REITs Depend Heavily on Capital Markets for Growth
Because REITs are legally only allowed to retain a maximum of 10% of taxable earnings, they must use debt and sell additional shares to fund growth of their assets, such as acquiring new properties or improving existing ones.
This means that the balance sheet of REITs will naturally show higher debt levels than most other sectors of the market. In addition, the share count will tend to rise over time as management sells new shares to fund the company’s growth.
For example, Realty Income has seen its diluted shares outstanding nearly triple from 80 million shares in fiscal year 2005 to 236 million shares in fiscal year 2015.
Source: Simply Safe Dividends
While a rising share count means that existing investors are getting diluted, unlike regular companies, this isn’t necessarily a bad thing. That’s because, as long as the additional money raised by selling new shares and/or taking on new debt results in AFFO per share growing over time, the capital raise is known as accretive.
This means that the increase in AFFO is more than the rise in share count, meaning that AFFO per share rises over time. That not only makes the existing dividend more secure, but also allows for dividend growth, which causes the yield to rise, attracting new investors, who bid the share price up. In this way, quality REITs can grow over many decades, generating exponentially rising income streams, and massive shareholder value.
Other Key Differences between REITs and Corporations
There are two other key things to remember about REITs that are slightly different than most other dividend-paying c-Corps.
First, due to how they structured for tax purposes, remember that REIT dividends are unqualified, meaning they are taxed as regular income, and thus at your top marginal income tax rate. This means that they make great candidates for tax-sheltered accounts such as IRAs. Investors can learn more about which type of IRA is better for dividend-paying stocks here, and a deeper look at how REITs are taxed can be found here.
A second important factor is to know whether or not the REIT is internally or externally managed. Most of the bigger, more popular REITs such as Realty Income Corp (NYSE:O) or Welltower Inc (NYSE:HCN) are internally managed, and this is generally preferable to an externally managed structure.
That’s for two main reasons. First, externally managed REITs, in which management doesn’t work for the REIT directly but is an external adviser that operates and manages the REIT’s assets, have higher operating costs. Typically the manager charges a fixed fee, a percentage of assets, for its services. There is also a performance incentive based on the growth of net asset value, or NAV, above a certain hurdle rate. In other words, externally managed REITs are the real estate version of a private equity firm; and high fees can eat into long-term investor returns.
Not only does that lead to higher operating costs, and thus lower profitability, (which can make dividend growth harder), but it can also result in conflicts of interest between shareholders and management. That’s because, if management is paid based on the size of a REIT’s assets, then it has an incentive to grow the REIT as large as possible, in order to maximize its own pay.
This can result in a REIT chasing after “growth at any price,” meaning buying poorer quality properties at inflated prices, funded by excessive shareholder dilution. You can see this with some of the lower quality REITs in which the share count rises high enough over time to make the NAV per share (the equivalent of tangible book value per share) stagnate or even decline.
That being said, some externally managed REITs can make good investments, but you have to be VERY selective, and make sure that management’s interests are aligned with shareholders. Why would anyone take the added risks of owning an externally managed REIT? Well because the best ones are managed by large asset management firms with massive scale, experience, and an army of high quality employees. Thus they are able to make deals that smaller, internally managed REITs might not know about or be able to go after.
Regardless of whether an investor is buying shares of a corporation or a REIT, it’s important to remain aware of an asset’s sensitivity to the economy. Let’s take a look at how REITs fared during the Great Recession.
