Why and How to Invest in REITs (Real Estate Investment Trusts)

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hotelIf you’re looking for an under-the-radar investment that has a history of great returns, then consider REITs. In this article, you’ll learn why and how to invest in REITs. Specifically, you’ll get the scoop on the three types, how they work, investment options, and how you make money.

After gaining a basic understanding of them, you’ll have sufficient knowledge to invest in them with confidence — after researching a specific REIT company, of course.

The first thing you should know about Real Estate Investment Trusts is that they are corporations. The term REIT is just a way of classifying companies that are in the business of buying, managing, selling, and investing in properties and/or mortgages.

Just as General Motors is in the automobile industry, there are companies in the REIT industry. So don’t get all discombobulated about the term. The reason, I believe, that people treat REIT’s like they are a three-headed snake is because real estate itself comes with a set of unique accounting rules. Building and managing malls is not exacly like manufacturing cars. But there’s no reason to fear REITs simply because there are some differences.

REITs are similar to other large public corporations in that they have shareholders. You’ll find the shares (stocks) of these companies listed and traded on the New York Stock Exchange, NASDAQ, and other exchanges. You can also invest in a basket of REITs through mutual funds and other ways.

So now that I’ve taken some of the scary mystery out of REITs, would you like to go a little deeper and learn more about them and what makes them worth considering for your investment portfolio?

Good! Let’s proceed.

Oh, and before I forget. In the spirit of full disclosure, I do have a REIT investment in my portfolio.

History of Real Estate Investment Trusts (REITs)

REITs date back to the early 1970’s. Back then, they were just a small glimmer in someone’s eye. But today, by some estimates, all the combined REITs have a market capitalization of well over $600 million in the U.S. (Market capitalization refers the market value of all their outstanding shares/stock). And there are over 170 REIT companies.

You can learn more about the growth of the REIT industry by visiting this link

Types of REITs

There are 3 types of REITs — Equity, Mortgage, and Hybrid

Equity REITs own and invest in properties. They primarily make their money from the rent they charge to the occupants of their buildings, apartments, malls, and other properties. Equity REITs are the most well-known and talked about REITs. You’ll also find subsectors for this category. For example, there are Retail, Residential, Office, and Healthcare REITs.

Mortgage REITs deal in property mortgages. They provide mortgage loans to real estate owners. They will also acquire mortgages and mortgage backed securities. Their revenue and profit is derived from the interest that they charge and earn on loans. It’s just like the interest you pay on your mortgage. Who ever you’re paying it to, that’s revenue for them.

Hybrid REITs deal in both physical properties and mortgages. So, in effect, they do what both the equity and mortgage REITs do. There’s nothing inherently special about combining the two approaches. It’s just another option.

How to Evaluate REITs

As you might expect, not all REIT companies are equal. They vary in size, assets, and performance. So just as you would analyze the stock of General Motors, you would do something similar with REITs. For example, when determining whether to buy GM’s stock, one of the metrics you’d examine is Earnings Per Share (EPS).

To calculate EPS, you would take the company’s total profit and divide it by the total number of outstanding shares. So if a company has $10 million in profit and 5 million outstanding shares, their EPS would be $2. Of course, ideally you’d like to see the EPS number increasing over time

Since REITs are sold on stock exchanges, you can perform this same analysis. However, for REITs there is another unique metric that carries much more weight for them than their EPS. It’s called Funds From Operations (FFO).

What Does FFO Mean and How Do You Calculate It?

Funds From Operations (FFO) is way of measuring the cash flow associated with a REIT. Companies will generally provide this information in their financial statements, but here’s how it’s calculated.

To calculate a companies FFO, you would do this:
Start with their Net Income (profits)
+ Add depreciation and amortization expenses (See Notes 1 & 2)
+ Add gains (profits) from the sale of assets (properties)
– Subtract losses from the sale of assets (properties)

Note 1: Depreciation – is the amount by which the value of a property has been lost due to age and wear and tear. There’s a formula for translating the loss into dollars.

Note 2: Amortization – the amount of money that has been paid to reduce a mortgage over a specified time period.

Click here if you want to read all the dirty details behind the FFO calculation.

So when evaluating a REIT, you want to see FFO numbers that are rising over time. You can also calculate a company’s FFO Per Share by taking the FFO dollar total and dividing it by the total number of outstanding shares.

Finally, there’s one other important thing you should know about the FFO. Unfortunately, not all companies calculate it the same way. Some leave out certain components. So when you make comparisons between REITs, you’ll have to dig further into the numbers and do some tweaking on your own to ensure you’re comparing apples to apples. It’s a pain, but shouldn’t be too difficult.

Other Factors to Consider When Evaluating REITs

Since REITs are all about real estate, you have to also look at them beyond their financial numbers and ask these types of questions.

– What’s the overall economy looking like as far as growth?
– What’s the strength of the real estate market? Are new homes being built?
– What is the level of spending on durable goods such as cars, appliances, furniture?
– What’s the employment outlook?

I think you get the gist. There are a lot of variable that affect the real estate market. So you’ll need to do your homework. But it’s no different than researching the pluses and minuses of any investment.

How Do You Make Money On REITS?

As I mentioned earlier, REITs are traded on the open market just like stocks. So if you buy them, and the share price increases, you would benefit if you then sold them. In addition. REITs are required by law to distribute 90% of the income they make to shareholders. That’s a very sweet deal.

Of course, there is a downside. Because REITs are required to pay out most of their income, that means there’s little left over to purchase and bulid more offices, malls, and appartments that could yield even more income. So when they decide to expand, it’s done so by taking on large amounts of mortgage financing debt. That’s another reason why you have to do your homework.

If you’re intrigued by REITs, here’s where you can go to find those that are listed on stock exchanges.  Each REIT company should have its own website where you can go to learn more about what they do specifically. Also, you’ll be able to read their annual reports and dig into their financial statements.

And if you’d prefer to invest in REITs through mutual funds, you’ll find the funds listed with the large mutual fund companies and brokerage firms. REITs are also traded as Electronic Traded Funds (ETFs), but this is a discussion for another article.

In conclusion, you now know why and how to invest in REITs. They aren’t the scary monsters some people make them out to be. They’re just a little different because real estate is a complex animal, that’s all. But with your newly found knowledge of the types of REITs available to you, their history, how to evalutate them, and where to find them, that’s more than enough to get you started. So go out there and determine if REITs are a good fit for your investment portfolio.