Many investors want to get into REITs because they perform exceptionally well during high inflation periods.
But few know how to choose the best REITs to optimize their portfolio. So, how do you choose the best one? Luckily, we prepared this guide for you.
How to Choose the Best REITs?
In order to identify the best Real Estate Investment Trust (REIT) to invest in, it is important to understand their types and key financial metrics.
There are broadly two classifications of these assets: Mortgage and Equity REITs.
Within equity, there can be retail, healthcare, office spaces, and residential sectors. Each has its pros and cons.
Once you select a type and sector, the next step is to evaluate them against competitors on key financial metrics.
Some key indicators include Funds from Operations (FFO), Debt-to-EBITDA, Credit Ratings, and Payout Ratios.
Lastly, an investor should compare whether the right option is to choose a REIT or an exchange-traded fund, mutual fund, or directly invest in securities.
Each is a unique asset class and has its own merits and demerits. Investors need to understand which and how much of each is best for their risk profile.
About REITs
Real Estate Investment Trusts (REITs) invest in real estate by either directly owning, operating, or financing income-producing real estate.
They pool money from investors just like a mutual fund. In this way, they let average investors in America enter one of the most capital-intensive industries without spending a lot of money.
Currently, these companies hold more than $3.5 trillion in real estate assets across America. Their total market capitalization exceeds $1.35 trillion.
There are broadly three types of REITs:
- Equity REITs
- Mortgage REITs
- Hybrids
Mortgage REITs do not invest directly in property. They buy mortgages or mortgage-backed securities. Equity REITs own real estate properties and make money by leasing them out.
Lastly, as the name suggests, hybrids work in both real estate markets.
Publicly traded REITs are mandated by the government to distribute at least 90% of their earnings back to their investors as dividends.
That’s why many investors consider them a stable source of passive income.
Understanding the Type of REITs
There are several kinds of REITs, depending on the industries or sectors they buy properties or mortgages. Some of these are:
- Residential REITs
- Office REITs
- Retail REITs
- Healthcare REITs
- Mortgage REITs
Let’s look at the key factors to consider when investing in any of them.
Residential REITs
Residential REITs own and operate multi-apartment rental housing.
To invest in them, it is crucial to study the affordability of buying a house in the cities in which they are present.
In large urban centers like New York, both rentals and occupancy are high because buying a home is not an option for most residents.
Companies invested in residential real estate in cities like this are a good bet for investment.
Office REITs
Office REITs own office buildings and other commercial real estate properties. Their tenants usually have long-term leases and operate their offices on these premises.
Occupancy of office spaces depends primarily on how the economy is doing.
In a strong and growing economy, there will be more new companies starting up and more employees being hired, so office space occupancies will go up.
If you want to invest in them, the best thing is to look for REITs with a strong property portfolio in major office centers like Washington, DC, or New York.
Retail REITs
About 24% of all REIT investments are in retail, which includes standalone shops and shopping malls.
When investing in them, the best thing is to choose ones that have the most substantial anchor tenants, such as grocery and home improvement shops.
This ensures a continuous flow of rental income and regular footfalls.
Secondly, look for solid cashflows, balance sheets, and low-debt REITs.
Healthcare REITs
Healthcare REITs own hospitals, nursing houses, assisted living facilities, and other healthcare real estate.
They make money from occupancy fees, private fees, and Medicare and Medicaid reimbursements.
With nearly 16% of American adults above 65, these occupancies are rising significantly and will continue to rise in the future.
When investing in them, look for companies that have significant experience in the healthcare sector and also have strong financials.
Mortgage REITs
These don’t own or operate any real estate. Instead, they own and buy mortgages and mortgage-backed securities. The most well-known ones are Fannie Mae and Freddie Mac.
They make money on the difference between the interest rate at which they buy the mortgages and the rate they offer them to investors.
Their performance depends a lot upon the prevailing interest rates in the market.
When rates rise, people take fewer mortgages, and the cost of funding also goes up. Hence profitability goes down. Defaults on existing mortgages also increase.
On the other hand, they tend to do very well when interest rates are low, and the economy is growing.
How to Evaluate REITs?
Apart from understanding the operating model of the REITs, investors should also understand the financial parameters on which to evaluate their performance.
REITs are complex businesses, and their reporting differs from other industries.
For example, their net incomes do not reflect their actual cashflows because they adjust for a lot of depreciation and amortization from assets that they own.
Investors often use a term called Funds from Operations (FFO) to judge real incomes. We’ll learn more about this and other REIT investing metrics here later on.
Management
Whether it is equity, mutual funds, or REITs, it is equally important to judge the quality of the management team handling your hard-earned money.
REITs are active investors; their management team makes decisions based on their analysis and insights to buy properties and manage leases.
Therefore, a lot depends on the quality of the team and their experience in dealing with varying economic conditions.
Here are a few things investors should look for in a management team:
- Track record of the team
- Understanding of the sector and years of experience
- How well compensated they are
- Is there a performance-based component of their compensation
Funds From Operations (FFO)
When evaluating a REIT, net income is not a good barometer to judge how much money it can generate in the future. Funds from operation (FFO) is a better metric.
Net income adjusts for depreciation and amortization.
Depreciation is simply an adjustment for the reduction in the value of assets over time. It accounts for the fact that an asset’s value reduces over time.
Amortization is the practice of spreading the cost of an intangible asset over its entire life.
Neither of these is actual costs incurred in a certain period.
Moreover, net income will also include capital gains or losses incurred during the sale of properties owned. These costs, again, don’t reflect the actual lease rent in the given period.
FFOs add back depreciation and amortization to net incomes and offset the gain or low from sale proceeds, thus reflecting how the REIT performed.
Debt-to-EBITDA
Debt-to-EBITDA is one of the best ways to check how leveraged a REIT is. It compares how much debt the company is carrying to generate “x” amount of earnings.
For example, if a retail REIT has a 5x Debt-to-EBITDA ratio, its total debt is five times the earnings it is reporting.
While there is no “perfect” Debt-to-EBITDA ratio, the best way to judge is to compare the number against peers in the same industry.
In the above example, compare the 5x with competitors in the same space. If you find that, in most cases, the ratio is 3x or 3.5x, then it is best to think twice before investing.
Credit Rating
Real estate investment is very capital intensive, so companies who operate in this industry need to be able to borrow money. Credit rating is a way to judge this ability.
Not only does a good credit rating mean easy credit, but it also means that the cost of obtaining said credit will be lower for the company. This implies higher profitability.
You can look at the credit rating provided by agencies such as Moody’s and compare them with others in a similar industry. The higher the rating, the better the ability to raise capital.
Payout Ratio
The dividend payout ratio is the percentage of net profit paid out as REIT dividends to investors. This measure helps you understand how sustainable the payouts are.
Above 100% dividend payouts are not uncommon in the industry, and there are many instances of REITs giving out even 200% or 300% payout.
However, these numbers are not the best indicator to understand what is happening. We need to see the payout ratio in terms of FFO rather than net earnings.
What Is a Good Dividend Payout Ratio for a REIT?
How can REITs offer more than 100% dividend payouts? This is possible because their net earnings do not actually reflect their cash flows, as explained earlier.
A better way to judge the payout ratio is to compare their payouts with FFO.
Compared to FFO, the typical ratio is about 70-80%. Anything closer to 100% indicates that there might be a dividend cut in the near future.
How Do You Tell if a REIT Is Overvalued?
You can compare the current annual dividend yield of the REIT with its own average yield over the last ten years.
The dividend yield is the ratio of the dividend payout over the year to the current stock price of the REIT. When it is lower than its own average, it means that the stock is overvalued.
Another effective way to check is to see if the company’s current dividend yield is lower or higher than comparable competitors in the same space.
Are REITs Better Than ETFs
Neither a REIT nor ETF is decidedly better than each other. Both offer a way to diversify an investor’s portfolio and can be profitable in certain circumstances.
ETFs are usually passive in nature, and most of them track standard indexes such as the S&P 500. REITs, on the other hand, are managed by professionals and invest actively.
Ideally, REITs should generate higher returns, but their fees and expense ratios are obviously higher.
Moreover, there are no guarantees in real estate investing despite having professionals to manage the portfolio.
ETFs are one of the cheapest forms of investment, not just in terms of fees and expense ratios but also from the perspective of taxable income.
They generate fewer “taxable events” than mutual funds and other instruments, making them very tax efficient.
Lastly, both can be good assets to invest in during a market crash. While ETFs protect investor wealth through diversification, REITs invest in real estate, which often does well during stock market downturns.
Overall, both can be good ways to diversify your portfolio, and there is no best option to choose from among them.
One interesting option is to purchase a REIT ETF, which offers the benefits of both worlds by creating a diversified REIT portfolio.
Are REITs a Good Investment in 2023?
Yes, we are currently in a market where inflation is likely to be high for the foreseeable future, and real estate investments have historically done well in such periods.
If we look at the last twenty years’ performance of REITs compared to the consumer price index, their ups and downs have nearly been in sync.
There is a good reason why higher inflation bodes well for real estate investment trusts: their long-term leases are already inflation-protected, and short-term leases adjust for rising as a matter of course when they renew.
Moreover, real estate prices automatically increase when inflation occurs, increasing the value of the holdings with REITs.
Lastly, investors prefer to have cash in hand during higher inflation, and REITs offer regular dividends each quarter, unlike most stocks.
Can You Get Rich off REITs?
Yes, a strong REIT portfolio might earn you healthy dividends and value appreciation.
However, most investors consider them passive income-producing investments rather than assets offering significant growth.
A well-chosen equities portfolio might be a better option for getting rich.
How much dividend you get and how much appreciation the REIT gets depends on the quality and the prevailing market conditions.
Earlier, we mentioned some parameters that would help investors decide which ones to invest in.
Before buying, always check their portfolio of properties and compare key ratios with competitors.
What Are Some Downsides to REITs?
REITs are not as profitable as buying a property directly, may be expensive to invest in, and have a lower potential to generate profit than mutual funds and other investments.
Buying property directly can be more profitable since, in this case, the investor owns the real estate asset, its entire capital appreciation, and rental increases.
REITs do not offer the same benefit since the investor does not control the assets. They don’t get a say in deciding which properties to buy and where.
Moreover, dividends are distributed mainly back to REIT investors, so their managers aren’t able to freely reinvest and earn growth like mutual funds or equities.
Those REITs whose returns are high are often expensive and might not be affordable for many smaller investors.
Lastly, REITs tend to perform relatively poorly in periods when interest rates rise because their cost of funding increases while overall mortgages go down.
How Much Should You Invest in a REIT?
Most investment managers suggest putting 5%-10% of the total portfolio into REITs.
They offer diversification into a different asset class and are an excellent way to hedge against a drop in equity portfolios during high inflation.
Another reason why they are a good investment is that they generate steady passive incomes through dividends.
They let you enter into real estate without spending a lot of money.
Moreover, unlike buying a house, they can be bought or sold easily over the stock market. They are very liquid and have lots of buyers.
What Is the Average Return on a REIT?
As per a report by Cohen & Seers, REITs have offered 10.6% annualized returns over the last fifteen years.
Other ways to invest in real estate, such as core and value funds, have performed much poorer than this.
Core funds have generated 6.5% returns, whereas value funds returned 5.6%.
Do REITs Outperform the S&P 500?
Yes, REITs have outperformed the S&P 500 in situations with rising interest rates and inflation.
Over the last 25 years, the Nareit equity REIT index has delivered a 9.6% annualized return, whereas the S&P 500 has offered 7.97% returns.
Over the last 20 years, during quarterly periods when interest rates were high, their return was 16.55%, and during other periods it was 10.68%, as per an analysis by Nareit.
In periods when treasury yields went up (indicating higher interest rates), they performed better than the S&P 500 half the time.
Final Thoughts
Choosing the best REIT requires understanding which segment they operate in and their important financial numbers, such as FFO, Debt-to-Income ratio, and more.
A REIT investment helps diversify investors’ portfolios and offers a great hedge against inflation. They are also a good source of passive income.
Most investment analysts suggest keeping at least 5-10% of your portfolio in them. They have consistently performed better than the S&P 500, so investing in them can be quite safe.
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