REITs Investing - a cost-effective alternative to buying a property!
We all think we know real estate, and we have all been involved with it in one way or another since we arrived in the hospital delivery room. The building where we got our first taste of the world is real estate. The house we were brought into, whether it is a family home or a flat, is real estate. The shopping malls and neighbourhood centres where we shop, the factories and office buildings where we work, the hotels and resorts where we holiday, even the acres of undeveloped land we have walked on - all of these are real estate. Real estate surrounds us. But do we really understand it?
For many years, we had a close relationship with real estate. We love our homes and assume they will increase in value. We admire past and present real estate tycoons like Lee Shau Kee, Conrad Hilton and the Rockefellers; we even find Donald Trump and Hui Ka Yan fascinating. Yet we think of real estate as risky investment and wonder how large Japanese corporations and other sophisticated institutional investors spent hundreds of millions of dollars on U.S. hotels, golf courses, large office buildings and other trophies in the 1980s, only to see their values plummet in the real estate recession of the late 1980s and early 1990s. On the other hand, the subprime crisis of 2007/08 forced the housing market to collapse not only in the US but also caused a global financial crisis. Over the last decade, while property values have risen significantly, we have seen staggering changes in occupancy and rental rates, especially for residential and office properties.
Is real estate a good investment? Real estate investment trusts (REITs), which own and sometimes lend on commercial real estate, have provided excellent returns for their investors - but will they continue to do so? Can you still make money with REITs regardless of the ups and downs of real estate cycles?
In this article, you will learn what REITs are and how to make money with them.
What is a Real Estate Investment Trust?
REITs are defined as Real Estate Investment Trusts. These are companies, that collect funds from investors and channelise them into operating, owning and financing income generating real estate. REITs are an effective and efficient method for investors to invest in real estate. However, unlike actual real estate, which is an illiquid asset and requires extensive maintenance, there are no such hassles with REITs. The real estate could be anything ranging from office spaces, malls, or even consumer property.
REITs were created when President Eisenhower signed into law the REIT Act title contained in the Cigar Excise Tax Extension of 1960. REITs were created by Congress in order to give all investors the opportunity to invest in large-scale, diversified portfolios of income-producing real estate. Today, around 200 REITs are listed on the New York Stock Exchange. The return on a real estate investment does not have to be meagre. From 1971 to 2003, the average annual return of equity REITs in the US was 13%. Over the same period, the Dow Jones Industrial rose by about 8% annually.
The performance of real estate companies in Europe and the USA can be tracked using various indices. For example, the EPRA index, which is compiled by the European Public Real Estate Association and calculated on the London Stock Exchange, describes the performance of the largest European listed real estate companies that pay high dividends. The NAREIT - National Association of Real Estate Investment Trust - is the American counterpart to the EPRA.
There are REITs in 19 countries worldwide, four in which REIT-like structures exist. The oldest are the USA (1960), the Netherlands (1969) and Australia (1985). Most REITs structures were created in the early years of the 21st century.
How a REIT works
REITs can be considered to be like Mutual Fund houses. Mutual funds involve pooling together investor money to diversify and hence reduce volatility and risk while aiming to provide satisfactory returns in equities. Similarly, REITs seek to pool investor money but instead invest in real estate. They are solely responsible for managing the estate and dividing the income to shareholders. The income generated is usually the rent paid on the estate. In addition to that, the capital appreciation is also paid to the shareholders.
There are primarily 4 positions involved in the formation and working of a REIT and the subsequent distribution of its units. They are as follows:
Sponsor: It is the sponsor who forms a REIT. The sponsor then transfers the property to the trust’s name. Hence builders and developers are usually those who play the role of the sponsor. The REIT enables them to raise funds.
Trustee: Like in any other trust, REITs have a trustee as well. He is appointed by the sponsor and is responsible for the units of the REIT on behalf of the unitholders.
Manager: A REIT manager is akin to a mutual fund manager. He is responsible for making investment decisions and managing the estate under the trust.
Unitholders: These are the common investors who buy units of the REIT. They become indirect owners of the estate owned by the REIT and thus, reap the benefits of steady dividend and capital appreciation.
These REITs are like any other stock trade on the stock market. Their price therefore also becomes a function of supply and demand, which is a function of the performance of that REIT.
Why are REITs so interesting - and for whom are they particularly suitable?
For many investors, interest, dividends and all other forms of distributions are extremely motivating, they love cash flows. And hey - what capitalist does not like it when the cash register rings regularly? Investors who have been around for a while may even live off their dividends, they depend on it.
It is precisely for such investors that REITs could be an extremely interesting investment. Because the business model "real estate" enables high dividend yields!
Of course, it is not only a high dividend yield that is important, but also its reliability! Fortunately, there are numerous REITs that fulfil this criterion. Some REITs have even been paying a dividend for more than 20 years - without any cuts during this period!
Conclusion: For those who love dividends, cash flows and interest payments, REITs are an extremely interesting investment vehicle, for they offer high and at the same time reliable flowing dividends.
Dividend hunters, what more do you want?
Why invest in REITs
Mark Twain once famously said, “Buy land, they’re not making it anymore”. While this may have been said in jest, it does convey an important thesis. It is a luxury to be able to own real estate in today’s increasingly overpopulated world. The supply is limited and the demand keeps rising. But it is just not possible for the common man to actually own a piece of land.
“Buy land, they’re not making it anymore” - Mark Twain
Firstly, the price of land is usually exorbitant. It is definitely above the paygrade of an average individual and would require them to undertake huge loans, which could eventually be counter-intuitive. The other aspect is about the hassle of buying land. It involves an immense number of processes, clearances, lease documentation, maintenance and cumbersome handling, which is too exhaustive. This is where REITs come into the picture.
REITs eliminate both problems. It makes owning land affordable, and while you will not physically own it, it certainly is a form of ownership. On top of that, you are no longer required to handle the ownership on your own. Professionals who know how to get the work done manage it. Hence, REITs is that one arrow which shoots down two targets simultaneously.
Additionally, real estate is a great way to diversify a portfolio. While equity is primarily believed to be a wealth generator and gold a good hedge to that, real estate returns have been promising as well. In 2000, the average U.S. home value was USD 126,000. In 2020, the figure was USD 259,000. While the annualized returns may not be staggering, it certainly is a viable option. And in the case of REITs, there is a pre-existing dividend being paid out. Hence, capital appreciation is the cherry on top of the cake. All these factors make REITs an attractive investment option.
What are different types of REITs?
You can invest your money in nearly any kind of real estate imaginable: apartment buildings, manufactured-home communities, malls, neighbourhood shopping centres, outlet centres, offices, industrial properties, hotels, self-storage facilities, nursing homes and hospitals – even timberland, movie theatres, and prisons. Different types of REITs are based on the estate they manage. There are broadly 8 main types:
Shopping centres, restaurants etc. constitute retail REITs. Any form of commercial real estate, which is given on rent for individuals or brands to sell something of some form, comes under Retail REITs. In fact, Retail REITs are the most widely present REITs.
While Retail REITs may seem the most reliable type since tenants run businesses and should be able to pay rent on time, the industry of the retail REIT should be examined as well. For example, the unforeseen circumstances brought upon by COVID pandemic led to an extensive shut down of retail shops. The direct impact would have fallen upon retail REITs. However, while the pandemic led to a shutdown across the board, few industries were able to recover faster than others. It is important to realize REITs like any other investment are not risk-proof. If the tenant fails to pay up the rent and defaults, it will have a direct impact on the unit value of that particular REIT.
An industrial building can be freestanding or located in a landscaped industrial park and occupied by one or more tenants. It is estimated that the total area of all industrial real estate in the United States is about 10 billion square feet, of which the actual occupants own about half. Ownership is highly fragmented, and public REITs own only about 1 percent of all industrial real estate. Industrial properties include distribution centres, large-scale warehouses, light manufacturing facilities and research and development facilities. REITs that specialise in industrial real estate can be very good investments, especially if their management has long-standing relationships with key users of industrial space and if they focus on strong geographic areas.
As the name suggests, these REITs manage residential and familial estate. These REITs tend to do good business in areas with dense populations and increasing demand for a home. When prices of owning a home go up, people tend to opt for rented apartments. The population density is directly linked to the working of the country and their economy.
For example, in a developing economy like India, which is already highly populated, the cost of owning a home is monumental especially in metropolitan cities like Mumbai and Bangalore. For the reason, REITs would want to buy residential properties in such a country and these cities, as it would not only ensure a constant stream of revenue due to the demand, but a steady increase in rent as well.
To invest in land for residential properties is also a part of a residential REIT. More about land investing, you will find here!
Healthcare REITs are becoming increasingly popular as the healthcare system of countries around the world strengthens and healthcare costs rise. Healthcare REITs invest in hospitals, nursing facilities, retirement homes, and so forth. The income stream for these REITs depends on occupancy costs, and medical costs.
These types of REITs also tend to do well in markets with an increasing older population. The demand for robust healthcare facilities is naturally a lot more present and the payments are expected to come in as well. Healthcare REITs can be tricky considering different markets have different categories of population and they may not be as profitable everywhere. It is especially essential to do due diligence for healthcare REITs.
These REITs invest in office spaces. Long-term leases signed by tenants looking to occupy the space for professional purposes provide income to these REITs.
Like other REITs we discussed, the location and target market for the operation of these REITs is what will decide the course of its performance.
In a booming economy with plenty of jobs on offer and entrepreneurial spirit, office leases are bound to be signed on the go and last for a long period of time. On the other hand, in laggard economies with a lot of unemployment, office vacancies will be a lot more. The decision to start and invest in an office REIT should therefore be made wisely.
As anyone who has lived in a flat knows, there is a universal problem with flats. It is the stuff. Where do you put your things? Usually there is no attic, no cellar and no private garage - and that means there is no storage space. This is where self-storage units come in. Usually they are built on the outskirts of the city, perhaps near the motorway or in an industrial area. The units usually range in size from 5x5 feet to 20x20 feet. These units were developed on an experimental basis in the 1960s and have been slowly but steadily growing in popularity ever since. They are rented out by the month and allow tenants to store items such as personal files, furniture and even RVs and boats. Even businesses that occupy expensive office space use them to store items that are not regularly needed. They are especially useful for those who are regularly relocated by their employers and for those who like to travel across America in their campervans.
There is a strong case for self-storage facilities being recession resistant, as in a recession both individuals and businesses save money by reducing the space they use. A reduction in residential or office space often leads to an increased need for storage space.
Do you want to know more about how it is going in storage space sector? I am sure that you know the Auction Hunter Ton Jones and Allen Haff. They bring their quest for treasure to auctions across America and sell their incredible finds for big profits. It is a nice series to learn more about Self-Storage REITs.
These REITs do not invest in the physical estate but the mortgages on those estates. These kinds of REITs are sensitive to change in the interest rate environment. In a low interest rate market, when housing loans are on the charge, these REITs do perform well but their stock trades at a discount due to excess supply. In high rate environments, the loan book shrinks due to lesser loans taken up. Hence, both the situations make it tricky for these REITs to perform. The catch is to find the sweet spot between the two scenarios to maximise gains.
Data Centre REITs
Data centre REITs are REITs that invest in structures housing digital equipment, housing computing servers as well as cell towers amongst other structures. Now why is this an interesting segment?
With every passing year, we are becoming more digitally dependent. Our lives are shifting to things like AI and 5G. In the coming years, digital infrastructure is going to be paramount. With almost every company investing in collecting data, data centres are going to be high in demand, as data heavy devices will need to be stored. Thus, the prices of such estate are bound to go up because of the demand. If you are confused about which stock to bet on in the tech industry, it is possible to bet on the entire tech industry by investing in data centre REITs.
How REITs grow
The increase in a company's value is, of course, the driving force behind the rise in its share price over time. There are a number of ways to measure a company's appreciation, but the measurement and valuation of income streams and cash flows is perhaps the most widely used metric in the world of equities. Moreover, it is the only metric allowed by today's accounting standards, as a company's assets must be reported on its books at historical cost, less depreciation, not at current fair market value.
Consequently, rising earnings are an important driver of a company's share price. Steadily rising earnings usually indicate not only that a REIT is generating higher income from its properties, but may also indicate that it is making favourable acquisitions or completing profitable developments. In addition, higher earnings are usually a harbinger of dividend growth. In short, growing cash flow means higher share prices, higher dividends and higher asset values over time. Value can be created in REITs through investment activities that are not reflected in current earnings or cash flow, but these latter metrics are not as easily quantified.
FFO and AFFO metrics
Investors in common stock use net income as key measure of probability, but custom in REIT world is to use two metrics, FFO and AFFO.
FFO - Funds from Operations
This is probably the most important metric of a REIT. Most of the other ratios and metrics are based on this. As the name suggests, FFO or Funds from Operation reveals how profitable a REIT has been. It is not the net income. FFO is calculated after some adjustments and calculations made on the net income and thereby gives a much clearer picture. FFO is a good starting point to understand how much a REIT actually earns.
A non-GAAP ratio indicates the cash flow from the operating activities of a real estate investment trust (REIT).
In many cases, FFO is also expressed per share outstanding and is a key metrics for the valuation of REITs. In many cases, FFO per share is even preferred to earnings per share (EPS). Real estate companies themselves usually use FFO as a benchmark for operational management.
FFO is calculated by adding depreciation and amortisation, as well as any income from the sale of real estate/properties (a non-operating profit) back to net profit. The corresponding formula is as follows:
Funds From Operations = Net Income + Depreciation and Amortisation - Gains on Sale of Real Estate.
Typically, both the FFO and the exact calculation logic as well as the individual components are reported in the annual report and/or the earnings presentations of the real estate companies.
AFFO - Adjusted Funds from Operations
The AFFO (Adjusted Funds From Operations) is a variation of the FFO and takes into account the fact that not all investments relate exclusively to the purchase of new properties, but that substantial capital sable maintenance measures (CapEx) typically also have to be carried out.
Since these maintenance investments are to be regarded as operating cash flows and reduce the cash generation of the portfolio, they should also correctly be considered as a component of an operating cash flow ratio.
Accordingly, AFFO is calculated as follows:
AFFO = Funds From Operations - Maintenance Investments.
Compared to FFO, AFFO is a better approximation of the operating cash flow of the existing real estate portfolio.
The final formula
The final formula looks like follow:
Revenues, including capital gains, minus:
- Operating expenses and write-offs
- Depreciation and amortisation
- Interest expense
- General and administrative expense
- = Net Income
Net Income minus:
- Capital gain from real estate sales
- Real estate depreciation
- = FFO
- Recurring capital expenditures
- Amortisation of tenant improvement
- Amortisation of leasing commissions
- Adjustment for rent straight-lining
- = AFFO
The 2 ways of Growth
Finally, REIT investors need to understand exactly how much of a REIT's growth is internal and how much is external. External growth through new developments, acquisitions and the creation of additional revenue streams is not always possible because there are not enough high-quality properties available at attractive prices, capital cannot be raised or the cost of such capital is high. Internal growth, on the other hand, generated organically by a REIT's existing resources, is more subject to management control, although it is subject to real estate market dynamics.
Active REIT investors will want to spend time analysing and applying historical and current valuation methodologies to seek maximum investment performance for their portfolio.
While REITs are listed like stocks on the stock market, their properties and valuation metrics are not comparable. It is not possible to value REITs using ratios and methods, which are applied to stocks. There are a number of tools to help us evaluate REIT stocks. These include NAV-based models, P/FFO or P/AFFO models, and discounted cash flow and dividend growth models – all of which have their strengths and weaknesses. Let us discuss them.
Net Asset Valuation
In the USA, real estate investment trusts (REIT) are usually valued according to their net asset value (NAV). The NAV method has the great advantage that the reference to the market value of the real estate assets must be disclosed for each valuation. Random effects from the accounting periods are suppressed. The NAV is therefore the better key figure than the discounted cash flow due to valuation certainty and traceability. The NAV is made up of the sum of the property values and other assets less the company's liabilities determined in this way. Divided by the number of shares issued, the intrinsic value of a share is calculated.
Price to FFO ratio is equivalent to the P/E ratio. While knowing absolute metrics like FFO and FFO per share helps gain insight about the REIT, an investment decision needs some comparison. That comes in with the P/FFO metric. It helps in understanding the correlation between the price of the REIT as well as the FFO or net earnings. A lower P/FFO of a REIT in comparison to its peers would seemingly be a good investment opportunity.
FFO per Share
Like there is the price per share in stocks, REITS have FFO per share. While a REIT may seem to have a high FFO, it is the FFO per share that is bound to reveal the true picture. FFO per share is calculated by dividing the FFO by the outstanding number of shares of the REIT.
P/AFFO is a measure of a REIT's financial performance. It is equivalent to P/FFO adjusted to take into account capital expenditure and regular maintenance costs, making it a more accurate REIT valuation tool than P/FFO. It is also a more accurate indicator of dividends a company will pay in the future and it can help potential investors make a decision on whether or not to buy shares in the company. P / AFFO is also referred to as funds available for distribution.
The discounted cash flow method is used to determine the value of a company or property. In this process, future cash flows are discounted to a valuation date, taking into account taxes to be paid and the cost of capital. The capital value or present value of all incoming and outgoing payments calculated in this way forms the discounted cash flow. The discounted cash flow method offers a possibility to estimate the future business success of a company.
The future periodic cash flows are estimated for the next financial years. Since the periods involved are sometimes longer, the time difference between the valuation date and the occurrence of a payment (e.g. valuation date plus two years) must be taken into account. Therefore, discounting is applied to the cash flow.
It is important to know that this is very simplified and can therefore only be used in practice to a limited extent. The idea behind the model is that all future expected cash flows of a financial asset are estimated, for example with the help of a regression line, and discounted with a suitable interest rate. Incidentally, the idea behind this is also used as the basis for valuing a company and thus also for valuing the shares of that company.
Pay-out ratio is the ratio of FFO, which REITs pay out to investors. The income earned by REITs has to be distributed among the unitholders, and that is done in the form of dividends. For example, a REIT earns USD 2 per share, and they pay out a dividend of USD 1.5 per share. Their pay-out ratio is said to be 1.5/2= 75%.
Usually REITs are expected to have a pay-out ratio in the range of 75-80%. Anything less indicates they are not doing enough. In addition, anything higher than that could indicate that there is going to be a cut soon. Hence, 75-80% is a good range to look at.
Debt to EBITDA
Most of the REITs carry heavy debts. They raise money, which becomes a part of their enterprise, and they utilise it to rent out or manage other estates. While a decent sum of debt can help accelerate growth, too much debt would lead to an impending downfall.
A good way to evaluate if the debt is manageable is using the Debt to EBITDA ratio. EBITDA stands for Earnings before Interest Tax Depreciation and Amortization. A debt to EBITDA ratio under 5 by industry standards is deemed to be acceptable. Anything beyond that could be a sign of concern and something to look into.
Interest coverage indicates the ability of the REIT to pay off the debt it has been carrying. A good and sustainable REIT should have good interest coverage. It is calculated by dividing EBITDA by interest expense. A higher ratio indicates that the EBITDA is on the higher side and the interest expense on the lower side and hence a high interest coverage ratio is a good sign for the REIT.
These were the primary valuation metrics to be seen for a REIT. Like in the case of stocks there are a lot more metrics and all of them convey a different story. However, having a good hold over these primary metrics will get you started well in analysing a REIT. It is also important to note, ratios and metrics in absolute terms do not yield much. Comparison with other REITs of similar types in the industry is bound to reveal more about the underlying performance of a particular REIT.
Advantages and Disadvantages of REITs
Let us take a look at the advantages and disadvantages of investing in REITs.
Good for diversification
As mentioned earlier, REITs provide a good diversification to an investment portfolio. A dividend yield of 5-6% coupled with capital appreciation of an asset class, which has historically always risen, is a more than decent return. It is less volatile than equities and owning a piece of estate feels quite nice too, does it not?
Apart from being less volatile, an important aspect is also that REITs provide a fixed income. It is similar to rent being received from an actual estate owned or a fixed deposit. That surety of receiving income is what makes REITs really stand out.
The fact that REITs trade on the markets make them extremely liquid. Feel there is going to be a boom in estate prices. Buy. Feel prices are going to slump? Sell. The buying and selling process in a physical estate is a lot more difficult and time consuming. You cannot just sell the estate the day you decide to do so. Finding a buyer, going through paperwork and finalising a deal is a very long process and a lot may change in that process. Hence, liquidity is possibly the biggest advantage of REITs.
REITs are regulated by exchanges of countries. This means that all the dealings that happens are extremely transparent with all the details given to investors for them to be able to make informed choices.
Low growth prospect
This is probably the most glaring con of REITs. Firstly, REITs pay you back 75-80% of their income as dividend. Hence, they are left with minimal funds to boost their operations; On top of that, the estate market is a tricky one. While in the stock market you will have a number of businesses that make it big over a period of time, the same cannot be said about estate. It is not a buy and hold market. There will be a number of troughs as well and it is unrealistic to expect a very high capital appreciation. In the overall sense, the yield stays limited to a particular range in the case of REITs.
Like any other asset class, REITs possess market risk too. Nobody who lived through the housing bubble crash of 2007-2008 will forget how badly it ended for everyone. Housing prices crashed to the absolute pits. Such a risk will always exist in the estate market, which is driven by pure demand and supply. Hence, while volatility might not be an issue on a monthly basis but over a period of time the risk still exists.
High Fees and no taxation benefit
While the returns we talk about are net returns, sometimes they could be significantly lower than the absolute returns since management fees could be high. High fees in certain cases could be a huge deterrent to the returns.
In most countries, REITs also do not provide any taxation benefit. Whatever dividend is earned through REITs has to be taxed.
What is the best REITs Strategy?
This is a tricky question that cannot be answered 100%. Personally, I have developed a mix strategy based on buy and hold and value investing. Strictly speaking, it is an alternative form of both.
Let us call my REITs investing approach the Buy-and-Hold-Strategy plus.
Since I base my investment decisions on value investing when I invest in equities, I felt that this could also be done when investing in REITs. But before I get to that, I would like to briefly explain the actual buy and hold.
Short Introduction of the Buy-and-Hold-Strategy
The principle of the buy and hold strategy is already in the name: buy and hold. It involves, for example, putting shares in a portfolio and leaving them there for several years or even decades. Buy and hold is one of the more passively oriented investment strategies with a comparatively long investment horizon.
The buy-and-hold strategy is conceivable for investments in shares as well as in exchange-traded index funds (ETFs) and many other types of securities. While stock market legends such as Warren Buffett and Mohnish Pabrai rely primarily on individual stocks in their buy-and-hold strategy, which they first subject to extensive evaluation in the sense of value investing, the US investor John Bogle linked the buy-and-hold strategy as early as the 1970s with long-term passive investment in indices that are as broadly diversified as possible. Many investors use ETFs for investments according to the buy-and-hold-strategy.
This is because, in view of the usual volatility on the financial markets, a long investment horizon may offer the opportunity to ride out price fluctuations according to the buy-and-hold principle. Investing in real estate is also conceivable according to the principle of the buy-and-hold strategy, and thus it is also possible with REIT investing.
My REITs Investing Approach
My REITs investing approach consists of several criteria that I go through step by step. First, I look at the REIT's business model, i.e. what kind of properties does the REIT invest in and in which regions. The bottom line is that I want to understand the REIT. Furthermore, I look for a significant competitive advantage that the REIT could hold. This could be properties with a good location or the big-name tenants such as Apple or LVHM, which can happen very well with retail REITs. I then look at the annual reports of the last 7 - 10 years and come up with a fundamental analysis of the REIT. Here I want to find a solid balance sheet and a healthy cash flow that can not only pay me a lush as well as sustainable dividend, but can also finance all liabilities from the business.
A REIT is a real estate company, a company that has management like any other company. And I pay particular attention to the management of a company. Here, the following points are very important for me:
- Biography: many of my questions regarding biography have to do with how easy or difficult it was for the person to rise in the business world. Running a public company is not an easy task. How did this person get there? Did they work their way up or was the way clear for them? Neither is better than the other - a well-connected and well-integrated CEO may run a much better company than a person from a poor background who worked their way up on their own, and knows no one but has insane skills - but I like to get an idea of the personal background.
- Leadership style: Is it a real entrepreneurial type like Richard Branson who goes skydiving on weekends, or someone who stays the course, strives for slow and steady growth and you have never heard of? The Branson-guy ran good stuff for business journalists who thrive on interesting stories, and some people are easier to write 5,000 words about than others. But often the others make more reliable managers.
- Founder: If the founder is not part of the current management team, it may indicate to the founder leaving. Steve Jobs left Apple the first time because the board thought someone else could run the company better than him and pushed him out. He may have been right at the time, but the fact that no one could make better Apple products than Jobs escaped them, and so the company went downhill until he came back. When he returned older and wiser, he not only saved the company, but he led a development of iconic products that changed entire industries. Knowing this history is quite important to understand the current managers of Apple and what a long shadow Steve Jobs casts over them.
- Board of Directors: The board hires and fires management. I am trying to figure out how they deal with both.
- Ownership: sometimes CEOs leave knowing they are out before the problems arise. So I look for founders, or executives with a large equity stake, who are committed skin and bones to the long-term success of the company.
Management should not work for themselves, but first and foremost for the company itself and its owners.
Margin of Safety
Ultimately, I would like to pay more for my REIT or company than it actually costs. A safety cushion of 25% or even more compared to the true value of the REIT would be very good to counteract any mistakes on my part or market fluctuations.
When to sell your shares
I will sell my shares if one or more of the following events occur:
- Management no longer works for the shareholders (betrayal)
- The moat is overcome
- I just want to reduce my base and thus eliminate my risk.
Reducing the basis means reducing the dollar amount you have invested in the stock. This is one of Buffett's biggest secrets to lowering risk and increasing total return. He buys companies that, over time, pay back the amount he invested in them by transferring a portion of their free cash flow to him. The free cash flow that flows to the owner year after year can reduce the owner's basis and the lower the basis, the lower the owner's risk. Buffett has a portfolio of nothing but companies that have already paid him back his initial investment. A dividend returns some of the owners' investment capital and reduces their basis.
In summary, this is my REITs investing approach to finding suitable REITs for myself. In my opinion, it is very important as an investor to take a close look at the company or REIT. You should not just invest wildly and hope that everything will turn out well. (That would also be speculating and not investing). So take your time when choosing your REITs and do your homework so that you do not get a nasty surprise in the end.
Why I like data centre, warehouses and residential REITs
We have already discussed residential REITs so let us talk about why I am a fan of residential REITs. Residential REITs are definitely the safest of them all in terms of certainty. The demand for homes is at an all-time high. Thus, prices continue to rise. In this supply crunch, many people are opting to take up homes on rent. In addition, that number is just increasing.
Offices could be shut, retail shops may not have enough traction but there will always be a need for homes. That makes residential REITs amongst the more reliable REITs when it comes to the broader categories of REITs. They are bound to do well in most market conditions at minimum risk.
This was about residential REITs. Now let us shed some light on data centre REITs.
For several years now, the digital transformation of many areas, whether in the world of work or in private life, has been progressing steadily. It should no longer be a secret that the Corona crisis has massively accelerated this development. From my point of view, the decisive factor is that this development will continue permanently and will permeate our lives even more strongly in the coming years and decades. Digitalisation in industrial processes, the Internet of Things (IoT), artificial intelligence (AI), smart homes, autonomous driving, digital learning, 5G technology and especially cloud-based applications of all kinds are among the areas that will play an even greater role in the future.
And as an investor, you should ask yourself how you can profit from this long-term, profound development, which is still in an early phase. However, many technology stocks are out of the question for investors who pursue an income strategy only, as they do not pay dividends.
In addition, however, one can also find companies among the real estate investment trusts (REITs) whose business model is based on digitalisation and which will profit from the advancing development. These are data centre REITs (companies that own and operate data centres).
In this context, data centre REITs should not be compared 1 to 1 with classic REITs, which "merely" rent out real estate and usually have a significantly higher dividend yield. I see data centre REITs more as technology companies with a real estate component. The companies rent out data storage capacities (from individual computer cabinets to customised "build to suit" solutions). They also offer interconnectivity and cloud connections to major cloud providers as well as comprehensive security solutions. Interconnection basically means the interconnection of several independent networks. This enables companies to exchange data with other companies directly and confidentially via a platform in a data centre as a secure location (cross-connection).
The demand for data centres has increased continuously in recent years and companies all over the world are expanding capacities. This is often done at large Internet hubs such as London (GB), New York City (USA), Seattle (USA), Frankfurt am Main (GER), Hong Kong (HK), Tokyo (JAP), Seoul (KOR) etc. The customers of the data centre companies include many of the well-known technology groups such as Google, Microsoft, Amazon, IBM, Facebook, Oracle, AT&T, Adobe, Sony etc., which ensure regular and secure turnover for the data centres.
In addition, the business model of the established data centre REITs has a certain moat. Data in all its forms and its protection are essential for most companies and therefore have a lot to do with trust in the respective partners. Without good reason, a company will not change its data centre once it has been chosen. While the dividend yield of data centre REITs is not particularly high in itself, it can score points compared to the dividend yield of many technology stocks.
However, data centre REITs are no longer an insider's tip and prices have risen significantly in recent years. The result is a current P/FFO ratio of over 20 for Digital Realty and Cyrus One and as high as 45 for Equinix. In any case, this cannot be called "cheap". Nevertheless, I am positive about the long-term prospects of the three companies and expect dividends to continue to rise. Definitely, worth a closer look for income investors.
Finally, and most importantly, we come to the industrial properties, especially the warehouse. Online trading has greatly increased the demand for new facilities. Industrial properties are easy to build. Basically, all you need are four walls, large gates for loading and unloading trucks and a large tin roof. Due to the relatively short development cycle, industrial property markets tend not to get overbuilt. I like this type of REIT because it is simple, understandable and boring. Just the right investment for a value investor.
Conclusion - REITs Investing
REITs are one amongst many other asset classes out there. They make it easier to invest in real estate and have their benefits but have their own risks as well. Like with any other asset class, it is essential for you to do research and know why you are investing in a REIT. In most countries, REITs are well regulated and should be easy for you to invest in them. Keep your expectations in check and have clarity of what REITs provide and this could be a great investment instrument for you.
What is my personal REITs Investing strategy?
In the previous paragraph, I said that I like to invest in residential REITs and data centre REITs. I try to combine several of the above styles. However, my main focus is on risk avoidance; most investors, myself included, buy REIT stocks not to turn out the lights and brag to their brother-in-law about their latest coup, but to preserve their capital, earn a good and predictable return and avoid disasters and even potholes. So I tend to focus on companies that I am sure will not do anything wrong. They have good management, own good quality properties in good locations, solid balance sheets and well, if you have read this article, you know the rest.
My final thought
Here is my final thought. There is no one right way to invest in REIT stocks; different strategies can work well if executed intelligently. The old adage is that bulls make money, bears make money, but pigs get slaughtered. Similarly, investors who switch from one style to another, perhaps to chase the hot REIT of the week, are hurting REIT stocks.
The key, of course, is knowing one's financial goals, performance criteria, risk and volatility tolerance, return requirements and willingness to pay capital gains taxes. But any active investment strategy requires knowing something about the REIT being bought or sold, including its management team, business strategy, assets and geographic locations, balance sheet and relative considerations, and having a pretty good idea of relative valuations and risks.