What is a "REIT" (Real Estate Investment Trust)?
REIT or a real estate investment trust (REIT) is a business that owns, operates, or finances real estate that brings in money.
REITs are like mutual funds –they collect the money of many investors and invest. This means that individual investors can get dividends from real estate investments without having to buy, manage, or finance any properties themselves.
How Real Estate Investment Trusts (REITs) Work?
Most REITs run their businesses in a simple way: they rent out space on their properties and use the rent money to pay dividends to their shareholders. Mortgage REITs don't own property; instead, they give money to people who want to buy property. These REITs make money from the interest they get on their investments.
Apartment complexes, data centres, healthcare facilities, hotels, infrastructure (such as fiber cables, cell towers, and energy pipelines), office buildings, retail centres, self-storage, timberland, and warehouses may be found in the property portfolio of a REIT.
In general, REITs concentrate in a single real estate sector. Diversified / Specialty REITs, on the other hand, may have a portfolio of diverse property kinds. For instance, a diverse REIT's portfolio may include both office and retail assets.
Many REITs can be bought and sold like shares.
Most of the time, a lot of people buy and sell these REITs, so they are considered to be very liquid instruments.
What Makes a REIT a REIT? (These are based on US regulations - applicable in general to many other countries also.)
To be a REIT, a company has to follow the rules in the Internal Revenue Code (IRC). One of these rules is that the company must own mostly long-term income-generating real estate and give the money it makes to its shareholders. In particular, a company must meet the following requirements to be a REIT:
- At least 75% of total assets into real estate, cash, or U.S. Treasuries
- At least 75% of gross income from rents, interest on mortgages that pay for real estate, or sales of real estate
- Give at least 90% of taxable income to shareholders as dividends every year
- Be a legal entity that can be taxed as a corporation
- Have a board of directors or trustees who run it
- Be owned by at least 100 people after the first year
- Not have more than 50% of its shares owned by less than five people
Different kinds of REITs
REITs come in three different kinds:
- Stock REITs. The majority of REITs are equity REITs, which own and manage real estate that brings in money. Most of the money comes in through rents (not by reselling properties).
- Mortgage REITs. Mortgage REITs give money to owners and managers of real estate either directly through mortgages and loans or indirectly by buying mortgage-backed securities. Their main source of income is the difference between the interest they earn on mortgage loans and the cost of funding these loans. This is called the "net interest margin." With this model, they could be affected by an increase in interest rates.
- Hybrid REITs. These REITs invest in the same way that both equity REITs and mortgage REITs do.
There are more ways to divide REITs based on how their shares are bought and held:
- REITs that are traded on the stock market. Individual investors can buy and sell shares of REITs that are open to the public on a securities exchange.
- Public REITs that aren't traded. These REITs are also registered with the stock exchanges, but they don't trade on national securities exchanges. Because of this, they are less liquid than REITs that are traded publicly. Still, they are usually more stable because they are not affected by changes in the market.
- Private REITs. These REITs are not registered with the SEC and don't trade on national securities exchanges. Most of the time, institutional investors are the only ones who can buy private REITs.
There are two main ways to assess performance of REITS.
Weighted Average Lease Expiry, also called weighted average lease to expiry, is a way to figure out how likely it is that a portfolio of properties will become empty. It is measured in years, but most people just use the abbreviation WALE for it.
Vacancy is one of the biggest risks that come with managing commercial properties. When a property or part of a property is empty for too long, it will hurt the property's income and the amount of money that is given to shareholders. Here, the metric WALE comes in handy as a tool for judging.
WALE is used by REIT investors to figure out how likely it is that a property or group of properties will be vacated. It is used to measure the overall tenancy risks of a property with multiple tenants. In other parts of the world, different abbreviations are sometimes used, such as WALT (Weighted Average Lease Term) and WAULT (Weighted Average Unexpired Lease Term), but they all mean the same thing. Investors in the Asia-Pacific area are more used to WALE.
WALE is calculated based on how many years are left on each tenant's lease. Each tenant's occupied area or income is compared to the total area or income of all the other tenants.
Depending on how long the tenant has signed a lease for, a "anchor tenant" who rents out a lot of space in a building can make the WALE for the property go up or down. Think about a building with three different tenants who all have different lease terms:
- Tenant A: Uses 20% of the space that can be rented (lease expires in 4 years)
- Tenant B: Uses 60% of the space that can be rented (lease expires in 5 years)
- Tenant C: Uses 20% of the space that can be rented (lease expires in 2 years)
- So, the weighted average time left on this property's lease is:
- o (0.2 x 4) + (0.6 x 5) + (0.2 x 2) = 4.2 years
From this example, you can see that tenants who take the bigger spaces in a building and sign very long leases can greatly increase WALE. In a REIT or a group property investment, this is why anchor tenants also get the best rental rates.
Keep in mind that Weighted Average Lease to Expiry can also be measured by how much money the building makes instead of by how much rentable space it has. On the other hand, rentable area is used in most financial reports by REITs and listed real estate securities.
Homes with long WALEs are less likely to be empty. Because of this, most people who invest in REITs think that the longer the WALE, the better. But this may not always be the case, depending on your investment goals:
Commercial buildings with long WALE, usually 5 years or more, usually have large tenants like government agencies or multinational corporations that have signed long-term leases. They don't have much to worry about when it comes to vacancies, but larger tenants usually mean that the property owner can't raise the rent as much as they could with smaller tenants. So, there will be a limit to how much they can grow on the inside.
Smaller businesses usually don't sign leases for more than 5 years in commercial buildings with shorter WALE, which is usually between 1 and 4 years. Compared to a property with larger tenants, there is a higher chance that it will become empty. But commercial properties like these can usually show stronger growth on the inside by raising rents every so often, which leads to better growth in property income.
But keep in mind that commercial properties with shorter WALE may have to pay more for advertising, legal, and leasing agent fees if the WALE is short.
So, if you want strong growth in your internal income, REITs with long WALE may not be the best choice for you. But if you want your income to be stable and predictable, REITs with longer WALE may be your best option.
Adjusted Funds from Operations (AFFO) is a Real Estate Investment Trust metric that measures how well a REIT (real estate investment trust) is doing financially.
It is found by taking the REIT's or property trust's funds from operations and subtracting recurring capital expenditures, leasing costs, and other important costs.
Most people in Canada and the United States use the term "adjusted funds from operations." In places like Singapore and Malaysia, which have large REIT or property trust markets, the term "distributable income" may be used instead.
AFFO is a good way to figure out how much cash flow the REIT or property trust has left over to give to its unitholders. It is also important to note that the Generally Accepted Accounting Principles (GAAP) framework does not recognise the term "AFFO." Because of this, different finance experts might use different ways to figure out Adjusted Funds from Operations.
AFFO measures the net amount of cash and cash equivalents that come into a business from regular, ongoing business activities. AFFO shouldn't be thought of as a replacement for cash flow or as a way to measure liquidity.
Metrics commonly used for comparison across REITs
- AFFO per share = AFFO divided by the number of shares outstanding
- Share Price to AFFO (like the PE Ratio): Price per Share/AFFO per Share
- Payout Ratio : Dividend per share / Adjusted Funds from Operations per share (In most countries, REITs are required by law to pay out more than 80% of their earnings as dividends)
- A real estate investment trust (REIT) is a business that owns, operates, or finances properties that bring in money.
- REITs give investors a steady stream of income, but they don't offer much in the way of capital growth.
- Most REITs are traded publicly like stocks, which makes them very easy to buy and sell (unlike physical real estate investments).
- REITs invest in most types of real estate properties, such as apartments, data centers, hotels, medical facilities, offices, retail centers, and warehouses.
- WALE and AFFO are metrics commonly used to evaluate performance of REITs.
- AFFO/ Share, Share Price – AFFO, and Payout Ratio are normally used to compare across REITs.
Hope you enjoyed this post on REIT, let me know what you think in the comment section below.
About the Author
Arun Panangatt, is a growth hacker and thought leader. He trys to help organizations and people find a purpose. He is father of an Autistic son and husband of a loving wife.
He talks about #innovation, #negotiations, #pricingoptimization, #realestatedevelopment, and #strategicpartnerships. He can be contacted on Linkedin, if you are excited to get in touch with him.
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