REITs Investment Introduction

A Real Opportunity 

While they have been around for over fifty years, real estate investment trusts (REITs) have been slow to move into the mainstream. This was partially a by-product of only a moderate number of REITs existing prior to the 1990s, but also a result of REITs’ characteristics, which are different from stocks and bonds and require specialized analysis. However, the low interest rate environment that has prevailed since the global financial crisis has introduced a new wave of investors to REITs. We believe a continuation of low rates, coupled with the addition of REITs as a new GICS sector at the end of August (they previously were a subgroup of financials), will likely result in continued growth for the asset class. In this paper, we provide an overview of REITs: what they are, their characteristics, what drives their performance, how to value them, as well as how to allocate to them within a diversified portfolio.

What Is a REIT? In simple terms, real estate investment trusts—or REITs—are investment vehicles that offer exposure to real estate. They are corporate entities that own, operate, develop, manage, acquire, or finance real estate. By filing as a REIT, a company avoids taxation at the corporate level in exchange for passing on 90% or greater of its taxable income to shareholders. This has historically resulted in significant and reliable income streams for investors. While there are different types of REITs, this paper will address those that are listed and publicly traded. A REIT typically falls into one of two categories. Equity REITs, which make up approximately 90% of REITs, generally own and operate real estate. Mortgage REITs lend to owners and operators or acquire real estate-related debt or mortgage-backed securities. Growth of an Asset Class REITs were first established in the United States in 1960 as a means to provide retail investors access to larger and more diversified portfolios of commercial real estate, similar to mutual funds. Originally REITs, like mutual funds, were designed as passive investment vehicles. However, over time, reforms were made to allow REITs to actively manage and operate their portfolios. At first, the REIT model was slow to catch on, with just over 50 equity REITs formed from 1960 to 1990. However, due to the savings and loans crisis and the closing of some tax loopholes, growth accelerated in the early 1990s, with 113 equity REITs launched from 1991 to 1995 and total market cap expanding from $9 billion in 1991 to $50 billion in 1995.

Today, US REITs have a market cap of $972 billion and own more the $1.8 trillion of commercial real estate (including non-listed REITs)

There are 219 REITs in the FTSE/NAREIT All REIT Index and 26 REITs in the S&P 500 Index. More than 193 trade on the New York Stock Exchange. In addition, the average daily trading volume has nearly doubled over the past five years, from $3.3 billion in 2011 to $6.0 billion in 2016.

A Diverse Asset Class 

REITs own and/or manage a variety of property types, or sectors, though the majority of US REITs specialize in a specific sector such as office buildings, regional malls, or apartments. As the real estate market has matured in the United States, specialty sectors such as data centers, timber, or infrastructure have developed. Each sector has its own unique economic drivers and lease terms , which can enhance diversification within portfolios. Due to the potential variance of performance among different property sectors, the average spread between the best- and worst-performing sectors over the last five years has been 40%. As such, it is critical to understand how each sector is impacted by both economic and real estate cycles.

Why Own REITs? 

US REITs can offer investors attractive risk-adjusted returns, a potential source of income, diversification benefits, and a hedge to inflation. • Attractive Long-Term Returns: Since their inception, REITs have historically outperformed stocks and bonds over every long-term time period except the last five years, where they lagged by only 70 bps.

• Strong Relative and Absolute Income: Due to the underlying property leases and requirement that they pass through 90% of their taxable income, REITs have generated attractive and consistent income.
• Enhanced Diversification: Real estate has historically had a low correlation to other asset classes
• Inflation Hedge: REIT dividends have historically grown faster than inflation as stronger economic growth increases the demand for real estate.

Drivers of Performance 

• Economic growth: Economic expansion is one of the primary drivers of commercial real estate, typically increasing demand for space, rents, and ultimately growth in net operating income (NOI). Resulting job creation and wage increases reverberate throughout all property sectors. Additional office space is required to house new employees; warehouse and distribution space is needed to address increased inventories; retailers, many with leases tied to a percentage of sales, pay higher rents to landlords as consumers spend more; new households are formed, increasing demand for apartments; and business and leisure travel accelerate, raising hotel occupancy and room rates.

• Demographics: Population change, immigration, migration patterns, and household income are significant contributors to the growth, development, and consumption of real estate. Equally important are the trends and preferences of large age cohorts. Millennials for example have put off getting married, having children, and buying a house, which has fueled multi-family housing and urban densification.

As demand and space requirements change, buildings may be at risk of becoming obsolete, and once-popular neighborhoods or destinations can experience a decline.

• Supply and demand: Excess demand and tight supply will favor landlords, whereas a prolonged, favorable environment can lead to a glut of new construction and downward pressure on occupancy and rents. A cycle of oversupply, equilibrium, and undersupply has historically been the norm for real estate. However, the global financial crisis was unique for the slow pace of new development prior to the crisis. Coupled with a near shutdown in new construction post-crisis, landlords have benefited despite a less-than-robust economic recovery due to constrained supply.

Valuing REITs 

While REITs share a number of valuation metrics with equities such as multiples, growth, and yields, other metrics are particular to real estate:

• Funds from Operations (FFO): Like most companies, REIT net income is reduced by depreciation expenses. However, unlike assets such as equipment, property generally appreciates. As a result, FFO adds back certain real estate–related deprecation expenses and is akin to EPS for equities.

• Adjusted Funds from Operations (AFFO) or Cash Available for Distribution (CAD): As FFO can overstate income, certain items like recurring expenses (e.g., tenant improvements, leasing expenses) and capital expenditures are subtracted and rent increases are included.

• P/FFO: Price to FFO can be thought of as a price to earnings (P/E) equivalent used to calculate relative value. However, as a result of different property sectors and individual companies having different ranges, the metric is better suited to top-down analysis. While some third-party research firms may provide P/Es on REITs, they treat depreciation as an expense, resulting in significantly higher ratios than P/FFO.

• Net Asset Value (NAV): NAV is one of the most important valuation metrics because the value of a REIT is mainly derived by the assets it owns. This is also why NAV doesn’t apply to companies that don’t own hard assets. Determining NAV requires calculating a REIT’s 12-month projected net operating income (NOI) and dividing by an appropriate cap rate. This results in an estimated value of a REIT’s properties. After including additional income sources, cash, and land and subtracting liabilities, we arrive at the NAV.

• Capitalization Rates: Capitalization rates (cap rates) represent the rate of return, or yield, based on the income that a property is expected to generate in its first year. It is calculated by dividing the property’s projected 12-month net operating income (NOI) and dividing by the current market value of the asset. The lower the cap rate, the higher the multiple on the asset.

• Dividend Yield: Due to the significant contribution to a REIT’s total return (on average around 60%), comparing yields among REITs as well as bonds (the 10-year Treasury and corporate bonds being most relevant) can provide investors as useful relative valuation tool.

Not every property or portfolio is created equal and, as a result, qualitative factors should be accounted for when valuing real estate. These factors include portfolio quality and location, development pipeline, pending acquisitions, lease term and structure, and management quality.

Investing in REITs 

What allocation should REITs have in a portfolio?

We believe REITs offer a hybrid of equity and bond characteristics, along with some distinct features of their own. Some have viewed real estate as akin to equities due to their strong total returns and volatility. Others equate REITs to bonds due to their high yields. In reality, real estate is a distinct asset class warranting a separate allocation within an investor’s portfolio, depending on one’s investment goals and risk tolerance.

An appropriate allocation to real estate can improve a portfolio’s potential to generate higher returns at lower volatility. Institutional investors have historically allocated strategically to real estate and at higher levels than other investors. Generally this is a result of better understanding the asset classes’ characteristics by employing dedicated analysts. While US institutions who choose to invest in real estate generally allocate between 7%–10% of their portfolios to commercial real estate today, others have held significantly higher levels.

REITs: A Real Opportunity

While some may consider REITs to be similar to either stocks or bonds, what makes them a distinct asset class is their differentiated source of returns. Through the contractual lease obligation of the tenant to the landlord (REIT), a stable income stream is generated. And through occupancy growth, rent growth, or redevelopment of properties, REITs have the ability to grow their income stream.

So, whether through attractive potential total returns, stable and significant income, enhanced diversification, or a hedge against inflation, we believe REITs can serve most investors’ objectives. Up until recently, listed real estate has not enjoyed the same wide-scale adoption as stocks or bonds. But through organic growth, strong results, and industry changes that formalise REITs as a separate asset class, that will likely change. As a result, investors who haven’t previously invested in real estate would be well served by taking a more in-depth look at the asset class.

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