REIT Industry Guide

Size of the REIT industry

REITs can invest in all property types, although most specialize in specific property types. There are around 160 US public REITs with a combined market cap of $1 trillion (Globally, there are 300 REITs with a market cap of $3 trillion).

Most REITs are publicly traded, which enable investors to gain access to a diversified collection of income-producing real estate similar to investing in mutual funds.  Unlike regular companies that can hold on to their profits, REITs must distribute at least 90% of their profits every year back to shareholders in the form of dividends.

As a result of the dividend requirement, the dividend yield on REIT stocks is above 4% – significantly higher than the 1.6% dividend yield for the S&P 500 overall.

In addition to facilitating diversification and high dividend yield, the other major benefit of REITs over other forms of real estate investment are the tax advantages.

REITs vs Real Estate

REITs are a tax-efficient, diversified alternative to direct real estate ownership and investment.  Rather than having to buy and maintain actual physical real estate properties, investors can simply own REIT shares, which are backed by physical assets managed by the REIT.

Risk, Returns and Leverage

Contrasting REIT vs Real Estate returns is a little more complicated.  REITs have generated 10% in annualized return over the long run (including the last 10 years).  Meanwhile real estate assets have grown at 2-3% annually, seemingly giving an advantage to REITs.  However, this is not an apples-to-apples comparison.  A huge accelerator of returns is leverage:  The average debt / total value for Equity REITs is 37.0% as of 2020 (Source: NAREIT).

Meanwhile, direct real estate investment can range widely, but at the high end investors can secure debt upwards of 80% of the total property value, which all else equal amplifies returns (and risk) significantly.

What are the largest REITs?

Below is a list of the top 20 largest public REITs in the world, by market cap:

Tax advantage of REITs

Entities qualifying for REIT status under the tax code receive preferential tax treatment: The income generated by REITs is not taxed on the corporate level, and is instead taxed only on the individual shareholder level. Specifically, REIT profits pass through – untaxed – to shareholders via dividends.

This is a tax advantage over C-corporations, which are taxed twice – first, on the corporate level, and then a second time on the individual level via a tax on dividends.

In order to qualify for this tax status, REITs must comply with certain requirements, the biggest one being that REITs are required to distribute nearly all profits (at least 90%) as dividends 

What are REIT dividends?

REIT dividends are cash distributions to REIT shareholders. REITs distribute almost all of their profits as dividends.

REIT dividends are typically “non-qualified” dividends, meaning they are taxed at ordinary income tax rates (up to 29.6%¹), as opposed to the lower capital gains (up to 20%) on the shareholder level. That doesn’t sound so great but remember that the is the only tax the investor pays because REITs entirely avoid a corporate-level tax.

In contrast, in a C-corp, there is a corporate-level tax (up to 21%), followed by a second tax on any dividends distributed to shareholders (albeit at the lower capital gains rate of 20% because C-corp dividends are typically “qualified dividends”).

Illustration of tax advantage of REIT over C-corp

This simple illustration shows the basic difference between the single pass-through taxation of a REIT and the double taxation of a C-corp. Note however that this is a simplification – REIT tax rules can get complex and notably tax breaks for depreciation can further increase the tax advantages of REITs

Download the source Excel file for this illustration. 

Requirements to qualify as a REIT

REIT Characteristics

Equity vs. mortgage REITs

Most REITs directly own the real estate and are called equity REITs. However, a few REITs simply own mortgages (Mortgage REITs) and collect income (interest income) from the mortgages.

Internal vs external management

REITs can be internally or externally managed

How to analyze REITs: Key REIT Terms and Metrics

When valuing REITs, investors look at both traditional profit metrics such as EBITDA, as well as real estate and REIT specific metrics, including:

1. Net operating income (NOI)
2. Funds from operations (FFO)
3. Adjusted funds from operations (AFFO)
4. Cap rates

Net operating income (NOI)

NOI is the most important profit measure in real estate.  It strives to isolate to core operating profits of real estate assets, so as to avoid muddying the waters with non operating items such as corporate overhead and major non cash items like depreciation. Its like EBITDA but with even more add backs to really focus on pure operating income generated by the properties.

Net operating income: Definition and formula

NOI captures profitability before any depreciation, interest, taxes, corporate level SG&A expenses, capital expenditures, or financing payments

Funds from operations (FFO)

While NOI is a useful profit measure for analyzing real estate down to the property level, FFO is a real estate specific metric for cash generated from operations. FFO is an attempt to reconcile accounting (GAAP) net income to a consistent measure of profit specifically tailored for analysis of REITs. In fact, most REITs provide FFO reconciliations in their filings.

Funds from operations (FFO): Formula and Definition

Though often misunderstood, FFO is not designed to be a measure of cash flow because it excludes working capital, capital expenditures and other cash flow adjustments

Adjusted FFO

Over time, analysts and REITs themselves have begun using slightly altered versions of FFO, generally called “adjusted FFO” or AFFO.  The reason for this is that FFO included things like nonrecurring items and notably omitted key outflows like capital expenditures.

Adjusted FFO and cash available for distribution: Formula and definition

While there remains some inconsistency across how these are calculated, the most common calculation is:

Adjusted funds from operations = FFO + nonrecurring expenses – capital expenditures.

Capitalization (“cap”) rates

The cap rate, along with NOI are arguably the most important metrics in real estate. Unlike NOI or FFO, however so far, the cap rate is not actually a measure of profit, but rather a yield measure.  It measures the a real estate property’s operating profit as a % of the property’s value. If you’re familiar with EV/ EBITDA multiples, the closest thing to a cap rate is is an inverse EBITDA multiple.

Cap rates are the primary shorthand by which different real estate properties are compared by investors.  For example a property with a 10% cap rate provides a better yield than a comparable property with a 7% cap rate.

Cap rate definition and formula

Cap Rate Example

A property with asking price of $1m and NOI of $125k will have a $125k / $1 m = 12.5% cap rate

As we’ve noted, cap rates are simply the inverse of a traditional valuation multiple like EV/EBITDA.

What factors influence the cap rate?

Just as with traditional multiples, there are many variables that can distort the comparison of properties using this metric, including:

1. Timing of NOI (LTM or forward)
2. Growth rates
3. Returns on capital
4. Cost of capital of properties (or REITs) being compared

However, in real estate, it is much easier to find comparable properties (with therefore similar growth, returns and cost of capital profiles), which mutes the problems described above

REIT Modeling in Excel

A REIT model will first forecast the financial statements and then apply the valuation methodologies discussed above to arrive at an investment thesis.

The key challenges in modeling REITs include modeling individual (same store properties, acquisitions, developments, and dispositions) using the appropriate drivers and occupancy rate assumptions: Obviously mature properties with stable occupancy rates will have a different forecast profile than properties under development.

A second challenge is working with a real company’s financial statements.  This requires digging into a REIT’s financial statements and insuring consistent and logical modeling of REIT-specific metrics and ratios like funds from operations (FFO) and adjusted funds from operations (AFFO / CAD).

In our REIT modeling course, we lay out the steps for building a complete set of REIT financial models, using a video based step by step approach.