A Guide About Investing in REITs

This is chapter two of a guide
to REIT stocks. Begin here.

An introduction.  

Experience this guide your way

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Who should read this guide

I wrote this guide with two readers in mind. The first reader has some experience in buying and selling stocks - and has a specific interest in understanding REIT stocks. To this reader, the guide will serve as a primer on REIT investing by describing the world of REITs.

The second reader already understands what a REIT stock is but would like to deepen his or her knowledge in the valuation of REITs. Chapter four introduces key valuation concepts, such as funds from operations and net asset valuation.  

Investing, it is often said, is more art than skill, and for the second reader, this guide to REIT investing should serve as canvas for painting. The two case studies - of Seritage Growth Properties and of Arbor Realty Trust - illustrate some of the key valuation metrics REIT investors look for.

A Brief Overview

The first section describes what initially attracts investors to buy REITs; mainly, it is the lure of real estate ownership and the high dividend yield. In the second section I highlight a few reasons why investors avoid REITs; for example, the REIT investor does not enjoy the same tax benefits as the private buyer of real estate.

The heart of the REIT guide lies in the third section. It is here that I introduce key valuation concepts. An understanding of a REIT's funds from operations, net asset valuation and qualitative (intangible) value are essential to any buyer of REIT stocks.The fourth and fifth sections are academic in nature.

The fourth section provides an overview of the evolution of REITs and some information on the REIT industry in the U.S. and globally. The fifth section describes the general forms in which investors buy real estate: private ownership, publicly traded firms and real estate operating companies, as well as some new investment vehicles, such as exchange traded funds and mortgage backed securities.

What is a Real Estate Investment Trust (REIT)?

REITs are like mutual funds. Both REIT managers and mutual funds managers use investors’ capital and debt leverage to purchase assets. In the most basic form, REIT managers buy real estate buildings, or mortgages backed by real estate, and distribute excess cash flow to investors. Mutual funds managers purchase stocks or bonds and distribute to investors any realized capital gains and dividends.

Both investment vehicles are required to distribute at least 90% of the taxable earnings to avoid paying federal taxes. And so, the REIT investor often compares the REIT's dividend yield to other fixed income instruments - a certificate of deposit or a checking account. In addition, to the dividend yield, the REIT investor places trust in both management and the economy that the value of the real estate assets will increase in time, which hopefully will up the price of the stock, too.

Written by

Noam Ganel is the Managing Director of Pen & Paper, a value-oriented stock research publication. He serves as  Vice President in Capital Markets at Silvergate Bank and holds the Chartered Financial Analyst (CFA) credential.  Click here for frequently asked questions.

The two things this guide does not address

Blindly buying stocks is easy. But whether you should buy stocks in the first place - and what kind of stocks - requires great effort and diligence. In part, the decision to buy stocks depends on your risk tolerance, return objective, time horizon and liquidity needs.

This is my way of saying that I wrote this guide not to entice you to buy specific REIT stocks, but to provide you with a resource as to how to think about REIT stocks in general.

Furthermore, while "what are the best REITs to buy in 2019" or "which REIT to buy right now" are popular key phrases on Google, the world of investing is not universal in that what is agreeable for one person may not be right for another. Quite the opposite.

In short, none of what I write about should be understood as stock investing advice.

"Buying a stock is fairly easy," said Mohnish Patrai. "It is 100 times harder to make a decision when to sell." With that in mind, this guide to REIT stocks does not answer the one-million-dollar question: when the best time is to sell a stock.

Some investors use rule of thumb rules such as if the stock multiplied in price in a period of less than three years; other investors claim that they buy stocks for the long haul and effectively will not sell a stock unless the company’s business fundamentals materially deteriorated (what Marty Whitman called investment risk.)

Because this is a highly subjective issue, without clear, data-driven principals to support one thesis from the other, I left the topic out of this guide.