Real Estate Investment Trusts (REITs) are one of the most popular investments for investors that want income producing investments. REITs are publicly traded or privately owned companies that own and operated commercial real estate, and are required by the Securities and Exchange Commission (SEC) to pay 90% of taxable income to shareholders in the form of dividends. The SEC also has other specific regulations for REITs including requiring the investment of at least 75% of total assets in real estate or cash, and generate at least 75% of gross income from sources related to real estate such as property rents or interest payments on mortgages financed by the REIT.
In general, REITs are classified into two categories.
- Equity REITs – owners of a portfolio of income generating real estate.
- Mortgage REITs – financiers of income generating real estate, that earn interest from mortgages or mortgage-backed securities (MBS) they own
The vast majority of REITs are equity REITs, and that is what we will focus on in this article. Equity REITs can be classified as either specialized (focused on owning one property type) or diversified (owning a wide range of property types. The most commonly owned property types are shopping malls, office buildings, warehouses, rental apartments, and hotels, however REITs also own more niche property types including seniors housing, timberland, farmland, self-storage, movie theaters, and hospitals.
General REIT Risks
REITs are publicly traded securities and come with the risks of investing in the financial markets. The most obvious example is that when there is a selloff in the stock market, REITs will be sold off as well. The correlation between REITs and equities between December 1989 and December 2017 was 0.59, meaning on average when the global equities increased by $100, global REITs increased by $59, and when global equities decreased by $100, global REITs decreased by $59.
A positive correlation with the broader stock market isn’t a bad thing at all, just don’t consider it a diversification tool or a hedge to your portfolio. REITs still have a significant positive beta (correlation with the stock market).
Different Valuation Metrics
Investors that have only invested in traditional equities may find themselves feeling lost the first time they try to value a REIT. Let’s use Brookfield Property Partners ($BPY), an office REIT as an example.
At first glance the Brookfield Property Partners doesn’t appear particularly overvalued, with a PE (price/earnings) ratio of 14.54. If you were looking for fairly priced stocks this is one you would consider digging deeper into the financials of, with an added bonus of a 6.64% dividend yield. The issue is that Yahoo Finance considers it an extremely overvalued stock, what gives?
Traditional metrics for valuing stocks such as the price/earnings (P/E) ratio and earnings per share (EPS) are not applicable when valuing REITs. To properly value a REIT is makes more sense to use metrics such as funds from operation and net asset value (NAV) to value the REIT. Many investors are not aware of the distinctions between these metrics
Potential Tax Liabilities
This is one of the the most common risk for investors in REITs, particularly for high net worth investors. REITs have a mandate from the SEC to pay at least 90% of taxable income as dividends. Dividends distributed by REITs are ordinarily taxed at the same rate as ordinary income, so if you choose to invest in REITs you should consider doing in in a tax sheltered account such as an IRA or a 401k.
Interest Rate Risk
Real Estate is one of the most sensitive sectors of the economy to interest rate changes. With lower interest rates debt financing is cheaper so the cost of a mortgage on a property or a construction loan for a new development is more affordable. This leads to a higher demand for raw land as well as property, and therefore real estate increases tend to price. As interest rates rise, real estate prices tend to fall for the reasons mentioned above, and “safer” investments such as government bonds offer a more attractive risk/return than at lower rates, so real estate values often decrease.
A REIT faces risk on a national level (regulation and taxation of property, national economic conditions) as well as on the local level (property taxes, local economic conditions). Generally speaking, the more diversified a company is geographically, the better. An international owner and operator of commercial real estate will have less geographic risk than a national operator, which will have less risk than a REIT which only operates in a small area.
REIT Risks by Property Type
Rental Apartment REITs
A REIT that owns and operates rental apartments can be a great choice for an investor that wants a low risk, income producing investment. People will always need a place to live, and when a recession hits people will continue paying their rent while they cut down on more discretionary purchases. A REIT that owns apartments will benefit from rising rents, and housing becoming less affordable. Ironically this also creates a massive risk for an owner/operator of apartment buildings – rent control regulation.
Food, water, and shelter are the three necessities for every person in the world. If any of these three become affordable it leads to a high probability of government involvement. In the real estate market, this usually means the government creating rent controls which either freeze the rent of occupied units, or create strict limits on how much rents can be increased per year (usually 1%-3% or a rent increase that is indexed to inflation). This leads to less income for the REIT.
Hotels are considered one of the riskiest commercial real estate property type. This is because there are no fixed rental contracts, for example rental apartments usually have one or two year leases and retail, office, and industrial properties often have 5, 10, or 15 year leases. This ensures that the owner /operator has a consistent revenue stream, so it is easier to run the business and make financial plans because the revenues and expenses are more predicable.
Hotels do not have fixed leases and are usually rented by the night or by the week. Therefore when there is a decrease in travel because of any number of reason such as a recession or high oil prices hotel REITs get hit quite hard. There are also risk on the operations side of the business if there is an increase in the minimum wage or anything else that can cause operating expenses to rise, and therefore for profits to decrease.
There are some great office REITs out there, companies that own and operate a portfolio of Class A office buildings at great addresses in big cities. These REITs can produce incredibly revenue during an expansionary economic cycle, and not be harmed too much during a recession because of their typically blue-chip tenants with long leases. However the game has changed recently with office REITs. Coworking companies now lease massive amounts of office space, particularly WeWork which has become the largest office tenant in London and New York City.
Many people that use WeWork absolutely love it but if you’re a REIT investor you need to be skeptical and go beyond the hype and marketing. WeWork reported a nearly $2B loss in 2018, and this trend continued in the first half of 2019. Coworking is a form of subleasing and has been around for decades in real estate, but it poses above average risks to landlords.
Industrial is a super hot property type as I write this in 2019. The eCommerce or “Amazon effect” has led to a lot more demand for industrial distribution centres near large urban areas. This has led to large rent appreciations for companies that own industrial property, and this means more revenue for REITs that own industrial properties.
A large risk with industrial is that many REITs will sign many tenants that are in one industry across multiple properties. For example a manufacturer and distributor of car parts will form a beneficial relationship with one REIT and lease multiple from them. This is not an issue in and off itself, but if there are economic headwinds for the industry that company is in, it could lead to bankruptcy and vacant properties for the REIT.
In my not so humble opinion, this is the mother of all risk in REIT investing right now. There is a massive shift happening in the way we make retail purchases, we are continuing to choosing the convenience of eCommerce over the experience of purchasing goods in person.
This chart explains it better than I can, look at the trend for eCommerce sales, it’s going up and up. Some of this increase comes from an increase in total retail sales, as the world economy grows, but a lot of it comes from changing consumer habits in North America and Western Europe. Less people are shopping at retail stores and more people are buying things online. This inevitably means higher vacancy rates and lower revenue for REITs that own retail real estate (hint, there are a lot of retail REITs).
The scary thing is that retail stores have done badly in the longest economic expansion on record. I expect to see a lot of retail companies filing for bankruptcy next recession, and a lot of retail landlords experiencing a high number of vacancies. I encourage you to read further into this, Wikipedia has good articles on the retail apocalypse and dead malls.