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A Steady Source of Income for Investors

By Scott Chan on February 5, 2018

Real Estate Investment Trusts (REITs) were created by law in 1960 in order to give regular folks a way to own real estate. REITs pool together investors’ money to invest in real estate properties. By owning shares in a REIT, an individual investor owns a small piece of the real estate owned and managed by the REIT.

To qualify as a REIT, at least 75% of a company’s assets and income must be connected to real estate investments. Also, a company must pay out at least 90% of its taxable income every year as dividend. (More on this later.)

Another reason to like REIT as an income investment: the value of real estate and rent tend to rise with inflation, which supports REIT dividend growth. In fact, historically, REIT dividends tend to rise faster than the Consumer Price Index. This gives investors a source of growing income that protects against inflation. Also, since REITs tend to sign their tenants to multi-year leases, their revenue and cash flow tend to be more predictable than those of other companies.

These features make REITs a long-time staple for income investors.

Three Types of REITs

There are three types of REITs: equity REITs, mortgage REITs, and hybrid REITs. Most REITs are equity REITs. They usually own and operate a portfolio of real estate properties. They make money by renting, leasing, or selling them.

Mortgage REITs don’t operate any real estate properties. Instead, they provide loans and mortgages to real estate owners and operators, and they invest in mortgage-backed securities. These types of REITs borrow a lot of money, and they use derivatives and other hedging strategies to manage interest rate and credit risks. This makes them more difficult to evaluate.

Hybrid REITs are REITs that combine features from both types.

REITs Usually Have a Special Focus

Many equity REITs focus on a certain type of real estate. For example, a retail REIT would specialize in shopping malls and retail stores, and a healthcare REIT would specialize in medical centers, hospitals, and other types of related buildings. Other specialties include residential, industrial, tech, and more.

Given this special focus, when choosing which REIT to invest in, an investor should consider the outlook for the industry that REIT operates in.

For instance, more and more people shop online instead of going to a store, so the long-term outlook for retail REITs may not be that great. They will likely have to start to diversify and rent to non-retail tenants.

As another example, healthcare REITs should benefit from the demographic trend of aging Americans and longer life expectancy. Additionally, the age of “Big Data” has created a lot of demand for data centers, benefiting technology REITs.

The Importance of Funds from Operations

When checking out REITs, it’s also important to pay attention to their funds from operations (FFO). FFO is a special metric REITs use to define cash flow from their operations. Generally FFO is calculated by adding depreciation and amortization back to income, and making other adjustments. Each REIT can define and calculate its FFO differently, so investors should read that REIT’s public filings and reports.

A REIT’s FFO is important because it gives a better idea of how well a REIT is doing than the standard measure of income. It also provides a clearer picture of how much dividend a REIT is capable of paying.

When an American company files tax returns, it report results under the generally accepted accounting principles (GAAP). However, GAAP income isn’t the same as taxable income. This is why you may come across REITs that report negative (GAAP) earnings but still pay out dividends because their taxable income is positive. A REIT will show how to derive taxable income from GAAP income in its annual report.

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