Companies that own manage, or provide financing for real estate that generates income are referred to as real estate investment trusts. A REIT must pay out dividends to its shareholders at a rate of at least 90% of its net income. In this article, we'll examine what real estate investment trusts are, their like, and how to rate one.

What Constitutes a REIT?

Many real estate investment trusts pay out dividends to their shareholders from the money they earn by leasing properties and collecting rent. Mortgage REITs (mREITs) provide mortgage financing rather than property ownership. These real estate investment trusts (REITs) generate revenue from interest earned on investments such as mortgages and mortgage-backed securities. Certain Internal Revenue Code conditions (IRC) conditions must be met before a firm can claim REIT status.

Different Real Estate Investment Trusts

Real estate investment trusts come in a wide variety of forms. Apartment complexes, regional shopping centres, office buildings, and hotels/motels are common forms of real estate owned by equity REITs. Some are diversified, while others don't fit well into any category.

Mortgage REITs are the second most common kind of real estate investment trust. While these REITs deal in real estate loans, they typically do not own or manage the properties against which such loans are secured. Mortgage REITs are unique and demand in-depth research. They are financial institutions that hedge their risk from fluctuations in interest rates through various tools.

Tips for Evaluating Real Estate Investment Trusts

A real estate investment trust is a type of dividend stock that primarily invests in physical properties. Together with high-yield bond funds and dividend stocks, these would be among the options you weigh if you're trying to bring in a steady cash stream.

The accounting for property, however, causes significant variations. Let's break it down with a basic example. Imagine that a real estate investment trust pays $1,000,000 for a building. Our REIT must depreciate the asset by generally accepted accounting principles.

FFO

Because depreciation is a non-cash expense, our REIT does not spend this money in year 10. So, to get the money from operations, we have to subtract the depreciation expense from the net income (FFO). Since our building undoubtedly hasn't lost half its value in the previous decade, the argument goes that depreciation unfairly decreases our net income. FFO corrects this assumed misalignment by excluding the depreciation expense. There are a couple more tweaks found in FFO.

AFFO

One thing to remember is that FFO is more indicative of cash flow than net income, but it still doesn't capture cash flow. One key thing from the example above is that the acquisition cost of the building was never included in. Capital expenses should be included for a complete picture. Adjusted funds from operations are the result of adding in capital expenditures.

Value of Assets Owned

Using our made-up balance sheet, we can learn more about net asset value, another frequent measure of REITs. After ten years, the building had depreciated to the point that its book value was barely $500,000.

Therefore, book value and associated ratios like price-to-book are mostly irrelevant when analyzing REITs, despite their frequently questionable applicability when analyzing ordinary stocks.

When valuing a property, NAV is meant to be used in place of the book value to more accurately reflect the property's actual market worth. Valuing a REIT's assets is necessary for determining NAV.

Analysis: Top-Down vs. Bottom-Up

Top-down vs. bottom-up analysis is commonly used when discussing stock selection. Betting on themes or sectors from a macroeconomic vantage point is the starting point for a top-down approach. The bottom-up method is based on analyzing individual businesses by their foundations.

Top-down and bottom-up analyses are both necessary when evaluating REIT companies. When looking at the industry from above, anything that changes the demand and supply of real estate might affect REITs. Positive trends in population and employment are a boon to all REITs. Briefly put, interest rates are a jumbled mess.

The Verdict

To qualify for the tax advantages available to REITs, real estate businesses must pay out sizable dividends to shareholders. Total return potential is comparable to that of small-cap stocks due to the combination of a stable income that can surpass yields on Treasuries and price volatility. Investors attempting to analyze a REIT need to be familiar with the accounting distortions brought on by depreciation and pay close attention to the effects of macroeconomic factors.