REITs: A Proven Long-term, High-yield, Equity Class
Over the last few decades REITs have proven themselves one of the best long-term ways for investors to build income, and wealth over time. As you can see, REITs have not just held their own nicely against both large cap companies, such as make up the S&P 500, but also small cap stocks. Meanwhile they have handily outperformed bonds, and inflation, as one would hope from equities, which have more built in risk than bonds, and should thus offer an appropriate risk premium.
Source: REIT.com
This great long-term performance has resulted in the REIT industry growing over the decades to over $1 trillion in market capitalization, and holding over $2 trillion in total assets. The industry has grown so large in fact, that S&P has recently changed its Global Industry Classification Standard, or CIGs system to make REITs its own sector, rather than grouping REITs into finance.
This change represents the growing importance of REITs to the overall stock market, and is likely to result in far more interest from institutional money, thanks to the need to hold prominent REITs as part of increasingly popular index funds. Which means that, going forward REITs should represent a potentially even more popular, liquid, and potentially less volatile asset class.
There are Many Different Types of REITs
While all REITs are similar in many ways, investors need to realize that this sector encompasses a vast array of differing real estate assets:
- Office
- Industrial
- Shopping Center
- Malls
- Single Family units (rental homes)
- Apartments
- Medical
- Data Centers
- Student Housing
- Hotels
- Triple Net Lease Retail
- Manufactured Homes
- Storage
- Timber
- Infrastructure
Investors can view a complete list of REITs here.
Note that there is also a separate class of REITs known as mortgage REITs, or mREITs. These are a far more complex, volatile, and challenging higher-yielding class of equities that isn’t suitable for investors seeking steady and growing incomes. That’s because the business model of mREITs is extremely interest rate sensitive.
It’s based entirely on buying and selling mortgage backed securities, and involves little or no owned properties. Therefore it should be owned only by the most risk-tolerant investors, who are willing to put in the extra effort to find only the best mREITs, hold throughout periods of falling dividends, extreme volatility, and buy on the corresponding dips, corrections, and crashes.
Getting back to traditional property-based REITs, as you can see from the above list there is a vast universe to potentially own, each with its own various nuances that investors need keep in mind. However, all REITs share common characteristics in that they derive the majority of their cash flow, which is what secures and grows the dividend, from real estate properties and rental income from tenants.
Important REIT Financial Metrics
Of course, being that REITs are generally owned as high-yield, dividend growth investments, naturally the dividend profile is the first thing that you’ll want to look at when performing your due diligence before investing. This consists of three factors: yield, dividend safety, and potential long-term growth prospects.
The most important of these is dividend safety, because nothing can potentially generate permanent losses of investor capital than a dividend cut, which generally sends shares crashing. However, because of the way REITs are structured for tax purposes, traditional methods of measuring dividend safety, particularly the EPS payout ratio, are not good means of knowing whether or not a payout is actually safe.
That’s because under generally accepted accounting practices, or GAAP, a company must include depreciation and amortization of its assets into its earnings calculations. However, the unique nature of real estate assets, particularly that well-maintained properties tend to appreciate rather than depreciate over time, means that GAAP earnings don’t actually represent a REIT’s ability to cover its dividend or grow it over time.
What you instead want to look at is funds from operations, or FFO. This is the REIT equivalent of operating cash flow. It adds back non-cash expenses such as depreciation and amortization back into net income, and subtracts gains or losses on asset sales; such as any properties that management may have sold over a period of time. The “EPS Payout Ratio” charts in our Stock Analyzer add back depreciation and amortization to net income for REITs.
Even more important is Adjusted Funds From Operations, or AFFO. This is the equivalent of a REIT’s free cash flow, or FCF. It subtracts maintenance capital expenditures, or capex, from FFO, to show how much cash the company is generating after running its operations and investing enough capital to preserve what it already owns.
This can be thought of as “Funds available for distribution” or FAD, and indeed some REITs actually call it that. The difference between AFFO and true free cash flow, as reported by regular corporations, is that FCF also includes growth capex, or the money the company is investing to grow.
Investors can retrieve these figures directly from the company they are interested in. Take a look at one of Realty Income Corp (NYSE:O) quarterly earnings reports here. You can see that AFFO per share was 71 cents versus reported net income per share of 27 cents. The company paid dividends of 59.7 cents per share during the quarter, representing a reasonable AFFO payout ratio near 85%.
There are several financial metrics beyond the payout ratio that dividend investors really need to understand. Investors can review the top 10 financial ratios I think are most important for investing here.
In addition to the unique non-GAAP figures reported by REITs, investors need to be aware that these companies rely on issuing debt and equity to keep their businesses running.
