A real estate investment trust is a company that owns, oversees, or finances structures that provide income (REIT). A REIT is required by law to distribute 90% of its income to shareholders as dividends. This post looks at REITs, their characteristics, and how to evaluate one.

Many REIT Types

There are numerous variations of REITs. Equity REITs often concentrate on owning specific property types, such as residences, neighborhood malls, workplaces, or lodging/resort properties. Some defy classification, while others are diverse, like a REIT that only invests in golf properties.

The other primary type of REIT is a mortgage REIT. These REITs provide loans backed by real estate, albeit they don't frequently own or manage real estate. Mortgage REITs must be specifically analyzed. These financial institutions use various hedging strategies to reduce their exposure to interest rate risk.

Examination of REITs

REITs are equities that pay dividends and have a real estate focus. If you were searching for income, you would consider them high-yield bond funds and dividend-paying stocks. Because they are dividend-paying businesses, REITs are valued similarly to other securities. The accounting treatment of property, however, results in some notable variations.

REITs cannot be evaluated effectively using conventional metrics like the price-to-earnings (P/E) ratio and earnings per share (EPS) Better measurements include funds from operations (FFO) and adjusted funds from operations (AFFO).

Let's illustrate with a shortened example. Let's imagine a REIT invests $1 million to buy a building. Our REIT is required by accounting rules to deduct depreciation from the asset. Assume that the depreciation is distributed in a straight line over 20 years. Depreciation costs amount to $50,000 annually ($50,000 per year multiplied by 20 years equals $1 million).

FFO

Depreciation is a non-cash item, thus our REIT doesn't use this money in year 10. Consequently, in order to generate operating funds, we deduct the depreciation charge from net income (FFO). The argument is that because our building didn't lose half its value over the previous ten years, depreciation unfairly lowers our net income. FFO cancels the depreciation charge in order to remedy the alleged misrepresentation. FFO also makes a few further modifications.

AFFOIn spite of the fact that FFO is closer to cash flow than net income, it does not measure it; it must be emphasized. In the scenario presented above, we did not factor in the $1 million spent to buy the building (the capital expenditure). The study would be more accurate if capital expenditures were taken into account. By including capital expenditures, the amount known as "adjusted funds from operations" is achieved (AFFO).

The Net Asset Value

With the help of our hypothetical balance sheet, we can better understand the other common REIT figure, net asset value (NAV). Our building's book value was decreased by 50% in year ten due to depreciation, leaving it with a worth of only $500,000 overall. For REITs, book value and other related measures, including price-to-book, frequently contested in regular equities analysis, are practically useless. The goal of NAV is to replace the book value of a property with a more precise estimation of market value.

To calculate NAV, the holdings of the REIT must be somewhat subjectively assessed. In the scenario mentioned above, the facility makes $100,000 in operating income ($200,000 in revenues minus $100,000 in operating expenses). One tactic would be to take advantage of operating income at a market rate. Our estimate of the building's value rises to $1.25 million if we assume that the market's current capitalization rate (cap rate) for this kind of development is 8% ($100,000 in operating revenue x 8% cap rate = $1,250,000).

Comparison of Top-Down and Bottom-Up

You may be familiar with the argument between top-down and bottom-up stock analysis. Top-down betting begins with a financial perspective and concentrates on subjects or sectors (for example, an aging demographic may favor drug companies).The key competencies of a corporation are the focus of bottom-up analysis. Top-down and bottom-up assessments are required for REIT stocks.

Anything that has an impact on the supply and demand for real estate can have an effect on REITs from the top down. Job and population growth are frequently favorable for all types of REIT. To put it briefly, interest rates fluctuate.

A REALT Tax

Most REIT payouts are taxed more heavily than other dividends since the Internal Revenue Service (IRS) does not categorize them as qualified dividends. Qualified dividends are taxed at 0%, 15%, or 20%, based on your tax bracket. Ordinary income tax, on the other hand, is sometimes imposed on REIT payments and is currently set at 37% for 2021.