What is a ‘Real Estate Investment Trust – REIT’
A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges like a stock. REITs provide investors with an extremely liquid stake in real estate. They receive special tax considerations and typically offer high dividend yields.
BREAKING DOWN ‘Real Estate Investment Trust – REIT’
REITs, an investment vehicle for real estate that is comparable to a mutual fund, allowing both small and large investors to acquire ownership in real estate ventures, own and in some cases operate commercial properties such as apartment complexes, hospitals, office buildings, timber land, warehouses, hotels and shopping malls.
All REITs must have at least 100 shareholders, no five of whom can hold more than 50% of shares between them. At least 75% of a REIT’s assets must be invested in real estate, cash or U.S. Treasurys; 75% of gross income must be derived from real estate.
REITs are required by law to maintain dividend payout ratios of at least 90%, making them a favorite for income-seeking investors. REITs can deduct these dividends and avoid most or all tax liabilities, though investors still pay income tax on the payouts they receive. Many REITs have dividend reinvestment plans (DRIPs), allowing returns to compound over time.
REIT History
REITs have existed for more than 50 years in the U.S. Congress granted legal authority to form REITs in 1960 as an amendment to the Cigar Excise Tax Extension of 1960. That year The National Association of Real Estate Investment Funds, a professional group for the promotion of REITs is founded. The following year it changed its name to the National Association of Real Estate Investment Trusts (NAREIT).
In 1965 the first REIT, Continental Mortgage Investors, is listed on the New York Stock Exchange (NYSE). By the late 1960s, major investors, including George Soros, become interested in research on the value of REITs. Mortgage based REITs account for much of the growth of REITs in the early 1970s, and they fuel a housing boom. The boom busts after the oil shocks of 1973 and the recession that follows.
In 1969 the first European REIT legislation (the Fiscal Investment Institution Regime [fiscale beleggingsinstelling: FBI]) is passed in The Netherlands.
International REITs
Since their development in Europe, REITs have become available in many countries outside the United States on every continent on Earth.
The first listed property trusts launch in Australia in 1971.
Canadian REITs debut in 1993, but they don’t become popular investment vehicles until the beginning of the 21st century.
REITs began to spread across Asia with the launch of Japanese REITs in 2001.
REITs in Europe were buoyed by legislation in France (2003), Germany (2007) and the U.K. (2007). In total, about 40 countries now have REIT legislation.
3 Main Kinds of REITs
1. Equity REITs invest in and own properties, that is, they are responsible for the equity or value of their real estate assets. Their revenues come principally from leasing space—such as in an office building—to tenants. They then distribute the rents they’ve received as dividends to shareholders. Equity REITs may sell property holdings, in which case this capital appreciation is reflected in dividends. Timber REITs will include capital appreciation from timber sales in their dividends. Equity REITs account for the vast majority of REITs.
2. Mortgage REITs invest in and own property mortgages. These REITs loan money for mortgages to real estate owners, or purchase existing mortgages or mortgage-backed securities. Their earnings are generated primarily by the net interest margin, the spread between the interest they earn on mortgage loans and the cost of funding these loans. This model makes them potentially sensitive to interest rate increases. In general, mortgage REITs are less highly leveraged than other commercial mortgage lenders, using a relatively higher ratio of equity to debt to fund themselves.
3. Hybrid REITs invest in both properties and mortgages.
Individuals can invest in REITs either by purchasing their shares directly on an open exchange or by investing in a mutual fund that specializes in public real estate. Some REITs are SEC-registered and public, but not listed on an exchange; others are private.
Some REITs will invest specifically in one area of real estate—shopping malls, for example—or in one specific region, state or country. Others are more diversified. There are several REIT ETFs available, most of which have fairly low expense ratios. The ETF format can help investors avoid over-dependence on one company, geographical area or industry.
REITs provide a liquid and non-capital intensive way to invest in real estate. Many have dividend yields in excess of 10%. REITs are also largely uncorrelated with stocks and bonds, meaning they provide a measure of diversification.
A real estate investment trust (REIT) that is controlled by a single company or investor and set up to own the real estate assets of the parent company for tax purposes. This tax mitigation strategy is generally used by large retailers and banks that have many storefronts or branches in numerous locations. There are two types of captive REITs: rental REITs, which are typically used by multi-state retailers, and mortgage REITs, which are used by large banks.
BREAKING DOWN ‘Captive Real Estate Investment Trust’
Captive REITs are an attempt to capitalize on the favorable tax treatment given to REITs. Rent for individual stores or branches is paid to the captive REIT by the parent company, which deducts them as a business expense, thereby reducing its taxable income. Another potential tax benefit for the parent company is through the dividends paid deduction (DPD) on dividends received from the captive REIT.
Funds From Operations Per Share – FFOPS
A metric for the performance of a real estate investment trust (REIT). REITs are shares offered to the public by a real estate company or trust that holds a portfolio of income-producing properties and/or mortgages. Most of its profits must be distributed as dividends. The funds from operations is calculated by adding net income, depreciation and amortization, and subtracting gains on sales of property. The funds from operations per share is calculated by dividing funds from operations by the total number of outstanding shares.
BREAKING DOWN ‘Funds From Operations Per Share – FFOPS’
The funds from operations per share is similar to the earnings per share that is seen with other securities. It represents the value of the REIT per share. Funds from operations and funds from operations per share are both metrics used in evaluating the profitability of a REIT.
Non-Traded REIT
A form of real estate investment method that is designed to reduce or eliminate tax while providing returns on real estate. A non-traded REIT does not trade on a securities exchange, and because of this it is quite illiquid for long periods of time. Front-end fees can be as much as 15%, much higher than a traded REIT due to its limited secondary market.
BREAKING DOWN ‘Non-Traded REIT’
Early redemption of a non-traded REIT can result in high fees that can lower the total return. Like exchange-traded REITs, non-traded REITs are subject to the same IRS requirements, which include returning at least 90% of taxable income to shareholders. Investors tend to seek exchange-traded and non-traded REITs for their income distribution.
Finite-Life REIT – FREIT
A real estate investment trust (REIT) that aims to sell its real estate holdings within a specified time frame so as to realize capital gains on its properties. Because of the definite date of their liquidation, finite-life REITs may be more liquid and trade closer to their net asset values than conventional REITs.
Finite-Life REIT – FREIT – Summarized
Finite-life REITs were introduced in the U.S. in the 1980s as an extension of REITS. FREITs are criticized for their inability to exploit a proper buy and hold strategy in terms of their underlying assets, which can result in poor performance compared to their generic counterparts.
Financial Management Rate Of Return – FMRR
A metric used to evaluate the performance of a real estate investment and pertains to a real estate investment trust (REIT). REITs are shares offered to the public by a real estate company or trust that holds a portfolio of income-producing properties and/or mortgages. The FMRR is similar to the internal rate of return and takes into account the length and risk of the investment. The FMRR specifies cash flows (inflows and outflows) at two distinct rates known as the safe rate and the reinvestment rate.
Financial Management Rate Of Return – FMRR – Summarized
Because the calculation for financial management rate of return is so complex, many real estate professionals and investors choose to use other metrics for real estate analysis. The benefit in using FMRR is that it allows investors to compare investment opportunities on par with one another.
Adjusted Funds From Operations – AFFO
Adjusted funds from operations (AFFO) refers to the financial performance measure primarily used in the analysis of real estate investment trusts (REITs). The AFFO of a REIT, though subject to varying methods of computation, is generally equal to the trust’s funds from operations (FFO) with adjustments made for recurring capital expenditures used to maintain the quality of the REIT’s underlying assets. The calculation takes in the adjustment to GAAP straight-lining of rent, leasing costs and other material factors.
Adjusted Funds From Operations – AFFO- Summarized
Regardless of how industry professionals choose to compute AFFO, it is considered to be a more accurate measure of residual cash flow for shareholders than simple FFO. This provides for a more accurate base number when estimating present values and a better predictor of the REIT’s future ability to pay dividends. This is a non-GAAP measure.
Calculating Adjusted Funds From Operations
Before calculating the AFFO, an analyst must first determine the REIT’s funds from operations (FFO). The FFO measures cash flow from a specified list of activities. FFO reflects the impact from the REIT’s trend in operations from leasing and acquisition activity, as well as interest costs. FFO takes into account the REIT’s net income including amortization and depreciation, but it excludes the capital gains from property sales. The reasons these gains are not included is that they are one-time events and generally do not have long-term effects on the REIT’s future earnings potential. The formula is:
FFO = Net Income + Amortization + Depreciation – capital gains from property sales
Once the FFO is determined, the AFFO can be calculated. To calculate the AFFO, an analyst should take the FFO and make the following adjustments:
1) Add in rent increases
2) Subtract capital expenditures
3) Subtract routine maintenance amounts
Example
As an example of the AFFO calculation, assume the following: a REIT had $2 million in net income over the last reporting period. During that time, it earned $400,000 from the sale of one of its properties and lost $100,000 from the sale of another. It reported $35,000 of amortization and $50,000 of depreciation. During the period, net rent increases were $40,000, capital expenditures were $75,000 and routine maintenance amounted to $30,000.
Given this information the FFO can be calculated as:
FFO = $2,000,000 + $35,000 + $50,000 – ($400,000 – $100,000) = $1,785,000
From this, the AFFO is calculated as:
AFFO = FFO + $40,000 – $75,000 – $30,000 = $1,785,000 – $65,000 = $1,720,000
The resulting figure is a more accurate estimate of the REIT’s earning potential than the FFO.
Commercial Real Estate
Commercial real estate is property that is used solely for business purposes. Examples of commercial real estate include malls, office parks, restaurants, gas stations, convenience stores and office towers. Commercial real estate is one of the three primary types of real estate; the other types are residential real estate and industrial real estate.
Commercial Real Estate – Summarized
Commercial real estate includes various types of real estate from gas stations to shopping centers. As its name implies, commercial real estate is used in commerce. Residential real estate is used for living purposes, while industrial real estate is used for the manufacture and production of goods. While residential real estate may be quoted in total price or rent per month, commercial real estate is customarily quoted in dollars per square foot through lease agreements, as businesses that occupy commercial real estate usually lease their spaces. An investor usually owns the building and collects rent from each business that operates there.
Types of Commercial Real Estate Leases
There are four primary types of commercial real estate leases, each requiring different levels of responsibility from the landlord and the tenant. In addition to rent, a single net lease makes the tenant responsible for paying property taxes. A double-net (NN) lease makes the tenant responsible for paying property taxes and insurance. A triple-net (NNN) lease makes the tenant responsible for paying property taxes, insurance and maintenance. Under a gross lease, the tenant pays only rent, and the landlord pays for the building’s property taxes, insurance and maintenance.
Commercial Real Estate Classifications
Commercial real estate can be a shopping center with multiple retail tenants or a skyscraper with dozens of tenants. Commercial real estate is categorized into different classes. Office space, for example, is divided into one of three classes: class A, class B or class C. Class A represents the best buildings in terms of aesthetics, age, quality of infrastructure and location. Class B buildings are usually older and not as good-looking as Class A buildings. These buildings are often targeted by investors for restoration. Class C buildings are the oldest, usually over 20 years of age, located in less attractive areas and in need of maintenance.
Investing in Commercial Real Estate
Investing in commercial real estate often requires a considerable amount of startup capital and extensive knowledge of the legal, financial and regulatory aspects of owning this type of property. Investors who don’t want to deal with these hassles directly can gain exposure to commercial real estate through real estate investment trusts (REITs). Commercial real estate REITs are publicly traded on stock exchanges, so they are easy to buy and sell, providing liquidity to investors who otherwise would not have it by owning commercial real estate properties directly. Commercial real estate REITs can provide income to investors as well as capital appreciation.
Cash Available For Distribution – CAD
A real estate investment trust’s (REIT’s) cash on hand that is available to be distributed as shareholder dividends. The value is calculated by finding the funds from operations (FFO) and subtracting recurring capital expenditures. Also referred to as funds available for distribution (FAD).
Cash Available For Distribution – CAD – Summarized
Cash available for distribution is the difference between funds from operations and recurring expenses. Recurring capital expenses that are typically subtracted from the FFO to determine the CAD value include replacing building roofs, HVAC system repairs, resurfacing of parking lots and other significant routine maintenance. The cash available for distribution and the funds from operations value are both ways that investors can help measure a particular REIT’s earnings and potential.
Real Estate
Real estate is property comprised of land and the buildings on it as well as the natural resources of the land including uncultivated flora and fauna, farmed crops and livestock, water and minerals. Although media often refers to the “real estate market” from the perspective of residential living, real estate can be grouped into three broad categories based on its use: residential, commercial and industrial. Examples of residential real estate include undeveloped land, houses, condominiums and townhomes; examples of commercial real estate are office buildings, warehouses and retail store buildings; and examples of industrial real estate are factories, mines and farms.
Real Estate – Summarized
Personal Property and Real Property
Personal property includes intangible property like stocks, bonds and other investments; it also includes chattels, like computers, beds and clothes, as well as fixtures like the dishwashing machine in your apartment – if you bought and installed it with the lessor’s permission.
Real estate is a special instance of real property, which is real estate – land and buildings – plus the rights of use and enjoyment that come with the land and its improvements.
Land that has no owner, e.g. land in Antarctica or on the moon, is not considered real estate.
Real estate is simply the land and any improvements on it. Renters and leaseholders may have rights to inhabit land or buildings that are considered a part of their personal estate but are not considered real estate.
Homeowning
Home ownership, also known as owner-occupancy, is the most common type of real estate investment in the United States. According to the National Multifamily Housing Council, roughly two-thirds of residents own their home.
Individuals who are in the market to buy a home to live in often need to borrow money in the form of a mortgage because home prices are generally well above the savings of young people starting a household.
Individuals shopping for a mortgage to invest in real estate in the form of an owner-occupied home are faced with a variety of options. Mortgages can either be fixed-rate or variable-rate. Fixed-rate mortgages generally have higher interest rates than variable-rate mortgages, which can make them more expensive in the short run. Fixed rate loans cost more in the short term because they are protected from future interest rate shocks.
Banks publish amortization schedules that show how much of a borrower’s monthly payments go to paying off interest debt versus how much goes to paying off the principle of the loan. Balloon loans are mortgages that don’t fully amortize over time: the borrower pays interest for a set period, 5 years for example, and then they must pay the remainder of the loan in a balloon payment at the end of the loan term.
In addition, mortgages can come with sometimes heavy costs, including transaction fees and taxes, that are often rolled into the loan itself. Once potential home owners have proven their eligibility and secured a mortgage from a bank, they must complete an additional set of steps to make sure the property is legally for sale and in good condition.
Commercial Real Estate
Buying or leasing real estate for commercial purposes is very different from buying a home or even buying residential real estate as an investment. Commercial leases are generally longer than residential leases, and commercial real estate returns are based on their profitability per square foot, unlike structures intended to be private residences. Moreover, lenders may require more money for a down payment on a mortgage for commercial real estate than for a home loan.
Investment Real Estate
Unlike other investments, real estate is dramatically affected by the condition of the immediate area where the property is located, hence the well-known real-estate maxim, “location, location, location.” With the exception of a national or global recession, real estate values are affected primarily by local factors such as the availability of jobs, crime rates, school quality and property taxes.
One can invest in real estate by buying residential or commercial real estate or by buying shares in real estate investment trusts (REITs) or mortgage backed securities (MBS).
Buying real estate directly results in profits (or losses) through two avenues: revenue from rent and appreciation of the real estate’s value. Rental money comes from land already developed into residential or commercial real estate. Appreciation can come from either developing raw land or from the appreciation of the area around the land you own, for instance the appreciation of real estate in some American cities due to gentrification in the early 21st century.
There are key differences in residential and commercial direct real estate investments. On one hand, residential real estate is usually less expensive and smaller than commercial real estate, and so it is more affordable for the small investor. Many thrifty small investors of modest means have increased their and their family’s fortunes by buying rental property over decades.
On the other hand, commercial real estate is often more valuable per square foot, and its leases are longer than for residential rental properties. With greater revenue comes greater responsibility, however; commercial rental real estate is more heavily regulated than residential real estate, and these regulations can be different not only from country to country and state by state, but also different in each county and city. Even within cities, zoning regulations add a layer of unwanted complexity to commercial real estate investments.
There is also increased risk of tenant turnover in commercial rental agreements. If the lessee’s business model is bad, their product is unattractive, or they are simply poor managers, bankruptcy can leave expensive real estate from generating revenue unexpectedly. Moreover, just as land can appreciate in value, it can also depreciate. A formerly hot retail locations have been known to decay into rotten shopping centers and dead malls.