We believe that direct real estate should be part of every balanced portfolio because it can generate healthy returns through rental income, tax advantages and capital appreciation. However, direct real estate tends to tie up cash for a long time and can require a lot of work or trust in a third-party manager. Publicly traded real estate investment trusts (or “REITs”) can be a great way to gain exposure to real estate and potentially earn higher returns.
In this article, we’ll explain how REITs work and share why they’re a popular option for some investors. Let’s start with the fundamentals.
What are public REITs and how do they work?
Public real estate investment trusts are companies that own, finance, or operate income-producing real estate(1). Investors can buy shares in publicly traded REITs to receive exposure to real estate ownership, without taking on the headaches of directly being a landlord. Investors can purchase shares as an individual stock, through mutual funds, or exchange traded funds (or “ETFs”). A REIT generates income and pays a majority of it out to its shareholders to maintain the status of a pass-through entity. By law, a REIT must pay out at least 90% of taxable income to shareholders in the form of dividends. Unlike corporations, publicly traded REITs do not have to pay federal or state income tax, which tends to mean that income otherwise used to pay taxes can be paid to the investor.
REITs invest in a variety of real estate assets. They can have equity investments in a wide variety of properties (from multifamily and office buildings to hospitals, shopping centers, hotels or even land) or may lend money to real estate buyers though debt instruments such as mortgages, mezzanine loans and preferred equity structures.
How many REITs are there?
As of March 2020, there are 219 listed REITs in the FTSE Nareit All REITs Index(2). Additionally, there are a handful of other listed REITs not included in this index, as well as private REITs that are not publicly traded. Below is a breakout of all the different REIT sectors, the equity market capitalization of each sector, and the number of REITs publicly listed in each(2). As you can see in the table below, the infrastructure and residential sectors represent the largest combined equity capitalizations by sector, while the mortgage REITs and retail sectors are the largest by number of REITs.
|Property Sector||# of REITs||Equity Market Capitalization ($B)|
Next, we’ll take a look at what it takes for a company to be considered a REIT, and how their performance is measured.
How does a company qualify as a REIT?
To be considered a REIT, a company has to meet the following qualifications(4):
- It must have a minimum of 100 shareholders.
- 75% of its assets must be in real estate
- The income generated from the REIT’s real estate assets (rents, interest, sales, etc.) must exceed 75% of its gross income.
- It must pay a minimum of 90% of taxable income in the form of shareholder dividends each year.
- It must be managed by a board of trustees or directors.
- It must be an entity that is taxable as a corporation.
- It cannot have five or fewer individuals owning more than 50% of the shares.
How are REIT earnings measured?
Public REIT earnings are measured differently than stocks because traditional metrics such as price-to-earnings (P/E) and earnings-per-share (EPS) are not as relevant. Two methods used to evaluate REIT earnings are funds from operations (FFO) and adjusted funds from operations (AFFO). Let’s take a look at each in more detail.
Funds from operations (FFO) is derived from a REIT’s income statement. To calculate this metric we take net income, add back amortization and depreciation charges, and subtract any gains from a property sale. While many believe this is a way to understand a REIT’s cash flow from operations, that is not the case. FFO is intended to be used as an operating performance benchmark in the industry. Many times, this metric will be paired with price to look at a REIT’s price-to-FFO ratio, which is similar to a stock’s P/E ratio.
Another way to measure performance is through adjusted funds from operations (AFFO). AFFO starts with a REIT’s funds from operations and then includes deductions to any capitalized / amortized recurring expenditures and straight-lined rents, along with some adjustments for non-cash accounting items. The expenditures are related to normal costs incurred that are needed to maintain a REIT’s properties. As for straight lining of rents, this allocates the rent and lease expenses evenly across the duration of the lease. AFFO is intended to give a better understanding of a REIT’s cash flow.
Given that REITs pay out most of their cash flow in the form of dividends, another metric that is widely used is the AFFO payout ratio. The AFFO payout ratio is calculated by taking the annual dividend rate divided by the projected AFFO per share. A ratio over 100% implies that a REIT’s current dividend is higher than its future estimated cash flow. This is typically a sign that a REIT may need to adjust its dividend moving forward.
What are typical REIT returns?
Since 1972, the average total return for REITs was 9.77%(5). Below is a chart that breaks out REIT sector returns since 1994(6).
|Sector||Total Returns Since 1994|
1. Returns started in 2012.
2. Returns started in 2015.
3. Returns started in 2015.
4. Returns started in 2011.
To better understand how REITs compare to the broader market, let’s take a look at a recent 20-year time period. If we look at the data from 12/31/1999 to 12/31/2019, we see that the FTSE NAREIT All Equity Index outperformed the S&P 500. According to Bloomberg data, the S&P 500 had annualized total returns of 6.1%, while the FTSE NAREIT All Equity REITs Index returned annualized total returns of 11.6%.
In addition, between 2010 and 2019, equity REIT dividend yields averaged 84% more than the S&P 500 dividend yield. According to Bloomberg data for the period of 1/1/2010 through 12/31/2019, the S&P 500 had an average 2.07% dividend yield, while the FTSE NAREIT All Equity REITs Index had a 3.79% dividend yield.