Real estate investment trusts (REITs) are excellent vehicles to own, manage and operate commercial real estate assets. According to the National Association of Real Estate Investment Trusts (NAREIT), as of May 2015, there were 224 REITs in the FTSE NAREIT All REITs index with an equity market capitalization of $927 billion. REITs own approximately $1.7 trillion in commercial real estate assets including listed and non-listed public equity and mortgage REITs.
REITs are income-tax-created entities that must hold real estate assets or mortgages pursuant to the following general regulations:
1. Be an entity that would be taxable as a corporation but for its REIT status
2. Be managed by a board of directors or trustees
3. Have a minimum of one hundred shareholders after the first year as a REIT
4. Have no more than 50 percent of the shares held by five or fewer individuals during the last half of the taxable year
5. Invest at least 75 percent of the total assets in real estate assets and cash
6. Derive at least 75 percent of the gross income from real estate sources, including rents from real property and interest on mortgages financing real property
7. Derive at least 95 percent of the gross income from real estate and mortgage sources and dividends or interest from any source
8. Have no more than 25 percent of the assets consist of nonqualifying securities or stock in taxable REIT subsidiaries
9. Required to pay out 90 percent of their taxable income as dividends to be exempt from paying income tax
REITs were formed in the 1960s as a way for individual investors to invest in commercial real estate companies and the like. They were created to be passive investment vehicles, similar to mutual funds, and if they pay out 90 percent of their taxable income as dividends, they are not subject to corporate income tax. The 90 percent payout requirement usually requires most REITs to pay out a high percentage of their funds from operations, (FFO) or net income plus depreciation/amortization less any gains and losses and therefore they do not generate sufficient internal net cash flow to grow their business organically. The average dividend as a percent of FFO since 1994 is 71.6%.
The majority of REITs own one or more of the four primary commercial property types: office buildings, shopping centers, apartments and industrial warehouses. All of these primary property types, except apartments, are encumbered with long-term leases that provide for very small annual rent increases usually equal to the annual increase in the consumer price index or fixed increases of 1%-2.5% or step rent increases every five years, from 2.5% to 5%. The high payout ratio of most REIT’s cash flow as dividends together with the encumbrance of long-term leases with fixed rent increases, are characteristics of REITs that do not allow for high levels of internal growth in profits and cash flow. This is in contrast to a corporate operating company (a company that makes or sells a product or service other than commercial real estate) that does not have these restrictions and therefore can grow very fast internally with sales and volume increases. If a corporation realizes sizable sales and volume increases in its business, this will increase net income, free cash flow and earnings before interest, taxes, depreciation and amortization.
To sufficiently grow their net operating income, FFO, dividends, stock price and business in general, REITs must grow externally via an acquisition model and strategy. A successful REIT business model should be based on increasing the net operating income of owned properties by increasing rents and lowering vacancies to increase effective gross income and lowering operating expenses to increase net operating income and growing externally by acquiring or developing property. The stock price of a REIT may increase, without external growth, but only in two ways. Either capitalization rate compression (the capitalization rate applied to the REIT’s net operating income decreases which increases the value of the REITs assets and hence the stock price ) or from FFO multiple (stock price of the REIT divided by the FFO per share) expansion. Today, the average capitalization rate of the large equity REITs is 4%-5%, while while the average FFO multiple of all equity REITs is approximatley 19 times, while it was less than 10 times 15 years ago.Â
The compression of capitalization rates and the expansion of FFO multiples has been an important driver of the increase in stock prices of many REITs during the last few years. And this is directly the result of the Federal Reserve’s zero-interest-rate policy program, which has lowered the cost of capital to unrealistic levels and increased the value of financial and real estate assets. A large number of REITs have not grown their asset base through acquistions and development since the Financial Crisis, but have enjoyed a rising stock price because of this valuation increase. However, the most successful and highest growth REITs like Simon Property Group, Inc, Boston Properties, Inc., Equity Residential and others have business models that include growing the net operating income of owned properties and acquiring or developing new properties to grow their business, dividend and stock price. Even if interest rates beging rising, these growth oriented REITs will fare much better than others who lack pro-external growth strategies.
