | Biography) A real estate investment trust (REIT) must pay out at least 90% of its taxable profit as a dividend to shareholders. In this article. REITs are relatively high-yield instruments. The top of each bar is in the 75% yield. Figure 1 . In fact. For others considering a smaller allocation or for those that do not want to be saddled by asset selection but require maximum diversification. most of the expected return of a REIT comes not from price appreciation but from dividends. by Robert Stammers. and the break from green to blue in the middle is the median yield. dividends plus price appreciation. REIT investing provides access to some of the benefits of real estate investing without the need for direct ownership. read Investing in Real Estate.

but the yields were dispersed: the 25% yield (the bottom of the blue portion) was about 4% and the 75% yield was more than 6. but you would assume additional risk. Therefore. Figure 2 compares the value of the NAREIT Index to the 10-year Treasury bond (T-bond) from the beginning of 1972 to almost the end of 2004: Figure 2 Copyright • 2009 Investopedia. This means only half of the REIT yields were between 4% and 6.87% to 15.8% during the same period. The most popular REIT index is the NAREIT Equity REIT Index. the yield on long-term U. it is hard to draw conclusions because most of the period was dominated by a secular (i. and the value of the NAREIT Index gained an impressive 15. if your goal is income. As of September 2004.5%. The strong negative 66% correlation between the two instruments suggests an inverse relationship.5% while the other half of REIT yields was outside this range.com Keep in mind that the chart of the NAREIT Index shown above includes both income and price gains.S. government treasuries was less than 5%.com You can see that yields vary by sector. long-term) decline in interest rates.Copyright • 2009 Investopedia. such implications would be more compelling if the few periods of sustained rate increases were met with declines in the NAREIT Index. However.e. REIT Total Returns Compared to Interest Rates Conventional wisdom says that higher rates are generally bad for REITs. Although we have over 30 years of data. The blue line starts at an indexed value of 100 and is plotted against the vertical axis on the right. The green line is charted against the left vertical axis.5% (the top of the green portion).15% (the peak of the green line). At the same time. . increases occurred simultaneously: during the five-year period from December 1976 to October 1981. you might do better with a REIT. Instead. the median yield among all REITs (the bar furthest on the right) was about 5. 10-year Treasury rates leaped from 6.

8%. There will be exceptions in the short-term. in the five years preceding 2004. we can probably assume that past returns such as these cannot be replicated into the future over the long run for the industry as a whole. For those considering a REIT investment as of late 2004. therefore.4% 18. Figure 3 shows a virtual mirror-image relationship between the price component of the REIT index and the medium-term interest rate. During that period.2% Unfortunately.6% 18.REITs did even better in later years as interest rates declined. In fact. from the 1989 point. price gains (as a percentage) exceeded . First. this would be a "red flag" for two reasons. we compare the same 10-year Treasury bond rates to a price-only index.8% 6 Year 7 Year 13. REITs had a good run over the five years preceding 2004: NAREIT Index Annualized Return for Period Ending September 2004 1 Year 2 Year 25. Figure 3 Copyright • 2009 Investopedia.com Although the overall correlation is weaker. REIT Price Returns Compared to Interest Rates Let's focus on just the price component of REIT stocks. we exclude dividends and isolate only on price changes to see what would happen to $100 if it were invested in 1972. the index produced an annualized gain of 18.7% 9. In other words.6% 26% Table 1 3 Year 4 Year 5 Year 20. In Figure 3 below. Table 1 shows the annualized return for the NAREIT Index. there is a strong inverse pattern over the last 15 years in the period shown above. including a steep annualized gain of 26% over the two preceding years.

some argue that in the case of residential and office REITs rising interest rates would drive up REIT prices because increasing rates correspond to economic growth and more demand. On average. or funds from operations (FFO). FRM (Contact Author | Biography) Filed Under: Bonds A real estate investment trust (REIT) is a real estate company that offers common shares to the public.CFA. Further. a real estate company must agree to pay out in dividends at least 90% of its taxable profit (and fulfill additional but less important requirements). But you will need to be selective in such an environment. you would consider them . Of course. price as a multiple of FFO). In this way. cash flow. you are usually reading about equity REITs. Second. While a handful of hybrid REITs run both real estate operations and transact in mortgage loans. They are finance companies that use several hedging instruments to manage their interest rate exposure. When you read about REITs. a company avoids corporate income tax. by David Harper. It is entirely likely that this interest rate will edge upward. To learn more about REITs. FRM (Contact Author | Biography) What Are REITs? by David Harper. office buildings or lodging facilities. most REITs focus on the "hard asset" business of real estate operations. By having REIT status. it is unlikely.such as. We will not consider them here. The REIT Status To qualify as an REIT with the IRS. Mortgage REITs require special analysis. These are called equity REITs. the medium-term interest rate is low by historical standards.CFA. A regular corporation makes a profit and pays taxes on the entire profits. for example. The good news about REITs is that high yields are a sort of hedge against price declines: if you buy a high-yield REIT. For example. Some are diversified and some are specialized. meaning they defy classification . But an REIT has two unique features: its primary business is managing groups of income-producing properties and it must distribute most of its profits as dividends. Here we take a look at REITs. an REIT simply distributes all or almost all of its profits and gets to skip the taxation. but they do not generally own or operate real estate. regional malls. Types of REITs Fewer than 10% of REITs fall into a special class called mortgage REITs. and then decides how to allocate its after-tax profits between dividends and reinvestment. If you seek income. then REIT prices would suffer. their characteristics and how they are analyzed. it would be safe to assume that interest rate increases are likely to be met by REIT price declines. If the 15 years of inverse correlation between rates and REIT prices shown above continued. Summary The 15-year period examined above shows there is a strong inverse relationship between REIT prices and interest rates. What Kind of Asset Is an REIT Stock? REITs are dividend-paying stocks that focus on real estate. an REIT stock is similar to any other stock that represents ownership in an operating business. any price decline will be mitigated by high income in the meantime. reaction by sectors will vary. an REIT that owns golf courses. as measured by earnings. see Basic Valuation Of A Real Estate Investment Trust (REIT) and The REIT Way.fundamental gains. While such gains could be replicated going forward. Equity REITs tend to specialize in owning certain building types such as apartments. These REITs make loans secured by real estate. it is entirely possible that prices could revert to prior multiples (for example.

000 in depreciation expense ($50. The blue bars add price changes for each year .along with high-yield bond funds and dividend paying stocks. they have averaged about 8% and never once fallen below 4. . REITs are analyzed much like other stocks. Let's illustrate with a simplified example. But there are some large differences due to the accounting treatment of property.they represent total return. Let's assume that we spread the depreciation over 20 years in a straight line. Each year we will deduct $50. price change plus income return. Suppose that an REIT buys a building for $1 million. but volatile nonetheless. Analyzing REITs As dividend-paying stocks.000 per year x 20 years = $1 million). You can see that stable dividends combine with price volatility to create a total return that is often promising. shown below. The red bars represent annual returns solely from dividends.8%. Consider 20 years of returns for the NAREIT Equity REIT Index (an index of about 150 traded REITs) between 1984 through 2003. Accounting requires that our REIT charge depreciation against the asset.

then our estimate of the building's value becomes $1.000 in revenues minus $100.000 in operating expenses). which is an estimate of intrinsic value. notice in the example above that we never counted the $1 million spent to acquire the building (the capital expenditure).000). . If we think the market's present cap rate for this type of building is 8%.000 per year). A more accurate analysis would incorporate capital expenditures. but $50. In year 10. Calculating NAV requires a somewhat subjective appraisal of the REIT's holdings.000 of the expense is a depreciation charge. the quoted share price should not stray too far from the NAV per share. This market value estimate replaces the book value of the building.250.000 (a.25 million ($100. where the 'net' in NAV means net of debt.a. we add back the depreciation charge to net income in order to produce funds from operations (FFO). too.000 accumulated depreciation (10 years x $50. we see the building generates $100.k. net asset value (NAV). but it does not capture cash flow.Let's look at the simplified balance sheet and income statement above.000 in revenues.are pretty much useless for REITs. the book value): the original historical cost of $1 million minus $500. So. (FFO includes a few other adjustments.) We should note that FFO gets closer to cash flow than net income. In theory. the book value of our building was only $500.000 in operating income ($200. One method would be to capitalize the operating income based on a market rate. Our hypothetical balance sheet can help us understand the other common REIT metric. In the above example. Therefore. our balance sheet carries the value of the building at $500. Counting capital expenditures gives a figure known as adjusted FFO.000 of expenses from $200. We then would deduct the mortgage debt (not shown) to get net asset value.often dubious in regard to general equities analysis . FFO fixes this presumed distortion by excluding the depreciation charge. In year 10. Assets minus debt equals equity. book value and related ratios like price-to-book . depreciation is a non-cash charge. Mainly. but there is no universal consensus regarding its calculation. However.000 in operating income / 8% cap rate = $1.. our REIT doesn't actually spend this money in year 10. Our income statement deducts $190. The idea is that depreciation unfairly reduces our net income because our building probably didn't lose half its value over the last 10 years. NAV attempts to replace book value of property with a better estimate of market value.000 because half of the original cost was depreciated. The final step is to divide NAV into common shares to get NAV per share.

Rising interest rates tend to be good for apartment REITs as people prefer to remain renters rather than purchase new homes. As mortgage debt plays a big role in equity value. For example. namely the institutional demand for REIT equities. it may be forced into ill-considered acquisitions in order to fuel growth. It is more important to weigh the proportion of fixed versus floating-rate debt. and further aim to realize economies of scale by assimilating inefficiently run properties. Population and job growth tend to be favorable for all REIT types. Top-down starts with an economic perspective and bets on themes or sectors (for example. But. Stable income that can exceed Treasury yields combines with price volatility to offer a total return potential that rivals small capitalization stocks. REITs typically seek growth through acquisitions. At the individual REIT level. because money was flowing into the entire asset class. On the other hand. Interest rates are. A rise in interest rates usually signifies an improving economy. In the short run. in brief. FRM (Contact Author | Biography) . you want to see strong prospects for growth in revenue. you sometimes hear of top-down versus bottom-up analysis. and FFO. such as rental income and related service income. REITs can be affected by anything that impacts the supply of and demand for property. in practice. an REIT that uses only floating-rate debt will be hurt if interest rates rise.CFA. a mixed bag. Capital market conditions are also important. it is worth looking at the balance sheet. Bottom Up When picking stocks. this demand can overwhelm fundamentals. Conclusion REITs are real estate companies that must pay out high dividends in order to enjoy the tax benefits of REIT status.Top Down Vs. Analyzing an REIT requires understanding the accounting distortions caused by depreciation and paying careful attention to macroeconomic influences. But acquisitions are a double-edged sword. You want to see if the REIT has a unique strategy for improving occupancy and raising its rents. Economies of scale would be realized by a reduction in operating expenses as a percentage of revenue. it is difficult to tell when leverage has become excessive. From a top-down perspective. which is good for REITs as people are spending and businesses are renting more space. Bottom-up focuses on the fundamentals of specific companies. In the current low interest rate environment. Some recommend looking at leverage. REIT stocks clearly require both top-down and bottom-up analysis. by David Harper. such as the debt-to-equity ration. REIT stocks did quite well in 2001 and the first half of 2002 despite lackluster fundamentals. REITs can often take advantage of lower interest rates by reducing their interest expenses and thereby increasing their profitability. an aging demographic may favor drug companies). If an REIT cannot improve occupancy rates and/or raise rents.

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