Real estate investment trusts are an asset class unlike any other. They're required to pay out 90% of their income. Their earnings look nothing like generally accepted accounting principles net income. And their quarterly and annual reports are stuffed with jargon.
I wanted to make a guide for the new REIT investor to help explain some of the terminology common to equity real estate investment trusts like Realty Income (NYSE:O) and National Retail Properties (NYSE:NNN). Here are five big ideas you should know before buying REITs.
1. Net income doesn't matter
More than any other industry, net income doesn't matter to a REIT. The best way to measure a REIT's profitability is to look at its adjusted funds from operations. This measure adds depreciation and amortization back to earnings and then subtracts routine capital expenditures necessary to maintain the properties owned by a REIT.
Adjusted funds from operations is the best indicator of financial performance because it removes accounting oddities to get to the bottom line -- how much did a REIT really earn. And by that I mean how much a REIT can pay out in a dividend. You can read more about this in a post about why REIT price-to-earnings ratios are so darn high.
2. Nets aren't just for basketball
REITs are in the business of buying real estate and leasing it to a tenant. Most leases fit under three basic structures. The most common for commercial real estate, which Realty Income and National Retail Properties both own and lease, is the triple-net lease.
A triple-net lease requires the tenant to pay all taxes, insurance, and maintenance costs. Double-net leases require tenants to pay just taxes and insurance. Single-net leases require a tenant to pay only the annual taxes. You get the idea -- the more "nets," the more costs the tenant, not the landlord, is responsible for paying.
How a REIT structures its leases is very important to its ongoing costs. Realty Income and National Retail Properties have very low maintenance costs as a percentage of revenue because they write primarily triple-net leases. Other REITs, like an apartment REIT, would have much higher maintenance and capital expenditure expenses because they pay for everything from repairs to property taxes.
3. How REITs acquire properties
REITs aren't just sitting ducks that pay big dividends. Most REITs are buying new properties quarter after quarter to expand their portfolios.
In commercial real estate, REITs buy property in sale-leaseback transactions and portfolio acquisitions. In a sale-leaseback transaction, a REIT buys a property from, say, a retailer, then immediately leases the property back to the original owner. This is financial engineering at its finest. A retailer might not want to own a billion dollars of retail property, so it can cash out by doing a sale-leaseback with a major commercial REIT.
In other corners of the real estate universe, portfolio acquisitions are more common. Here, a REIT buys a portfolio of one or many properties from another real estate investor or another real estate investment trust.
4. REITs are very interest rate sensitive
A REIT isn't an asset-light software company; it's a slow-growing, asset-heavy mix of properties that bring in monthly checks. Because REITs are slow-growing, capital-intensive businesses, their cash flows are relatively easier to predict than, say, the cash flows from an up-and-coming fast-casual restaurant.
Generally speaking, investors value REITs based on their dividends. In recent years, Realty Income and National Retail Properties share prices have moved in tandem with the 10-year U.S. Treasury yield. At any time, Realty Income and National Retail Properties have been valued so that their dividend yield is 2%-3% higher than the 10-year U.S. Treasury rate.
The point here is that REITs trade a lot like bonds in that they tend to trade inversely to changes in interest rates.
5. Economic risk changes with lease terms
Not all REITs are created equally. Office REITs tend to rise and fall with the economy, as businesses can more quickly cut ties to an office building when employees are laid off. On the other side of the coin, retail REITs like Realty Income and National Retail Properties are less cyclical as they sign long-term leases, often lasting 10 years or longer.
The best gauge for a REIT's cyclicality is its average lease life. Realty Income and National Retail Properties usually lock in tenants for a decade or more, so a short recession has very little impact on their revenue.
Office REIT Boston Properties (NYSE:BXP) reported in its third-quarter supplement that nearly 66% of its square footage would need to be released by the end of 2016. Less than 6.5% of National Retail Properties' square footage and 7.1% of Realty Income's square footage will need to be released in the same period. Whereas Boston Properties' customers can cut and run quickly, the retail REITs' customers cannot.
Fool contributor Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.