In a Million Dollar Nutshell ? REIT Stocks Are The Best of All Worlds ?
A REIT is a landlord’s business. If you buy shares in a REIT, then you become a landlord. You get fairly fixed income coming in from rent but your share price will be variable because leases have to be renegotiated when they free up. Every ∼10 years we swing from a real estate sellers market to a real estate buyers market, which presents opportunity for entry and exit. However, REITs are still suited to long term investors who don’t want quarterly surprises. They’re inflation buoyant and tax efficient; a liquid way into real estate without big barriers to entry, but also without leverage (a disadvantage). Your earnings can come from all kinds of tenants in all kinds of buildings, but to ultimately value and plot the paybacks of a REIT, you’ll need it to host great tenants on long leases. That’s how you invest in REIT stocks.
Let’s Take a Closer Look at How to Invest in REITs!Disclaimer: I do not own any Real Estate Investment Trusts at the time of writing. Disclaimer: chrismorrissey.money does not provide financial advice. All content is purely informational. Consult independent advice.
Real Estate Sector
Without real estate we’d be living in caves. It’s a $2 trillion dollar sector, so let’s set the scene for a building you might be sitting in right now! A basic materials firm supplied the materials, we can invest in them. A construction firm built it, we can invest in them. A real estate agent sold it, we can invest in them. A landlord bought it and collects rent from it, and until recently there have been barriers to entry here. You could only take a real estate venture into your own hands, not buy into it on the stock exchange. Now, you can buy shares on the stock exchange of a company that already does real estate and does it well.
You can own a whole portfolio of commercial real estate, playing the landlord role and earning your worth in tenant’s rent.
The scariest thing about Real Estate Investment Trusts is the name.
I’m going to train you in how to probe these landlord stocks and how to truly invest in REITs. Let’s get started!
How You Make Money Buying a REIT ?
Real Estate Investment Trusts sound sophisticated but they’re really just another business. If you buy shares of a REIT, those shares entitle you to a share of that REIT’s earnings. 90% of what you’re due goes straight into your bank account, and the rest is reinvested to keep the business going and bolster future earnings potential. Nothing untoward here.You would be investing in a management team who buys real estate. They collect rent from it on their income statement from tenants, operate it hands on, and care for it like a baby on their balance sheet. It’s not just by amassing a great portfolio of real estate and increasing rent or occupancy in the building that REITs can grow their earnings. They can also introduce ancillary revenues in the form of storage fees or parking fees. Perks like storage and parking incentivise tenants to resign on at the end of their leases, re-committing to another year, 5 years, or even 10 years if that’s how long the lease runs.
- Maintenance and repairs for their buildings
- Commissions to the real estate agency industry for directly handling the leases
Sometimes a REIT can share building costs with tenants but that depends on the type of lease and the type of real estate we’re talking about.
REIT investing is all in the details. It’s almost its very own asset class, entirely independent of stocks and bonds but also rivalling stocks and bonds. I say REITs are a hybrid between stocks and bonds because agreeing a fixed lease with a tenant brings a stable income stream like bonds. However, all leases come to an end at some point and when they free up, the state of the economy affects them. That brings a variable income stream like stocks. There’s also property appreciation to account for.
The Real Estate Cycle ?Rent rates go around and around in a 10 year cycle. Understand the cycle because it is massively important to REIT investing. Let me take you around that cycle and make it clear.
It’s a time when unemployment is at a high. This probably coincides with an economic downturn, a bust. People are sleeping on their friend’s couches right now. The Fed is desperately trying to lower interest rates to re-stimulate the economy and get people taking out loans again so the country can get back on its feet. But for now people are just too devastated. In terms of property, landlords have low occupancy in their buildings. They certainly can’t be increasing rent! This is a harsh time to be in the REIT business.
The next stage of the cycle; the Fed’s jump leads are starting to work. The economy and the housing market are back on the road to recovery with some new real estate projects being undertaken. With job growth and consumer spending increasing again, occupancy rates in apartments, malls and offices alike are starting to get back on the rise. Perhaps then with the newfound demand, it’s time for our REITs to start pushing up rents? Yeah, why not?
Okay, now the recession is fading from memory. The construction industry is putting up tons of new builds left, right, and center! You’d think our landlords would be loving this, but there are undertones of a buyers market now. When there are so many new builds, buyers have a lot of choice. That works against the bargaining power of house sellers and our landlords. There’s too much property supply for demand, so buyers can’t be forced into paying higher and higher rents anymore.
Property is roaring! New builds are going up everywhere you look. Supply growth is rapid, so our REITs are even bringing down rents now to compete in this strong buyers market. Studies show REITs are actually underperforming as the Fed thinks about pumping the brakes again on the economy (raising interest rates to make it harder to borrow). But that doesn’t slow down the gusto to build, build, build!
Square 1 – Again.
And bang, we’re back at square one. Never forget that I said this was a cycle! Supply growth was rapid, too rapid. It led to an oversupply that took the market power away from our REITs. When the real estate sector at large took its eye off demand, it really took its eye off the ball and landed us in this real estate recession, back at square one again where the cycle will start turning once more.
The cycle spans around a 10 year time frame. It’s clearly a predominantly cyclical industry and the key is to get slightly ahead of everyone in reacting to the cycle. Too far ahead and you go down with it, too late and you’ve missed your chance (this is every contrarian’s money making idea). Every cycle is different with different factors pulling the levers of construction bullishness (which is our measure of supply) and absorption of that supply (which is a measure of demand).
The best thing you can do is admit that this cycle is based on the traps and snares of human nature. It doesn’t always coincide and parallel with wider economic health, or the wider debt cycle, but it typically will.
Crucial Cap Rates ➕
The price to earnings ratio is a well-known measure of how much value we’re getting for our money with a stock. A cap rate is just an upside down version of the P/E. So instead of price over earnings, it’s earnings over price. That gives us the yield, so if a block of flats makes $50,000 a year from rent and costs $1 million to buy, the cap rate is 5%. In other words, the yield is 5%.A high cap rate is a good cap rate and a good cap rate is what we should be demanding. The popularity of a building weak in a regional area? Cap rate better be high to compensate. Tenants only sign for short leases? Cap rate better be high to compensate. Old building requiring loads of repairs and maintenance? Cap rate better be high to compensate. It’s common sense not to find many opportunities out there that are very high reward – low risk, or low reward – high risk.
Here are the top six types of real estate stock out there. These are the specialisms out there to choose from, each with its own real estate cycle time frame to research. The premise of the cycles is the same, it’s only where we are in the cycles which is different. If you come to understand more than one type of REIT, you can rotate between them over time.
Industrial REITs ?
Let’s kick off with some industrial-heavy REITs. The real estate we’re talking about here are warehouses, manufacturing plants and assembly plants.
What drives demand for such plants is demand by consumer spending. I don’t know if you’ve ever been in a warehouse but it’s pretty simple; four walls and a concrete floor doesn’t require too much in the way of maintenance from our REIT which is great. Tenants occupy capacity at around 80% at the thin end of a cycle (square 1) and 95% at the peak (square 4). The tenants will pay rent on a lease about five years long on average.
How to Invest in Data Centre REITs
We’re taking an unconventional turn. Data centre REITs own and operate tech centres full of servers, comms equipment and other technologies. You’ve seen places like this in movies. Huge enterprises (great tenants) sign off on very long leases for data centres, but remember, a long lease agreement has hedge-like qualities. If it’s signed at a time of real estate oversupply, that uncompetitive rate is locked in! It would be a rental roll below what the REIT could have gotten during a more balanced spell in the cycle.
Growth and risk in data centres is driven by the unrelenting advance and disruptiveness of I.T. outsourcing and cloud computing. It’s a niche area of reinvesting to go and read about.
How to Invest in Residential REITs
These REITs probably do as you first expected, rent out low rise, mid rise, and high rise apartments. Rental agreements for apartments are locked in only for about a year, and I recommend researching the tenant demographic and working backwards from there for insights. For example, tenants are middle aged. That tells me that occupancy rates and demand in general is going to be driven by unemployment and job growth.
It’s the old rent vs buy debate too. Pay attention to that, as high interest rates make mortgages less affordable for homeownership which is advantageous to these REIT stocks who offer a rental solution. Getting on the housing ladder and off the rental rigmarole is a naturally difficult thing to do. The government are compelled to fight against it being so difficult, which means the government is fighting against this very common type of REIT.
The Airbnb Shadow Market!
Maybe as an alternative to investing in a residential REIT, you decide just rent out a spare room you have on Airbnb. That’s actually a shadow market for these residential REITs. Airbnb increases supply in the market just like a construction firm would. So if you want to invest in a REIT in this area that has a wider moat to keep new disruptions like this at bay, I would go with student housing or RV parks.
How to Invest in Lodging REITs
These are mainly hotels, but also casinos and boutiques also count. Compare what it costs to run a hotel vs a warehouse, a lot more! Those costs are fixed, sunk, meaning they can’t be pulled back but yet renters only lease for about one night, two nights or maybe three nights in a hotel. With other buildings, we’re assured the tenant will stay for at least a few months if not a year. This is an obstacle to low cap rates for lodging REITs.
There’s no denying that occupancy can swoop very low in a hotel or casino, as can our room rates (our rent revenue). Therefore, cyclicality in lodging is very, very pronounced and it blows off our vision of what catalysts genuinely move these REITs stock prices. What we can say for sure is that thecap rates ought to be highand like data centre REITs, it’s another one to go and read about.
How to Invest in Office REITs
Going by the averages, you’ll probably spend about ten years of your life working. While you sit there in your office, there’ll be a Real Estate Investment Trust earning rent out of it. Through investing in an office REIT, you can own a piece of this sub industry where demand is driven by job growth and your earnings are committed through leases that last about as long as about one real estate cycle.There are also big benefits in the lease types that most office REITs manage to get.
Neatly, most office operating costs are passed onto the businesses working inside. There are actually a few types of lease which gradually lead to this type, the most attractive being the all expenses paid lease where the tenant fronts all costs. Look for ‘net’ or ‘gross’ leases.
The tenant will sometimes pay less rent if they incur more maintenance costs in the lease agreement. These maintenance costs can include insurance, and may well vary over the course of the tenancy unlike the rent payment. If the nature of the real estate is such that operational costs can be largely variable, the REIT would do better with a net lease if switching costs for their tenants is high (as in, the tenant can easily pack up and move somewhere else). This applies to all REIT types, not just office REITs. If your REIT stock does use this very attractive type of of triple net or gross lease, check demand is not being hurt in any way. It also goes without saying thataiming for the longest lease terms available will mean you enjoy more fixed than variable income.
As a general rule of thumb, longer and more favourable leases are possible when the building is in good nick . There are 3 agreed upon categories to classify a building’s “nick”. Here they are;
How to Invest in Retail REITs
These REITs charge rent on shops, restaurants, cafes and malls[/mks_highlight]. Malls come in all different types and are often held down by “anchors.” Think big brand names like Tesla and Apple that draw people to a mall. As a reward for doing that from the REIT who owns the mall, those brands get to pay lesser rent to have a pop-up shop or what have you.Look for malls in affluent areas near lots of households. Retailers like to rally their own demand but the general indicator is still consumer spending.
The health of the high street comes into play here too. This is a big issue. Business is cutthroat and we don’t care about the current tenants survival as long as our real estate is eventually occupied by someone. A clustered city centre with dense traffic will always be useful space, but until brick and mortar retailers find a store concept that’s sustainable and competitive against what’s online, then the quality of renters in our high streets will swoop lower and that will, in turn, lead to higher cap rates.Leases are five to ten yearslong again, nearing a full cycle. Costs are covered by the retailer but often if a tennat hasn’t seen sales increase over the duration of their lease, they shouldn’t need to worry about rent increases from the landlord.
Key REIT Metrics
We’ve got our cap rates for buildings, but what else can we use to tell us how to pick one REIT stock over another?
Net Asset Value
Equity is value, worth. In this business it goes by the term ‘net asset value’. The ratio of price to net asset value tells us how much worth we’re getting for our money in the same way that a price to book value metric would do. The difference is that net asset value takes into account how property prices can appreciate, and doesn’t miss intangible assets like book value does because there rarely are big intangible assets for a REIT. This measure of worth is the liquidation level of worth, which is key to remember. If we were to dismantle the entire business and sell it off as parts tomorrow, net asset value is close to what we would get. That’s why as you begin your REIT investing journey, you shouldn’t find many REIT stocks that trade for less than aprice to net asset value of one. That’s where they benchmark as well.
Price to funds from operations is also a useful a multiple. Higher than 16 is a real endorsement for management. Price to adjusted funds from operations is the metric that shows us how much cash flow we can expect to receive from owning a REIT over time. And it’s the metric to use because it adjusts for real estate upkeep costs.
It All Goes into Your Bank Account
These stocks have a 90% payout ratio on average, so 90% of the cash that’s available for redistribution is redistributed back to you. It’s not put back into the real estate business itself.Management rely on banks for money to finance their new real estateprojects as leverage is very cheap in real estate, so credit ratings really matter here.
If you make an account for free on Moody’s, Standard and Poor’s, or Fitch’s website you can check the investment grades of these real estate investment stocks. Make sure it’s BBB or above. Debt to EBIDTA levels indicate whether debt is controllable and in terms of the interest payments due on that debt, EBITDA to Interest does the trick.
Tax Free and Inflation BuoyantREIT stocks don’t face corporate tax, so you’ll will only be taxed once at personal income level. They also ride inflationreally well because buildings are hard assets and landlords can just increase rent!
The Bottom Line
REITs are worthwhile. They’re not just another industry to own stocks in, they represent diversification into a completely new type of investment. They are a useful grey area to make finding the ratio between stocks and bonds, that little bit easier. I also think their merit holds despite the common objection: “I already own my house.”
The complications come in the cycles, they’re messy! Various REIT cycles are not in sync with other types of REITs, so the whole bigger picture is much more difficult to understand as a whole.
REITs are stocks that can grow and offer fixed income at the same time, which is bizarre in a good way. They’re also are best suited to investors with a long term view who aren’t wanting quarter-to-quarter earnings surprises.