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Most real estate investors likely have some familiarity with real estate investment trusts (REITs). They know that a REIT is a company that holds a portfolio of income-producing real estate, which allows most REITs to pay attractive dividends to investors. However, there is a lot more to REITs than that.
Investors also need to know how REITs report their earnings as well as how they fund their operations, since it differs from most publicly traded companies. Once investors have a better understanding of those aspects, they can better analyze whether a REIT can continue paying its investors generous dividend income even as it invests money to grow its commercial real estate portfolio.
Making sense of how REITs make money
The business model of most REITs is easy to understand. The company will own a portfolio of real estate property, like office buildings, which it leases to tenants who pay rent. REITs use this money to cover expenses on the property, such as the mortgage. Anything left over is known as that property's net operating income (NOI).
Corporately, however, REIT financial reporting can get a bit more complicated. That's because they use Generally Accepted Accounting Principles, or GAAP, when reporting their earnings as well as several non-GAAP, REIT-specific metrics. As a result, investors need to pay attention to the right set of numbers when gauging a REIT's performance.
GAAP financial metrics keep REITs in compliance with tax rules. One of the requirements for a REIT is that it must distribute at least 90% of its taxable income to investors to maintain its special tax status.
However, the taxable income of a REIT is typically much less than the actual cash flow it produces in a reporting period due to large write-offs like depreciation. While this keeps its taxable income low, it masks the true earnings power of a REIT, which is why most use several non-GAAP metrics to show investors a more accurate picture of their cash flow. The most common is funds from operations (FFO), which adds back depreciation while subtracting any gains on the sale of real estate. As such, it serves as a good proxy for the cash flow a REIT generated that it could have paid out to investors via a dividend.
A case study in REIT financial reporting
To show why this distinction matters, we'll use a real-life example by looking at Boston Properties (NYSE: BXP), which is the largest office REIT by market capitalization. During the third quarter of 2019, the company reported $0.70 per share of net income on a GAAP basis. That had it on track to earn $3.28 to $3.30 per share for the full year.
At first glance, that's a bit of a concern since Boston Properties pays a dividend of $0.98 per share each quarter, or $3.92 per share on an annualized basis, implying a more than 100% dividend payout ratio. However, after adjusting for noncash charges like depreciation and the loss on the early redemption of some debt, Boston Properties generated $1.64 per share of FFO during the third quarter, which had it on track to produce $6.98 to $7.00 for the full year. Those numbers suggest it has a much more comfortable dividend payout ratio of 56% of its FFO. As such, the company is retaining cash that it can allocate in a variety of ways such as paying down debt, buying back stock, or expanding its portfolio.
How REITs finance growth
In addition to using a distinct set of financial metrics to measure their performance, REITs also finance growth differently than most traditional corporations. Typically, businesses use a large portion of their retained earnings to build new factories or launch new products, for example.
However, because REITs need to pay out at least 90% of their taxable earnings in dividends to maintain their tax status -- and many also choose to pay out 70% to 80% of their FFO -- they don't retain very much cash to fund expansion. Instead, they primarily finance income-producing property acquisitions or developments by issuing new debt and selling stock. Because of that, REIT investors need to keep a close eye on a company's credit metrics to ensure it has the financial flexibility to continue growing its portfolio as well as its dividend.
Several ratios help REIT investors gauge whether a company has a strong enough credit profile to support both its dividend and its ability to continue expanding. These include:
- The debt ratio, which is total debt divided by assets.
- The coverage ratio, which is EBITDA divided by interest expense.
- The fixed charge ratio, which is EBITDA divided by interest expense plus preferred dividends.
- The debt-to-EBITDA ratio, which is total debt divided by EBITDA.
- The debt-to-equity ratio, which is debt divided by a REIT's equity market capitalization.
Credit rating agencies typically look at those metrics, as well as many other factors, to determine the credit quality of a REIT. In particular, they usually like to see that a REIT has a debt-to-EBITDA level of less than 6.0 times to give an investment-grade rating. That rating threshold makes it cheaper and easier for a company to borrow money to finance acquisitions and development projects.
Those numbers, however, are more like guidelines as credit rating agencies will also factor in other things like a REIT's size, cash flow stability, and FFO payout ratio to determine its credit rating. That's why Boston Properties, for example, has a higher-end credit rating even though its debt-to-EBITDA ratio stood at 6.5 times at the end of the third quarter. It offset that higher leverage with a low 56% FFO payout ratio. Because it has an investment-grade credit rating, the company can easily tap low-cost funding for acquisitions and development projects.
What investors should look for in a REIT
While most people invest in REITs for the dividend income, they have historically also produced healthy capital appreciation. As a result, REIT performance has been exceptional, with the sector's average total annual returns outpacing those of the S&P 500 over the last several decades.
One driver of the sector's strong total returns has been the ability of many REITs to increase their dividends consistently. While rising rents and falling interest rates have helped boost REIT income, the main factor fueling dividend growth has been the ability of REITs to build and buy additional cash-flowing properties.
The most successful have done that by targeting a conservative financial profile, which includes having a dividend payout ratio of less than 80% of FFO and a strong investment-grade balance sheet backed by low leverage metrics. That has given the top REITs the financial flexibility to focus on making investments that grow their FFO on a per-share basis.
Boston Properties, for example, has done an excellent job using its financial flexibility to grow shareholder value in recent years. It has completed about $2.6 billion of developments since 2014 -- and has another $3.6 billion in active development projects underway -- and has completed about $2.1 billion of property acquisitions since 2013. These investments have grown the company's FFO from $4.90 per share in 2012 up to a projected range of $7.45 to $7.65 per share in 2020, allowing it to increase the dividend 42% over the last three years.
Boston Properties maximized its per-share growth rate because it didn't sell any stock to finance expansion. Instead, it used its strong balance sheet to fund growth and the selective sale of noncore properties to help keep leverage from growing out of control, with it only rising from 5.7 times in 2014 to a peak of 6.8 times in 2018. This approach has helped the company generate a more than 60% total return since the start of 2013.
How to pick the right REITs
Since REITs must distribute 90% of their GAAP earnings, they can't entirely rely on retained cash to finance growth. Instead, they need to use a combination of the money they do retain as well as stock issuances, property sales, and additional borrowings to finance acquisitions and development projects so that they can grow their dividends. Because of that, investors need to pay close attention to a REIT's financial profile to ensure they have the flexibility to pay their dividends as well as expand. Those with a solid financial foundation are in the best position to continue growing over the long term, which is why REIT investors should prioritize those companies.
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