The Brick and Mortar of REIT

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A Real Estate Investment Trust (REIT) is a property investment company. Unlike other property investments, it is traded on an exchange, similar to listed securities such as ordinary shares and exchange-traded funds.

This makes it an attractive option for ordinary investors to invest in real estate. A small amount is required to participate in this asset class, rather than a large capital outlay that is required for an outright property purchase. In addition, a REIT is the most liquid and inexpensive form of real estate investment in comparison to actual real estate investment. However, as with any investment, the value of your investment may increase or decrease over time.

For a Real Estate Fund to be qualified as a REIT, at least 75% of profits must come from property rental and 75% of the company’s assets must be involved in the rental business. REITs must also payout 90% of their income to investors in the form of a dividend payment. In exchange for operating within these relatively strict rules and to encourage investment in real estate, REITs are exempted from corporation or capital gains tax on property investments.

What are the advantages for income investors?

Having to pay out 90% of rental income as dividends makes REITs an attractive option for investors looking for income. The special tax arrangements also mean dividends are only assessed for tax once.

REITs have long-term lease agreements with their tenants, which helps to make rental income and dividends relatively reliable, though of course there are no guarantees.

Net asset value (NAV)

REIT returns to investors come in two parts – dividends and changes in Net Asset Value (NAV).

NAV represents the value of all the assets owned by the REIT. For example, if the assets owned by the REIT, less any debt, are worth $1m and there are one million shares in issue, the NAV per share is US$1. If the value of the properties increases, either through market movements or development activity, the REIT’s NAV will grow. If a REIT, or the sector in which it invests, is in demand the share price may rise above the NAV. The same process in reverse might push the REIT to a discount or below the NAV.

REITs with a long track record of growing NAV per share often trade at a greater premium – and are worth extra attention from investors. As a general rule, REIT share prices have tended to move in line with the NAV.

Since REITs must pay out most of their income to investors, it’s hard for them to build up enough capital to reinvest in new properties from their own profits. For companies looking to expand, that leaves two main means of funding growth – selling new shares or taking on debt.

The level of debt in a REIT is something investors should keep a close eye on. REIT debt is usually measured in relation to the NAV through what’s called loan-to-value (LTV), the proportion of the property portfolio that is funded by borrowings. A higher ratio means more leverage. Using debt can stop investors from having to stump up more cash or risk being diluted, as they would be if the company chose to sell new shares. However, it does bring extra risk.

Because property prices are cyclical, property values can change quickly. A REIT with a high level of debt can quickly find itself in trouble as LTV shoots up – especially if a downturn also hits rental income. It can reduce its ability to service or repay debt.

Different REITs can afford different levels of debt, depending on how reliable their rental income is. However, we tend to think that LTVs of more than 40% are comparatively high and should be avoided in normal times.

REITs provide an attractive income-earning opportunity for investors as they tend to provide high dividends as a passive income stream. Both REITs and stocks can provide a steady income stream for investors. However, REITs in nature focus more on providing an income stream than stocks do. REITs, therefore, prove to be excellent portfolio diversifiers for investors who want to benefit from the real estate market without outright property ownership.