Many investors have probably considered becoming a landlord at some point in their life. But between the time it takes to conduct due diligence on acquiring available properties, to the hassles and responsibility inherent in managing a property, most may simply pass on the opportunity.
REITs, or real estate investment trusts, were created as a simple solution for the smaller investor who has neither the financial wherewithal or expertise to invest in real estate. REITs are pools of typically brick and mortar properties that are owned and leased, or owned and operated by real estate professionals. Investors can buy REITs that specialize in apartments, single tenant commercial operations, enclosed shopping malls, hotels, and many other types of operations.
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The upside is that you become part owner by a click of the mouse. The downside is that REIT analysis is much different and perhaps more complicated than looking at the regional real estate market.
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Since most REITs are operated in a way to provide dividend income to its shareholders, there is generally less focus on the collective value of the underlying real estate and more emphasis on the cash generating ability of the assets. Most corporations are looked at on an earnings per share basis (EPS), which includes a standard charge against company assets, generally known as depreciation expense.
Dissimilarly, almost all of the assets of a REIT are buildings or property which clearly don’t suffer from typical depreciation and may actually appreciate over time, depending on where they are situated or how they are maintained. So depreciation is eliminated from the accounting mix, and a measure known as Funds From Operations, or FFO is calculated. A more precise measure, Adjusted Funds From Operations, or AFFO, takes recurring capex and other charges into account and is seen as an even more accurate measure of how much free cash the trust has available to pay shareholders on a quarterly basis.
Why You Should Consider Them Now
In an era of low interest rates, income generating assets continue to be given a premium valuation by the market. I would argue that REITs are no exception. Many REITs are viewed as highly interest rate sensitive and tend to trade along with the bond market. Over the past six months, longer-term interest rates have been creeping up, which has lead to a meaningful sell off in many REITs.
Some REITs have dropped in value by as much as 20 percent. While it is certainly possible that sell offs will get deeper if rates rise further, I think now is a good time to dip in, with the assumption that there is a low likelihood of a rampant rate rise.
Some may argue that buying intermediate-term bonds is a safer play than investing in real estate assets – and that may be true. However, most REITs have associated dividend growth, raising their dividends annually for shareholders – a feature that few bonds possess.
If, for example, you buy shares in apartment REIT Mid-America Apartment Communities (MAA) today, a REIT I personally own, your yield will be right around 4 percent. Depending on the credit quality, you may be able to find a 10-year bond with a higher yield.
However, I’m expecting that MAA’s dividend will rise at least 5% over the next 10 years. If it does, my yield on cost will rise to roughly 6.5 percent. When a 10-year bond matures, it is difficult to predict where yields may sit. REITs and other conservative dividend growth vehicles provide inflation protection that bonds don’t.
What Should You Buy?
Since different investors require more diversification and may comfortable taking on more risk than others, it’s difficult to recommend REITs that will make sense for everyone. Allocation of somewhere between 5 and 15% of total assets would represent reasonable exposure to REITs in my opinion.
For those more conservative, some of your mega-cap REITs like Simon Property (SPG), health-care property owner HCN and commercial landlord Realty Income (O), as well as Mid-America Apartment are some ideas.
For those more aggressive I would look at NorthStar Realty Finance (NRF), New Senior Investment Group (SNR), and STORE Capital (STOR).
The recent REIT sell off has provided an opportunity for investors to grab some improved and growing yields. Since the forward rate environment is still difficult to predict, if you are new to the space, while I wouldn’t be afraid to nibble, I’d probably recommend against going hog wild.