Investing In Real Estate Investment Trusts (REITs)

Written by Mark Roussin

Big Ticket Fund

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When I set out to begin my investing journey in my early 20’s, I have to admit I was not all that familiar with the nature of Real Estate Investment Trusts (REITs) or real estate in general. Fast forward a decade and not only has my profession in accounting led me to serve large real estate corporations, both public and private, but my investing approach, or strategy if you will, has me now heavily focused on the REIT sector.

I firmly believe every investor should maintain some exposure to REITs within their portfolio. This goes for the young investor getting started with the endless amounts of risk they could take, to the middle-aged investor looking for moderate levels of risk within their portfolio, to retired folks looking for stable/reliable returns on their investments. REITs are a total return investment that provide high-quality dividends while also providing the potential for moderate capital appreciation.

Investing in real estate is a tried and true method of successful investing that created many of today’s richest people in the world. In fact, a study done by Forbes in 2018 listed Real Estate as the industry having the third most billionaires in the world, at 220, or 10% of all billionaires. 

What attracts people to real estate is the fact that the industry is usually a predictable business thanks in part to rental income, which makes this kind of investment highly attractive to long-term investors.

What Is A REIT?

A REIT is a Real Estate Investment Trust, which essentially is, as described by the National Association of REITs (NAREIT), companies that own or finance income-producing real estate in a range of property sectors.

These companies have to meet a number of requirements to qualify as REITs. Most REITs trade on major stock exchanges, and they offer a number of benefits to investors. REITs provide all investors the chance to own valuable real estate and present them with the opportunity to access dividend-based income and total returns.

The thing that is attractive to investors is the high-yield and predictable income streams they can attain from investing in REITs due to their tax structure. In order for a company to maintain their “REIT status,” they must comply with a set of rules as follows:

  • Invest at least 75% of total assets in real estate
  • Derive at least 75% of gross income from rents from real property, interest on mortgages financing real property, or from sales of real estate
  • Pay at least 90% of taxable income in the form of shareholder dividends each year
  • Be an entity that is taxable as a corporation
  • Be managed by a board of directors or trustees
  • Have a minimum of 100 shareholders
  • Have no more than 50 percent of its shares held by five or fewer individuals
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Why REITs Belong In Your Portfolio         

REITs tend to be a quality investment that are similar to non-REIT value stocks in terms of expected performance and have better returns than low-risk bonds.

REITs tend to pay higher dividends than non-REIT stocks in part due to their tax structure. REITs are required to pay out 90% of their otherwise taxable income to investors in the form of dividends in order to keep their REIT status. This structure forces REIT management teams to make the most of their capital as they do not have the luxury of investing back into their company through income as much as non-REITs do, but they gain tax advantages through their REIT status.

Not only do they pay out at least 90% of their income, but they receive large amounts of steady income through the contractual rents paid by the tenants of their properties.

Since real estate is obviously vital to both people and businesses, the demand for properties is always there, regardless of economic conditions.

REITs can be a solid defensive play for investors in the event the economy begins to slow as well, which has been a hot topic of discussion of late. In a recession, REITs have the ability to decrease rents for tenants who may be struggling in order to keep properties filled. In return, income streams tend to remain relatively resilient and consistent over the full cycle.

As I mentioned earlier, REITs can be a great investment for all types of investors, but particularly for retired folks, who rely heavily on steady income streams to meet their financial needs. The strong dividend returns found through REITs checks that box.

Source: NAREIT

Since their creation in 1960, REITs have grown in size, impact and market acceptance. In fact, in 2016, the S&P 500 introduced its newest sector, Real Estate, as their 11th sector. In years past, Real Estate entities fell under the Financial sector. The creation of headline real estate sectors – populated mainly by REITs – in leading industry classification standards underscores the growing importance of REIT-based real estate investment in the equities marketplace.

Source: NAREIT

REITs now own more than $3 trillion in gross real estate assets, with more than $2 trillion of that total from public listed and non-listed REITs and the remainder from privately held REITs.

Next, let’s take a look at REIT performance over the years as compared to other investment options. Though often considered a “boring investment,” REITs tend to outperform the greater stock market year in and year out. REITs, as a whole, have historically crushed the returns of literally every major asset class including, stocks, bonds, high yield bonds, utilities, value stocks, growth stocks, and just about any other class you can think of.

“Crushed” is not an understatement when you look at the below chart:

As you can see, over the last 20 years, REITs have far outpaced the S&P 500 and the DJIA, by almost double. This is often talked about, but investors still do not have enough REIT exposure in their portfolio for some unknown reason.

How To Value A REIT

Ok, so by know I have your attention on what an important role REITs can play in your portfolio and you are getting the itch to invest. However, you may be interested but asking yourself, how do I value REITs? Great question! Let me explain.

REITs are very different from normal stocks when it comes to valuation metrics. Normal investors who are not accustomed to investing in REITs tend to focus on earnings per share (EPS) and price-to-earnings, or P/E ratios to name a couple. REIT investors focus on what is called FFO or Funds From Operations.

The single largest difference between FFO and net income is depreciation. For most businesses, depreciation is an acceptable non-cash charge that allocates the cost of an investment over a period of time, or life of the asset. However, real estate is different in that real estate properties often appreciate over time rather than depreciate like most other fixed-plant or equipment investments. Net income, a measure that includes the reduction of income by depreciation, is, therefore, an inferior gauge of performance. As a result, it makes sense when valuing a REIT to use Funds From Operations (FFO), which excludes depreciation.

REITs are required to show the reconciliation between net income and FFO for investors in the quarterly and annual financial statements. In addition, FFO will also take out large one-time items such as gains or losses on sales. Taking things one step further, REITs also often report AFFO figures, or Adjusted Funds From Operations. AFFO can be at a company’s discretion, but it’s the company’s way to better normalize earnings from normal operations. AFFO tends to be a more precise measure of residual cash flow.

As such, when using a value metric, REIT investors like to look at price-to-FFO or price-to-AFFO metrics compared to recent history or other common industry REITs.

It’s also worth noting that some REITs will have different terms for this concept. Cash Net Operating Income (NOI) is another common one.

Let’s take a look at an example.

Example REIT FFO Analysis

Realty Income (O) has long been a “fan favorite” and one of the most well-known REITs for investors over the years, and for good reason. The company also trademarked the name “The Monthly Dividend Company” as they pay their shareholders monthly rather than quarterly, like most dividend paying stocks. The company has consistently performed at a high level, paying uninterrupted dividends for over 584 months, with 101 dividend increases. Consistent and growing dividend is what Realty Income is all about.

Here is a quick snapshot of how the company presents their FFO reconciliation within the financial statements:

You can see the company started with net income and then made depreciation, impairment, and gain/loss adjustments to arrive at their FFO number. From here they then divide the FFO by the weighted-average shares for the period to come up with an FFO per share amount, comparable to EPS for non-REIT stocks.

Next, an investor can then see how a company is trading in terms of their price and FFO, otherwise known as Price-To-FFO, or P/FFO. Here is a quick snapshot:

Chart created by author

Using 12/31/2018 figures and today’s closing price of $71.79, the stock currently trades at a P/FFO of 23x. That is high for Realty Income, as they have traded at an average P/FFO of about 19x, suggesting the stock is currently overvalued based on recent five-year historical averages. Here is a look at a charted graph of Realty Income’s daily P/FFO over the last five years.

Chart created by author

This is just the first way to start assessing whether a REIT is appropriately valued. There are many other valuation metrics one can use and much more due diligence that goes into reviewing a REIT, just like any non-REIT investment, that one must make before investing.

Advanced REIT Valuation using the Dividend Discount Model and Discounted Cash Flow

Since the majority of the value of a REIT comes from its dividends (cash flows to investors), they are the perfect candidates for applying DCF valuation, as well as the Dividend Discount Model (DDM).

We can treat these two models the same, however, since the math behind them is almost identical, and REIT cash flow is equivalent to REIT dividends.

The basic dividend discount model formula is:

    {\HUGE\[\frac{\text{Next year's dividend}}{\text{Cost of equity - Dividend growth rate}}\]}

If you’re familiar with projecting out cash flows for DCF valuations, you’ll know that the “terminal value” used at the end of your projections is:

    {\HUGE\[\text{Terminal value} = \frac{\text{Next year's cash flow}}{\text{Discount rate - Terminal value growth rate}}\]}

Notice the similarity? The basic dividend discount model is just the terminal value calculation performed at year 0 instead of year 5 or 10. It’s also called a “perpetuity.”

For REITs, since they distribute 90%+ of their income as dividends, their free cash flow is basically identical to their dividend. In both cases, you would use the Adjusted Funds From Operations (AFFO) figure provided in the annual report.

Most practitioners will actually use a multi-stage DDM, in which they forecast the dividends at a certain growth rate for a few years, then at a different growth rate for another few years, then, finally, use the terminal growth rate.

Again, this is basically identical to a DCF analysis where you project out the cash flow growth using different growth rates over different periods. And it is exactly what the Old School Value DCF does.

Using Old School Value’s DCF Valuation Tool to Value a REIT

So, knowing that DDMs and DCFs are pretty much the same for REITs, as long as you use AFFO as your dividend/cash flow figure, let’s see how Old School Value’s tools can help analyze a REIT.

The first thing you need is the REIT’s most recent AFFO. You can find this in the REIT’s annual filings.

Or, instead of looking up SEC filings, you can usually use a shortcut within Old School Value’s tools: AFFO is typically very close to Net Income + Total Non-Cash Adjustments, which you can find on the “Cash Flow Statement” page:

Realty Income (O) Cash Flow Statement
Realty Income’s Cash Flow Statement
Source: Old School Value

Add up the 2018 (or TTM) figures:

CF Net Income$365M
CF Total non-cash Adjustments$564M

As it turns out, O’s reported AFFO from their annual report was $925M. Very close, and saves you a lot of trouble when you’re just trying to get an initial screen. (You’ll obviously want to do your complete diligence by reading the annual report and getting the exact AFFO before you buy, however.)

From there, you can click on over to the DCF Valuation tool. Enter $929M (or $925M if you looked it up) as the DCF start value. You can see that AFFO growth has been around 7.5% lately, so that’s a pretty good starting growth rate.

Since real estate should be a little less risky than stocks, I use a personal discount/hurdle rate of about 7.5%. Plug that into the page, and this is what the valuation looks like:

Realty Income DCF Analysis Output – Old School Value

The Fair Value (red line) comes out to be almost exactly the current price.

Taken together with the Price to FFO metric looking relatively high historically, it suggests that this may not be the best time to buy O.

Risks to Watch Out For

REITs can be a great investment opportunity, but there are some things to check for before investing.

Expenses & Fees

REITs pay their managers well — sometimes too well. They also have to pay for property management. You’ll want to check the REIT income statement to make sure expenses are not an overly large portion of the revenue.

IN O’s case, these expenses all come under the Selling, General, & Administrative line item. You can see the details in their 10-K, but if you look in OSV and hit the “%” button to see things as a percent of revenue, you’ll get this:

Source: Old School Value

You can see that total SG&A is coming in at around 6.3%, with a bit of an uptick in the latest year. It turns out this was because of a one-time CEO severance package, so their normal rate should be similar to previous years.

This isn’t a bad expense ratio, but watch out for REITs that are much higher than this. There are plenty in the 20% or higher range!

Management Incentives

Along with excessive fees, watch out for managers that have little skin in the game (low insider ownership). Old School Value makes it easy to see this — just go to “Key Stats” and see recent insider transaction amounts and total insider ownership.

The other big component of this is whether the REIT is internally or externally managed. Internally managed REITs mean the managers are employees, and this is far preferable for you.

Basically, external management can lead to conflicts of interest with shareholders, because external managers are compensated partly by total assets under management and partly by meeting certain performance metrics.

External managers are much more likely to have less focus on the portfolio and be willing to make lower-return investments to grow their fee base (assets under management) faster. They’ll also be more willing to issue new shares at a discount to their current net asset value, which is extra-diluting to you.

Not all external managers are bad actors, of course, and this model is still prevalent in other countries, such as Japan and Australia. But it’s not worth the risk.

Size Matters

A lot of the folks on Seeking Alpha and will tell you that small cap REITs are where the best opportunities are, because there are more that are under-valued. While I believe this is true, there are also more risks in the small cap REITs.

Most are too small to attract large institutional investors, which means less scrutiny and research of these firms, which means the risk of management shenanigans is higher. So just proceed with caution.


In this article, you learned what a REIT is, why they’re attractive investments, and how to analyze them for inclusion in your portfolio.

I hope you all enjoyed this piece on REITs and their place in your portfolio. Good luck and happy REIT investing!

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