The “Short” Journey to Going Long in Real Estate Investment Trusts

The housing market is in recovery, a slow and painful one, but a recovery nonetheless. And no, I’m not saying this because I’ve been obsessing over house prices, builder confidence indexes, construction permits numbers and foreclosure rates (ok, I’ve done that too), but because the hedge funds, where the smart money lies, are moving back into real estate. And I’m trailing behind.

I decided to get into real estate investing about four months ago – right around Christmas when the budgets and the belts are too tight to really be thinking about investments. Well, I’ve never had a deep pocket anyway so I decided to jump in with whatever I could scoop together and hope for the best.

My research took me into the real estate investment trusts territory – a nifty vehicle that allows small investors like me to invest in large-scale, income-producing real estate. But first I had to do some research.

REITs?

The US Congress passed the Real Estate Investment Trust Act in 1960 and three years later, the first REIT was formed. REITs could be either publicly traded on a stock exchange or non-traded – you can invest in both types with small exceptions.

As of January 1, 2012, there were 166 publicly traded REITs registered with the Securities and Exchange Commission and about 1,100 non traded REITs that have filed tax returns with the IRS. Apart from public and non-public, REITs can also be equity, mortgage or hybrid REITs. Equity REITs, the most common type, own and operate income-producing real estate.

Mortgage REITs provide funds to real estate owners either directly in the form of real estate loans, or indirectly through buying mortgage backed securities (No mortgage protection needed as this is indirect real-estate investing). Finally, hybrid REITs use the investment strategies of both equity and mortgage REITs.

Are REITs The Right Investment For You?

The first question you need to ask yourself before you jump into REIT investing is what you are looking to get out of it. REITs are an appropriate investment for both large and small investors who have a preference for current income and would like to add exposure to the real estate market to their portfolio.

REITs however are not suitable for those investors looking for capital appreciation – REITs distribute 90 to 100 percent of their pre-tax earnings to shareholders through dividends but the value of their shares tends to change very little.

REITs are also not for you if you want to minimize your taxes – the dividends you will receive are added to your total taxable income so you will owe more taxes at the end of the year.

How to Choose Your REIT

Professional investment managers usually have to screen hundreds of REITs in all their forms – public traded and non-traded, private, mutual funds and ETFs – to find the one tailored to the needs of their clients. What’s more is that traditional metrics like price-to earnings multiple, earnings-per-share ratio and growth are not too helpful in the valuation of a REIT.

But there are a couple of quick and useful tips I can give you on what to look at when trying to evaluate a REIT:

Quantitative Metrics

Capitalization Rate – Cap Rate is the expected net annual operating income for a given property, divided by the purchase price of that property. For example, if a firm pays $100 million for a building with annual operating income of $10 million, the cap rate for that building is 10%.

The metric is used to determine how effectively the REIT’s assets are generating cash flows. REITs usually first pick a Cap Rate for their acquisitions and then calculate how much they are willing to pay for the property based on their estimate of the operating income the building will generate.

Net Asset Value – NAV is the adjusted asset value of the properties held by the REIT. It is usually quoted “per share”, which means the value is divided by the number of total outstanding shares.

Funds From Operations (FFO) and Adjusted Funds From Operations (AFFO) – FFO is a measure of the cash flow generated by the REIT. It is calculated by adding up net income, depreciation and amortization and subtracting gains on sales of property. REITs typically disclose their FFOs in the footnotes of their financial statements and are required to show their calculations.

Some investment professionals go a step further and calculate the AFFO, which is generally equal to the REIT’s FFO with adjustments made for recurring capital expenditures used to maintain the quality of the REIT’s assets as well as rent increases.

Qualitative Metric

Management – When investing in a REIT one should always consider the managers’ qualifications, experience and track record. REITs can be “internally managed” with management employed directly by the REIT, or “externally managed” pursuant to a management contract with no direct employees.

Private REITs and registered but non-traded REITs are usually externally managed on a for-fee basis by a party manager. Publicly traded REITs can be either internally or externally managed but as a general rule, once they reach a certain size, most public REITs will “internalize” their management through an exchange of stock with the owners of the advisor.

Internalization is considered to better align management and the shareholders by limiting the enterprise value growth going solely to the management.

Goals – Some REITs might prefer to have more cash on hand, while others might be looking at aggressive acquisitions. Furthermore if it’s a non-traded REIT it’s important to learn what its exit strategy is.

In most cases the REIT will provide investors with a liquidity event by either listing on a public exchange or by selling the assets in the portfolio and distributing the net liquidation proceeds to investors.

Kind of Assets Held – Last but not least, one should always consider in what kind of assets the REIT is investing. REITs can invest in a variety of property types: shopping centers, apartments, health care facilities, office buildings, hotels, warehouses and others.

Some REITs prefer to specialize in one sector such as timberlands or data centers, while others diversify with many different types of buildings.  REITs can also choose whether to invest in real estate located in a single city, a state, across the country or even abroad.

The Investment

After carefully considering the pros and cons of REIT investing, I decided to go ahead and invest into a REIT ETF. My pick was the SPDR Dow Jones REIT ETF – an exchange traded fund which tries to invest in companies whose charters are the equity ownership and operation of commercial real estate.

The ETF is tracking the performance of the Dow Jones U.S. Select REIT Index and is aiming to invest at least 95 percent of its total assets in the securities comprising the index. The fund holds 85 securities in total with 47.98 percent of the assets going to the top 10 holdings.

It has over $2.1 billion in assets under management and charges investors 25 basis points a year in fees for its services.

I bought about 300 units of the ETF on January 4 when it was trading for about $73 apiece, which placed my initial investment at $21,900. The ETF closed at $80.24 on Thursday, April 18, and if I exited my position back then I would have pocketed a nice return of $2172 or $2295 with the dividends.

I’m still holding on to the ETF units as I’m sure there is still plenty of upside potential. The REITs included in the ETF have posted strong earnings over the past three-quarters and some have boosted dividends.

The Bottom Line

REITs are a great way to get exposure to a diversified portfolio of real estate assets and often enjoy an attractive dividend yield. As any other financial asset, they do carry a certain risk so I advise to always turn to an investment professional for advice before jumping into a REIT investment.

About author Anton Aleksandrov – Anton is an economist freshly graduated from the United States who is interested in real estate investment opportunities. He is one of the more recent additions to the iNVEZZ  journalist team and his area of expertise is real estate investment trusts.