The Truth About REITs

Compared with the rest of the investing scene, real estate investment trusts -- affectionately referred to as REITs -- don't garner as much interest or enthusiasm among individual investors.

Sure, a group of astute investors has discovered that REITs, like any other investment, offer investors strong returns if a good company is purchased at a good price. More often than not, it's been the Income Investor who's been drawn toward REITs. This is because REITs are required by law to pay out 90% of their net income to shareholders.

Rarely appears on screens
Screening is less likely to work as well for REITs as it would for, say, retailers such as Abercrombie & Fitch (NYSE: ANF  ) or Gap (NYSE: GPS  ) , which are customers to mall REITs such as Simon Property Group (NYSE: SPG  ) . This is due to the large depreciation expense that a REIT is likely to carry, which means generally accepted accounting principles (GAAP) net income is likely to understate the cash profitability of a REIT. This, in turn, will cause P/E ratios, which investors often use as screening criteria, to be out of whack in relation to the cash profitability of the business.

Another favorite that investors screen for is double-digit revenue or profit growth. REITs rarely deliver that type of growth, and when they do, it isn't for very long. However, a solid REIT investment is likely to deliver mid-single-digit profit growth along with a mid-single-digit dividend yield. Combine the two and it's not uncommon to average a double-digit total return on an annual basis.

The other reason REITs won't often show up on screens is that many investors screen for low levels of debt, and that doesn't reflect the reality of the REIT industry. After all, when was the last time you paid cash for a piece of land or a building?

What are the earnings?
With net income not offering as much insight into the business, what can an investor use to gauge the profitability of a REIT? Much like free cash flow allows further insights into the cash profitability of a consumer or industrial business, funds from operations (FFO) and adjusted funds from operations (AFFO) offer a similar level of insight for REITs. A similarity shared by FFO, AFFO, and free cash flow is that they all require analysts to decide what is and isn't included in the calculations, particularly when it comes to capital expenditures for maintaining property and for purchasing or expanding property.

The makings of a winner?
Though earnings are always important and at the forefront, other factors must also be examined when evaluating a REIT. These aren't too different from what you look for when evaluating a company in a more familiar industry. Being able to trust management and understanding its compensation are just as important for a REIT as for any other business. Since REITs tend to have management teams with years of experience in the industry and often a decent ownership stake in the business, some of this risk is mitigated.

REITs also need to earn returns on debt and equity capital that exceed the cost of that capital. Owning the shares of a REIT with a mix of debt and equity capital cost of 13% and an 11% return on those properties is not going to be a pleasant experience.

Whether it's a REIT or a consumer products company with a dividend, we all want companies that have room to continue upping those dividends over time. For REITs, the best way to look at this payout ratio is to look at the dividends paid in relation to AFFO. It's also important to look at a REIT's history of growing AFFO and how it accomplished that growth. Having the ability to slowly increase rent and a history of successfully renovating a property as it ages go a long way toward ensuring returns for the REIT investor.

Trouble waiting in the wings?
There has been a great deal of rumbling in the media lately about a real estate bubble. No doubt there are some places in the country where prices have moved up quickly. A recent chat with a friend who's in the market for a house confirmed this when the topic moved to REITs. When I mentioned that he should consider looking into a few REITs as possible investments for his IRA, his face took on an expression of severe pain. He then explained how REITs are doomed, just like the rest of the real estate market. Unfortunately, this isn't an uncommon belief these days.

It may, however, not be a strong theory to lean on. Commercial and residential real estate are quite different. For instance, the dynamics of Kimco (NYSE: KIM  ) purchasing property and my friend buying a house are vastly disparate. And when one experiences trouble, it doesn't imply the other will suffer the same fate. If the housing market slows down, it doesn't mean business at Public Storage (NYSE: PSA  ) will see a slowdown of similar proportions. That said, it doesn't suggest Public Storage won't endure some form of volatility in its shares. REITs, like most businesses, are vulnerable to economic slowdowns, but the vulnerability will vary by geography and industry.

Foolish final words
If you compare a well-managed REIT and an equally well-managed business in another industry, you'll quickly see that the only difference is the product being sold. In this case, it's real estate, which makes the difference in how expansion is financed and how the company is measured.

REITs, however, aren't the mysterious beasts they often seem to be. At the end of the day, a company that offers a desirable product, is managed for the long term, and treats its shareholders like partners will prosper whether it's a REIT or a retailer.

Lastly, this has been a very simple primer on REITs, which make up a broad investment category that offers a great deal of variation between industry segments. Fortunately, there are a number of sound resources out there to help the individual investor learn about REITs, including Foolish content, the NAREIT website, and Investing in REITs by Ralph Block.

Mathew Emmert has served up a few market-beating REIT selections in Motley Fool Income Investor. Consider taking a free trial to see which REITs made the cut. If you're not satisfied, we'll give your money back. No questions asked.

NathanParmelee has no financial interest in any of the companies mentioned. You can view his profile here. The Motley Fool has an ironclad disclosure policy.


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