Due to the large number of REITs currently trading on public exchanges, investors can examine the industry and invest in only the best-of-the-best.
To do so, an investor must be familiar with REIT analysis. This isn’t as simple as it seems; REITs have certain unique accounting features that distinguish them from conventional equities when it comes to evaluating their investment potential (particularly with regards to valuation).
With that in mind, this post will go over how to value real estate investment trusts, with two step-by-step examples based on a genuine, publicly traded REIT.
What is a REIT?
Before going into how to examine a real estate investment trust, it’s important to know what these investment vehicles are.
A REIT is not a company whose sole purpose is to own real estate. While real estate corporations do exist (for example, the Howard Hughes Corporation (HHC)), they are not the same as real estate investment trusts.
The distinction is in the manner in which these legal entities are formed. REITs are not corporations, but trusts. As a result, they are taxed differently, making the REIT’s investors more tax efficient.
Real estate investment trusts pay no tax at the organizational level in exchange for completing specific standards that are required to continue doing business as a ‘REIT.’ One of the most significant requirements for maintaining REIT status is that it distributes 90% or more of its net income to its shareholders.
There are a number of key distinctions between ordinary stocks and REITs. REITs are structured like trusts. As a result, fractional ownership of REITs that trade on the stock exchange is referred to as ‘units’ rather than’stocks.’ As a result, “shareholders” are really “unit holders.”
Distributions, not dividends, are paid to unitholders. REIT distributions aren’t called dividends since they have a different tax treatment. There are three types of REIT distributions:
When it comes to taxation, the ‘ordinary income’ element of a REIT payout is the most straightforward. Ordinary income is taxed at your regular income tax rate, which can be as high as 37 percent.
A ‘deferred tax’ might be thought of as the’return of capital’ element of a REIT distribution. This is due to the fact that a return of capital lowers your cost base. This means that when you sell a REIT, you only pay tax on the’return of capital’ component of the payout.
The final component, capital gains, is exactly what it sounds like. Short-term capital gains are taxed at a lower rate than long-term capital gains.
By REIT, the percentage of distributions from these three sources varies. Ordinary income makes up the vast majority of the distribution. Around 70% of distributions will be ordinary income, 15% will be a return of capital, and 15% will be capital gains (although, again, this will vary depending on the REIT).
Because the majority of REIT payments are taxed as regular income, they are best suited for retirement funds.
Retirement accounts eliminate this disadvantage, making REITs extremely tax-efficient.
This isn’t to say that owning a REIT in a taxed account is a bad idea. Regardless of tax implications, a good investment is a good investment. However, if you have the option, REITs should be put into a retirement account.
So, how does a REIT’s tax status differ from that of other types of investment vehicles? To put it another way, how much does a REIT’s tax efficiency increase the after-tax income of its investors?
Consider a corporation that earns $10 before taxes and distributes 100% of its profits to investors. The chart below indicates how much of the $10 would go to investors if the company were organized as one of the three basic corporate entity types (corporations, real estate investment trusts, and master limited partnerships):
REITs are far more tax-efficient than corporations, owing to the fact that they avoid double-taxation by avoiding tax at the corporate level. REITs, on the other hand, aren’t as tax-efficient as Master Limited Partnerships.
REITs are more desirable than corporations because of their tax efficiency. The rest of this article will go through how to identify the most appealing REITs depending on their valuation.
Non-GAAP Financial Metrics and the Two REIT Valuation Strategies
The final section of this article explained what a REIT is and why investors like this investment vehicle because of its tax efficiency. This section will explain why traditional valuation criteria cannot be used to evaluate REITs, as well as alternative methods that investors might use to examine their pricing.
As a result, depreciation is a large expense on these investment vehicles’ income statements. Depreciation is a real cost, but it is not a cash cost.
Depreciation is significant since it accounts for the up-front capital expenditures required to develop value in a real asset over time; nevertheless, it should not be used for determining dividend safety or the likelihood of a REIT defaulting on its debt.
Depreciation might also change over time. More depreciation is recorded (on an absolute dollar basis) at the beginning of an asset’s useful life in a traditional straight-line depreciation plan. Because of the volatility of depreciation expense over time, valuing a REIT using net income (as the typical price-to-earnings ratio does) is not a viable technique.
So, how might a smart security analyst account for a REIT’s real economic earnings?
Traditional valuation systems have two primary possibilities. The first evaluates REIT valuation using economic earnings potential, whereas the second evaluates REIT valuation using income generation capability. Below, we’ll go over each one in depth.
Rather than utilizing the usual price-to-earnings ratio (P/E ratio), REIT analysts frequently employ a slightly different variation: the price-to-FFO ratio (or P/FFO ratio).
The ‘FFO’ in the price-to-FFO ratios stands for funds from operations, a non-GAAP financial statistic that strips out the REIT’s non-cash depreciation and amortization charges to reveal the REIT’s cash earnings.
The National Association of Real Estate Investment Trusts (NAREIT) has established a widely accepted definition for FFO, which is listed below:
“Net income before gains or losses from the sale or disposal of real estate, real estate-related impairment charges, real estate-related depreciation, amortization, and accretion, and preferred stock dividends, and including adjustments for I unconsolidated affiliates and (ii) noncontrolling interests.”
The price-to-FFO ratio is calculated in the same way that the price-to-earnings ratio is calculated. We divide REIT unit price by FFO-per-share rather than stock price by earnings-per-share. See the example in the following section for further information.
The other method for determining a REIT’s value does not employ a Non-GAAP financial indicator. Instead, the present dividend yield of a REIT is compared to its long-term average dividend yield in this second technique.
If a REIT’s dividend yield is higher than its long-term average, it is undervalued; on the other hand, if the trust’s dividend yield is lower than its long-term average, it is overpriced. See the second example later in this post for more information on this second valuation technique.
The next two sections will provide extensive examples of how to construct valuation metrics relating to these unique legal entities now that we have a high-level description of the two valuation approaches available to REIT investors.
Example #1: Realty Income P/FFO Valuation Analysis
This section will walk you through the process of calculating REIT valuation using the price-to-FFO ratio. To make the example as relevant as feasible, we’ll utilize a real-world publicly traded REIT for this example.
The security that will be used in this example is Realty Income (O). It is one of the largest and most well-known REITs among dividend growth investors, thanks in part to its monthly dividend payment schedule.
For investors who rely on their dividend income to cover their living expenditures, monthly dividends are preferable to quarterly payouts. Monthly dividends, on the other hand, are uncommon. As a result, we compiled a list of roughly 50 equities that pay monthly dividends. Our monthly dividend stock list can be found here.
When computing the P/FFO ratio, REIT investors must select whether to utilize forward (forecasted) funds from operations or historical (previous fiscal year’s) funds from operations, just as they do with equities.
Investors must locate the company’s press release announcing the publishing of this financial data in order to find the funds from operations recorded in the previous fiscal year.
Note: Adjusted FFO is better than’regular’ FFO since it excludes one-time accounting charges (typically from acquisitions, asset sales, or other non-recurring operations) that artificially inflate or deflate a company’s reported financial performance.
Realty Income is currently trading at $72 per share, reflecting a price-to-FFO ratio of 21.3 (using last year’s financial performance as the denominator).
Alternatively, an investor could look at a company’s most recent quarterly earnings press release for forward-looking expected adjusted funds from operations for the current year, which is usually (but not always; some companies do not provide guidance) included in the company’s most recent quarterly earnings press release.
Realty Income revised its full-year outlook in its most recent quarterly earnings report, now expecting adjusted FFO-per-share in the range of $3.53 to $3.59 in 2021. Based on 2021 projected performance, the midpoint of adjusted FFO guidance ($3.56 per share) implies a 2021 P/FFO ratio of 20.3, making Realty Income look cheaper.
So, after calculating the price-to-FFO ratio, how do investors assess whether Realty Income is a good investment today?
First, investors should compare the current P/FFO ratio of Realty Income to its long-term historical average. If the current P/FFO ratio is high, the trust is probably overvalued; on the other hand, if the current P/FFO ratio is low, the trust is a good buy.
Realty Income stock has traded for an average P/FFO ratio of 18.9 over the last ten years, indicating that shares are currently expensive.
The second comparison that investors should make is with the peers of Realty Income. This is critical: if Realty Income’s valuation is attractive in comparison to its long-term historical average, but the stock is still trading at a considerable premium to other, similar REITs, the stock is most likely not a good time to buy.
Finding an appropriate peer group is one of the most difficult aspects of a peer-to-peer value comparison.
Fortunately, big publicly traded firms are required by the Securities and Exchange Commission to self-identify a peer group in their annual proxy filing. This filing, which appears as a DEF 14A on the SEC’s EDGAR search database, includes a table that looks similar to the one below (which was submitted on April 3, 2017 by Realty Income):
In this proxy filing, every publicly traded company is required to disclose a similar peer group, which is extremely useful when an investor wishes to compare a firm’s valuation to that of its peers.
Example #2: Realty Income Dividend Yield Valuation Analysis
The third technique for establishing whether a REIT is trading at a favorable valuation, as previously said, is to look at its dividend yield. This section will walk you through the process of evaluating REIT valuations using this technique.
Realty Income provides a monthly dividend of $0.2355, which equates to $2.826 in annual dividend income per unit at the time of writing. The company’s current unit price of $72 represents a 3.9 percent dividend yield.
The current dividend yield of Realty Income is compared to its long-term average in the graph below.
The current dividend yield on Realty Income is 3.9 percent, with a 10-year average dividend yield of 4.5 percent. Realty Income’s lower-than-average dividend yield implies that the stock is now expensive.
Because the trust’s dividend yield is lower than its long-term average, it’s safe to assume that now isn’t the greatest time to add to or start a position in this REIT. Most REITs in its peer group have yields exceeding 4%, therefore a peer group analysis would likely produce a similar conclusion. The previous portion of this article contains instructions for determining an acceptable peer group for any public corporation.
For real estate investment trusts, the dividend yield valuation method may not be as reliable as a bottom-up study using funds from operations.
- It is more efficient. Most Internet stock screeners provide dividend yields, but some don’t have the capacity to filter for stocks selling at low multiples of funds from operations.
- It can be applied to a variety of asset classes. While FFO is only reported by REITs (and some MLPs), it is evident that any dividend-paying investment has a dividend yield. As a result, the dividend yield valuation strategy can be used to value REITs, MLPs, BDCs, and even companies (albeit the P/E ratio remains the best way for corporations).
Final Thoughts
There are unquestionably benefits to investing in real estate investment trusts.
These securities provide investors with the economic benefits of real estate ownership while simultaneously providing a completely passive investment opportunity. Furthermore, REITs are tax-advantaged and typically offer higher dividend yields than the S&P 500’s average dividend yield.
REITs, like businesses, have analytical peculiarities that make them more challenging to assess. This is especially true when it comes to determining their worth.
The following are two analytical methodologies that can be used to value REITs:
Each has its own set of advantages and should be part of any dividend growth investor’s toolset that includes real estate trusts.
Bonus: Watch the video below to hear our chat with Brad Thomas on The Sure Investing Podcast about sensible REIT investing.
Is REIT a good investment in 2021?
Three primary causes, in my opinion, are driving investor cash toward REITs.
The S&P 500 yields a pitiful 1.37 percent, which is near to its all-time low. Even corporate bonds have been bid up to the point that they now yield a poor return compared to the risk they pose.
REITs are the last resort for investors looking for a decent yield, and demographics support greater yield-seeking behavior. As people near retirement, they typically begin to desire dividend income, and the same silver tsunami that is expected to raise healthcare demand is also expected to increase dividend demand.
The REIT index’s 2.72 percent yield isn’t as high as it once was, but it’s still far better than the alternatives. A considerably greater dividend yield can be obtained by being choosy about the REITs one purchases, and higher yielding REITs have outperformed in 2021.
Are REITs a good buy now?
- No corporation tax: A company must meet certain criteria in order to be classed as a REIT. It must, for example, invest at least three-quarters of its assets in real estate and pay shareholders at least 90% of its taxable income. If a REIT fits these criteria, it receives a significant tax benefit because it pays no corporate tax, regardless of how profitable it is. Profits from most dividend stocks are effectively taxed twice: once at the corporate level and then again at the individual level when dividends are paid.
- High dividend yields: REITs offer above-average dividend yields because they must pay at least 90% of taxable revenue to shareholders. It could, for example, offer a secure dividend yield of 5% or more, but the typical S&P 500 company yields less than 2%. If you need income or wish to reinvest your dividends and compound your gains over time, a REIT can be a good solution.
- Total return potential: As the value of its underlying assets rises, a REIT’s total return potential rises as well. Real estate values rise over time, and a REIT can grow its worth by employing a variety of tactics. It might either build properties from the ground up or sell valued assets and reinvest the proceeds. A REIT can be a good total return investment when this is combined with substantial dividends.
- REITs were designed to provide average investors with access to commercial real estate assets that would otherwise be out of reach. Most people can’t afford to buy an office tower outright, but there are REITs that can.
- Diversification of your financial portfolio: Most experts think that diversifying your investment portfolio is a smart idea. Despite the fact that REITs are technically stocks, real estate is a distinct asset class from stocks. During difficult economic times, REITs tend to keep their value better than equities, and they’re a terrific way to add stable, predictable income. These are only two examples of how an all-stock portfolio’s inherent risk can be mitigated.
- Real estate transactions might take a long time to buy and sell, but REITs are a very liquid investment. A REIT can be bought or sold at any time. Because traded REITs can be purchased and sold like stocks, it’s simple to receive money when you need it.
- Direct ownership and management of a property is a business that demands time and effort. REIT shareholders do not own the properties or mortgages in its portfolio, thus they do not have to deal with property maintenance or development, landlord services, or rent collection as a property owner or management would.
How are REITs doing in 2021?
So far in 2021, the REIT sector has posted increases in every month, including a +1.77 percent average total return in May. In May, 58.24% of REIT securities had a positive total return. In May, hotels and student housing REITs outperformed all other property types, while corrections and health care REITs saw the biggest drops.
Why are REITs a bad investment?
Real estate investment trusts (REITs) are not for everyone. This is the section for you if you’re wondering why REITs are a bad investment for you.
The major disadvantage of REITs is that they don’t provide much in the way of capital appreciation. This is because REITs must return 90 percent of their taxable income to investors, limiting their capacity to reinvest in properties to increase their value or acquire new holdings.
Another disadvantage is that REITs have very expensive management and transaction costs due to their structure.
REITs have also become increasingly connected with the larger stock market over time. As a result, one of the previous advantages has faded in value as your portfolio becomes more vulnerable to market fluctuations.
What is a good p FFO for a REIT?
The best tool for analyzing REITs is probably the price-to-funds-from-operations (P/FFO) ratio. P/FFOs have been in the high teens, with some going into the 20s, in the present interest rate environment. P/FFOs have been consistently low for various REITs, with some falling below 10.
What are the safest REITs?
These three REITs are unlikely to appeal to investors with a value inclination. When things are uncertain, though, it is generally wise to stick with the biggest and most powerful names. Within the REIT industry, Realty Income, AvalonBay, and Prologis all fall more generally into that category, as well as within their specific property specialties.
These REITs are likely to have the capital access they need to outperform at the company level in both good and bad times. This capacity should help them expand their leadership positions and back consistent profits over time. That’s the kind of investment that will allow you to sleep comfortably at night, which is probably a cost worth paying for conservative sorts.
Can you lose money in a REIT?
- REITs (real estate investment trusts) are common financial entities that pay dividends to their shareholders.
- One disadvantage of non-traded REITs (those that aren’t traded on a stock exchange) is that investors may find it difficult to investigate them.
- Investors find it difficult to sell non-traded REITs because they have low liquidity.
- When interest rates rise, investment capital often flows into bonds, putting publically traded REITs at danger of losing value.
Are REITs taxed differently?
Dividend payments are assigned to ordinary income, capital gains, and return of capital for tax reasons for REITs, each of which may be taxed at a different rate. Early in the year, all public firms, including REITs, must furnish shareholders with information indicating how the prior year’s dividends should be allocated for tax purposes. The Industry Data section contains a historical record of the allocation of REIT distributions between regular income, return of capital, and capital gains.
The majority of REIT dividends are taxed as ordinary income up to a maximum rate of 37% (returning to 39.6% in 2026), plus a 3.8 percent surtax on investment income. Through December 31, 2025, taxpayers can deduct 20% of their combined qualifying business income, which includes Qualified REIT Dividends. When the 20% deduction is taken into account, the highest effective tax rate on Qualified REIT Dividends is normally 29.6%.
REIT dividends, on the other hand, will be taxed at a lower rate in the following situations:
- When a REIT makes a capital gains distribution (tax rate of up to 20% plus a 3.8 percent surtax) or a return of capital dividend (tax rate of up to 20% plus a 3.8 percent surtax);
- When a REIT distributes dividends received from a taxable REIT subsidiary or other corporation (20% maximum tax rate plus 3.8 percent surtax); and when a REIT distributes dividends received from a taxable REIT subsidiary or other corporation (20% maximum tax rate plus 3.8 percent surtax); and when a REIT distributes dividends received from
- When allowed, a REIT pays corporation taxes and keeps the profits (20 percent maximum tax rate, plus the 3.8 percent surtax).
Furthermore, the maximum capital gains rate of 20% (plus the 3.8 percent surtax) applies to the sale of REIT stock in general.
The withholding tax rate on REIT ordinary dividends paid to non-US investors is depicted in this graph.
Do REITs do well in a recession?
It’s crucial to remember that nothing can fully protect you against a recession. Any venture has weaknesses and hazards, and each economic downturn presents new obstacles.
While no recession is the same as the last, there are some real estate sectors that are more robust during a downturn. Real estate investments that meet people’s basic requirements, such as housing and agriculture, or that provide important services for economic activity, such as data processing, wireless communications, industrial processing and storage, or medical facilities, are more likely to weather the storm.
Investors can own and manage properties in any of the asset classes, but many prefer to invest in real estate investment trusts (REITs) (REIT). REITs can be a more affordable and accessible method for investors to enter into real estate while also obtaining access to institutional-quality investments in a diversified portfolio.
Data centers
We live in a data-driven technology era. Almost everything we do now requires data storage or processing, and the demand for data centers will only grow in the next decades as more technological or data-driven gadgets are released. During recessions, more people stay at home to watch TV, use their computers or smartphones, or, in the case of the recent coronavirus outbreak, work from home, increasing the need on data centers. According to the National Association of Real Estate Investment Trusts, there are currently five data center REITs to select from, with all five up 33.73 percent year to date (NAREIT).
Self-storage
Self-storage is widely regarded as a recession-proof asset type. As budgets tighten, some families downsize, relocating to other places to better their quality of life or pursue a new work opportunity, or downsizing by moving in with each other to save money. This indicates that there is a higher need for storage.
The COVID-19 pandemic, on the other hand, has had an unforeseen influence on the storage industry. While occupancy has remained high, eviction moratoriums and increasing cleaning and safety costs have resulted in lower revenues. According to NAREIT, self-storage REITs are down 3.51 percent year to date. However, this industry is expected to recover swiftly, particularly for companies like Public Storage (NYSE: PSA), the largest publicly traded self-storage REIT, which has a strong credit rating and a diverse portfolio.
Warehouse and distribution
E-commerce has altered the way our economy works. Demand for quality warehousing and distribution centers has soared as more consumers purchase from home than ever before. Oversupply of industrial space, particularly warehouse and distribution space, is a risk, given that this sector has been steadily growing for the past decade; however, as a result of COVID-19, it has already proven to be the most resilient asset class of all commercial real estate, making it an excellent choice for a recession-resistant investment. Prologis (NYSE: PLD), one of the major warehousing and logistics REITS, and Americold Realty Trust (NYSE: COLD), a REIT that specializes in cold storage facilities, have both proven to be quite durable in the present economic situation, with plenty of space for expansion.
Residential housing
People will always require housing. Residential housing, which can range from single-family homes to high-rise flats or retirement communities, fulfills a basic need that is necessary even in difficult economic times. During economic downturns, rents may stagnate and evictions or foreclosures may increase, but residential rentals are a relatively reliable and constant source of income. Despite the COVID-19 challenges, American Homes 4 Rent (NYSE: AMH), which specializes in single-family rental housing, and Equity Residential (NYSE: EQR), which specializes in urban high-rises in high-density areas, are two of the largest players in residential housing, both of which have maintained high occupancy and collection rates.
Agriculture
Aside from housing, agriculture and food production are two additional critical services on which our country and the rest of the world rely. Our existing food system is primarily reliant on industrial agriculture, but more and more autonomous and regenerative agricultural projects are springing up, allowing for more crop diversification, increased productivity, and reduced economic and environmental risk.
Wireless communication
Wireless communication has grown into a giant sector, with American Tower (NYSE: AMT) and Crown Castle International (NYSE: CCI) being two of the world’s largest REITs. Cell tower REITs that provide telecommunication services are an important part of our world today, and while growth prospects can be difficult to come by, very good track records and rising demand make this a terrific real estate investment that will weather any economic downturn.
Medical facilities
Medical facilities, senior housing, hospitals, urgent care clinics, and surgery centers all provide a vital service that will always be in demand, even during economic downturns.
Retail centers
Before you abandon ship when you see this category, let me state unequivocally that retail is not dead, at least not in all forms. Grocery stores and other retail outlets that provide critical services and products will continue to be in demand, as they did during the last pandemic. The issue here is for retail REITs to invest in the vital service sector with such focus that other sectors such as tourism, restaurants, or general shopping and goods do not put the company or investment at risk.
What is the 2% rule in real estate?
Purchasing a property and renting it out can help you pay off your mortgage while also potentially generating additional cash. Renting out your property can also provide you with passive income, allowing you to focus on other things while still earning money. Buying and renting properties is a simple method to begin investing in real estate. What do you need to know?
In real estate, the two percent rule relates to what percentage of the total cost of your residence you should ask for in rent. To put it another way, for a $300,000 property, you should be asking for at least $6,000 a month to make it worthwhile.
However, in metro real estate markets, the 2 percent guideline is frequently impossible to achieve. However, the average rental cost in a place like Philadelphia is $1,660, while the average home is $203,000. This can be a decent rule of thumb for determining what you would need to charge in order to be cash-flow positive relatively soon. In other words, charging $4,000 for an average home rental will be out of line with the local rental market.
Capital gains tax on real estate investment property will apply if you are not intending to live in your investment property (If you live there for at least 2 years, you can minimize – or even eliminate – your capital gains tax responsibility).
If you own property for less than a year, you’ll pay the same amount in taxes as if you were earning regular income. It’s considered a long-term capital gain if you’ve owned the property for at least a year. These profits are taxed at a reduced rate of 0%, 15%, or 20%, depending on your income and filing status.
Weak Growth
REITs that are publicly listed are required to pay out 90% of their profits in dividends to shareholders right away. This leaves little money to expand the portfolio by purchasing additional properties, which is what drives appreciation.
Private REITs are a good option if you enjoy the idea of REITs but want to get more than just dividends.
No Control Over Returns or Performance
Investors in direct real estate have a lot of control over their profits. They can identify properties with high cash flow, actively promote vacant rentals to renters, properly screen all applications, and use other property management best practices.
Investors in REITs, on the other hand, can only sell their shares if they are unhappy with the company’s performance. Some private REITs won’t even be able to do that, at least for the first several years.
Yield Taxed as Regular Income
Dividends are taxed at the (higher) regular income tax rate, despite the fact that profits on investments held longer than a year are taxed at the lower capital gains tax rate.
And because REITs provide a large portion of their returns in the form of dividends, investors may face a greater tax bill than they would with more appreciation-oriented assets.
Potential for High Risk and Fees
Just because an investment is regulated by the SEC does not mean it is low-risk. Before investing, do your homework and think about all aspects of the real estate market, including property valuations, interest rates, debt, geography, and changing tax regulations.
Fees should also be factored into the due diligence process. High management and transaction fees are charged by some REITs, resulting in smaller returns to shareholders. Those fees are frequently buried in the fine print of investment offerings, so be prepared to dig through the fine print to find out what they pay themselves for property management, acquisition fees, and so on.
