Real Estate Investment Trust (REIT)- Meaning, Types and Valuations

What are Real Estate Investment Trusts?

Real Estate has always been a lucrative investment avenue for investors, be it a commercial real estate or a residential real estate investment. However, for small investors it is always difficult to find a property that comes under a budget and can provide them with a decent return as well. Traditionally real estate investment allowed you to look for a property, get it registered in your name and either sell it for capital appreciation or allow others who may be interested to use the property for residential or commercial purposes against a fixed income rent. Many a times it was also seen that real estate developers were suffering against a non-willingness to buy a certain property once the project had already begun or even completed such as in case of Shopping Malls, Residential Real Estate properties etc.

Modern markets globally started coming up with solutions where more money collectively could be pooled together by various small and large investors as well, in order to invest in real estate properties. This lead to the development of Real Estate Investment Trusts or more commonly known as REIT’s.

As the name suggests, Real Estate Investment Trusts is a company that owns, operates and finances income producing real estate or related assets. This generally includes hotels, shopping complex, warehouses, apartments etc. REIT’s give individuals and organization’s an opportunity to invest in large-scale income producing properties and mortgages.

 

How do REIT’s work?

Similar to a Mutual Fund, the first step is the formation and registration of the REIT. Once the registration process is complete and the fund is qualified as a REIT, investors are given an opportunity to buy shares. Investor’s money is pooled together by the company and the amount collectively is used by the company to purchase real estate assets, real estate loans or both. Such investment is again as in case of a Mutual Fund is professionally managed by one or more fund managers, using a defined investment strategy.

As for the return part of the investment is concerned, the REIT benefits in different ways depending on the types of REIT’s as discussed below.

 

Types of Real Estate Investment Trust (REIT’s)

Broadly classifying there are two types of REIT’s that are available:

1. Equity REIT’s– In simple terms Equity Real Estate Investment Trust or Equity REIT’s own properties as their primary business such as office buildings, shopping malls, apartment buildings and lease such spaces to interested tenants against fixed lease rentals which forms the primary source of investment return for the REIT which is ultimately distributed to its shareholders/unit holders.

 

Risks of Equity REIT’s

• Equity REITS tend to be cyclical in nature and can be sensitive to recessions and period of economic crisis.

 

• Too much supply may lead to lower prices & higher vacancy rates in cases of hotel rooms etc. This would ultimately effect the rental income earned by the REIT.

 

 

2. Mortgage REIT’s or mREIT’s– Mortgage Real Estate Investment Trusts or mREIT’s as compared to Equity Real Estate Investment Trusts do not directly purchase properties or real estate’s, instead they invest in mortgages & mortgage backed securities. When banks give loans to home buyers, they sell such mortgage to mortgage buyers as mREIT’s and the interest earned on such loan accounts for the return on investment made by the Investment Trust.

 

Risks of Mortgage REIT’s

•  Interest rate changes are a major factor in market movements. Changes in interest rates can lead to a drop in the earnings for mortgage REIT’s.

 

• Different mortgage securities that REIT’s buy may have different credit risk. Some are backed by the federal government and are comparatively safer. On the other hand some may carry a higher risk depending upon the specific investment being made.

 

Another type of Real Estate Investment Trust is known as a Hybrid Real Estate Investment Trust. This is not very different from the ones that are already discussed. A Hybrid REIT simply invests its cash pool in both the types of REIT’s as above, mREIT’s & Equity REIT’s.

 

How to Invest in Real Estate Investment Trusts (REIT’s)?

 A question that an investor is still confused about is; how can I invest in a REIT? The answer may seem like a shocker as one may not have felt that it was so easy. There are actually couple of options that you can choose from such as:

 

• You can purchase shares of a REIT simply from your demat account or your broker just like one may invest in the shares of a publically traded company.

 

• Many a times it happens that a REIT may not be publically traded as a security on a stock exchange. Mutual Fund schemes or REIT Exchange Traded Fund’s (ETF) can also be an easy gateway into the REIT market.

 

Valuation of REIT’s

Traditional valuation methods were not cut out for an effective REIT’s Valuation as its operations are different from traditional companies.  There are a lot of methods for an effective REIT valuation, but the three listed below are most widely used.

 

• Net Asset Value (NAV) Method– NAV is one of the more commonly used metrics when it comes to security valuations and it has also been seen as a popular benchmark in valuation of REIT’s. Under this method a subjective market value is assigned to the assets held by REIT’s and any mortgage liabilities that may account for against the assets being held is subtracted in order to obtain the Net Asset Value. A higher NAV means that the REIT has a strong earning potential and good management. The total NAV can further be divided by the outstanding number of shares of the REIT to obtain the per share NAV.

 

• Fund From Operations or FFO Method– FFO provides a direct formula based approach in order to correctly value a REIT. We use the cash flow from the REIT’s operations under this method by calculating the Fund From Operations by using the formula mentioned below.

 

Fund from Operations/FFO= Net Income+ Depreciation+ Amortization- Gain on sale of property

 

• Adjusted Fund from Operations or AFFO Method– Some believed that the FFO method overstated a REIT’s profitability. FFO arguably overlooked the expenses that were necessary to maintain the income from the properties. This called for a further adjustment in the FFO formula as below:

 

Adjusted Fund from Operations/ AFFO= FFO – Recurring Capital Expenditures – Straight-lined Rents

(Straight Lining of Rents is calculated by distributing the total rent expenses over the life of the property).

 

Pro and Cons of Investing In REIT’s

Advantages of REIT’s

• REIT’s is an easy way for an investor to invest in real estate assets. Investor can enjoy the benefit of real estate investing without actually having to buy one.

 

• Investments in Real Estate Investment Trusts have lower liquidity risk as compared to a direct investment in real estate.

 

• REIT’s are a regulated investment avenue; hence the risk of fraud is minimal. This however is no guarantee of return on your investment.

 

• REIT’s provides an investor with high cash dividends.

 

• REIT’s are a good way for someone who is looking for a fixed income investment.  They carry a higher dividend payout due to the 90% payout policy rule.

• It is a good way to diversify your portfolio.

 

Disadvantages of REIT’s 

• Growth is the one thing that an investor often wishes to achieve. Due to a higher payout ratio it becomes difficult for REIT’s to grow over a long term period. This is also the reason that the dividend payout ratio of many REIT’s remain the same.

 

• Due to a larger joint ownership, one does not have any control over the property.

 

• Property taxes payable by the REIT often takes up a major chunk of the operating income of the REIT.