A Guide To Investing in REITs - Intelligent Income by Simply Safe Dividends PDF

6/6/2019 A Guide to Investing in REITs - Intelligent Income by Simply Safe Dividends
A Guide to Investing in
REITs
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Investing in Real Estate Investment Trusts (REITs) can provide dividend investors
with high yields, steadily growing payouts, nice diversi cation, and an attractive
income stream for retirement living.
However, REITs have a number of complexities and risks that should be

understood before making any investments.
Before jumping into the essential information investors need to know about
REITs to make better informed decisions, it is worth highlighting some of the
sector’s appeal. You're reading an article by Simply Safe Dividends, the makers of online portfolio
tools for dividend investors. Try our service FREE for 14 days or see more of our
most popular articles
When it comes to building wealth few industries are more time tested, or
successful, than real estate. In fact, real estate is the third biggest creators of the
world’s billionaires:
Source: Forbes
This is understandable given that real estate has a several built-in advantages
that naturally make it appreciate in value. For example, the growing global
population generally leads to both economic growth and higher demand for
land and properties involved in housing and industrial development.
In addition, the ability to use leverage (i.e. buying real estate properties with
debt, such as a mortgage) means that investors can generate substantial returns
on investment.
Furthermore, real estate is usually a predictable and cash-rich business thanks

to rental income, which makes this kind of investment highly attractive to long-
term investors. And nally, real estate owners enjoy numerous tax advantages,
including the ability to deduct depreciation expenses from earnings and
mortgage interest from taxable income.
But for most retail investors, the idea of investing in real estate other than their
own homes can be intimidating. After all, owning a rental property can be
extremely hands on and time intensive. In addition, there are numerous legal
implications and risks that becoming a landlord involves. Most people simply
don’t have the time or desire to get involved with these matters.
Fortunately, there is a much simpler way for long-term income investors to

pro t from real estate, one that is no more di cult than buying shares on a
stock exchange.
What are Real Estate Investment Trusts?

Real Estate Investment Trusts, or REITs, were created in 1960 as a new, tax
e cient means of helping America fund the growth of its rapidly increasing
demand for all types of real estate.
Basically, REITs are pass-through equities in which the company pays no federal
income tax as long as it pays out at least 90% of its taxable income as
unquali ed dividends to investors.
The result is a naturally high-yielding class of equities with many REIT stocks
sporting dividend yields in excess of 5%. Due to its high payout ratio, which
leaves little retained cash ow, the REIT business model is predicated on
constantly raising capital from the debt and equity markets in order for
management to grow its portfolio of cash-producing properties; thus allowing
dividend growth and share price appreciation over time.
REITs: A Proven Long-term, High-yield,

Equity Class
Over many decades, REITs have been one of the best long-term asset classes for
investors to build income and wealth over time. As you can see below, $100
invested across all REITs at the start of 1972 would have grown to more than
$7,000 in 2018, representing compound annual growth of about 10%.
Source: Simply Safe Dividends, REIT.com
A 10% annualized return is on par with the broader stock market's long-term
performance. However, as MarketWatch noted:
"The main reason to own REITs isn't to improve your portfolio's return,
though sometimes that will happen. The bigger reason is to reduce volatility,
increase diversi cation and provide a source of income."
And REITs have certainly done just that over the years. In about one out of eveyr
four calendar years since 1975, REITs' returns varied by at least 25 percentage
points from those of the S&P 500 Index, according to MarketWatch. In most of
those years, REITs earned a higher return.
Furthermore, per Andrew Rubin, a portfolio manager at Fidelity, the growth rate
of REIT dividends has outpaced in ation in 18 of the last 20 years,
demonstrating their in ation-hedging qualities.
The REIT industry's solid long-term performance and diversi cation bene ts
have resulted in it growing over the decades to more than $1 trillion in market
capitalization and holding over $2 trillion in total assets. The industry has grown
so large, in fact, that in 2016 Standard & Poor's adjusted its Global Industry
Classi cation Standard system to make REITs their own sector (Real Estate),
rather than grouping them into Financials.
This change represents the growing importance of REITs to the overall stock
market and is likely to result in far more interest from institutional money,
thanks to the need to hold prominent REITs as part of increasingly popular index
funds. Which means that, going forward, REITs should represent a potentially
even more popular and liquid asset class.
There are Many Di erent Types of REITs

While all REITs are similar in many ways, investors need to realize that this
sector encompasses a vast array of di ering real estate assets. There are
around 200 publicly listed REITs that operate across various industries:
O ce
Industrial
Shopping Center
Malls
Single Family units (rental homes)
Apartments
Medical
Data Centers
Student Housing
Hotels
Triple Net Lease Retail
Manufactured Homes
Storage
Timber
Infrastructure
Note that there is also a separate class of REITs known as mortgage REITs, or
mREITs. These are a far more complex, volatile, and challenging class of stocks
that are unsuitable for conservative investors seeking steady and growing
incomes. That’s because the business model of mREITs is extremely sensitive to
interest rate uctuations (rather than steady contractual rental income).
mREITs are based entirely on buying and selling mortgage-backed securities,

and involve little or no owned properties. Therefore, they should be owned only
by the most risk-tolerant investors, who are willing to put in the extra e ort to
nd only the strongest mREITs, hold throughout periods of falling dividends,
extreme volatility, and buy on the corresponding dips, corrections, and crashes.
Getting back to traditional property-based REITs, as you can see from the above
list there is a vast universe to potentially own, each with its own nuances that
investors need keep in mind. However, all REITs share common characteristics
in that they derive the majority of their cash ow, which is what secures and
grows the dividend, from real estate properties and rental income from tenants.
Important REIT Financial Metrics

Of course, being that REITs are generally owned as high-yield, dividend growth
investments, naturally the dividend pro le is the rst thing that you’ll want to
look at when performing your due diligence before investing. This consists of
three factors: yield, dividend safety, and potential long-term growth prospects.
The most important of these is dividend safety, because nothing can potentially
generate permanent losses of investor capital more than a dividend cut, which
generally sends shares crashing. However, because of the way REITs are
structured for tax purposes, traditional methods of measuring dividend safety,
particularly the EPS payout ratio, are not good means of knowing whether or not
a payout is actually safe.
That’s because under generally accepted accounting practices (GAAP) a

company must include depreciation and amortization of its assets into its
earnings calculations. However, the unique nature of real estate assets,
particularly that well-maintained properties tend to appreciate in value rather
than depreciate over time, means that GAAP earnings don’t actually represent a
REIT’s ability to cover its dividend or grow it over time.
Instead, investors want to look at a REIT's funds from operations (FFO). This is
the REIT equivalent of operating cash ow. FFO adds non-cash expenses, such
as depreciation and amortization, back to net income, and subtracts gains or
losses on asset sales, such as any properties that management may have sold
over a period of time.
Even more important is Adjusted Funds From Operations (AFFO). This is similar
to free cash ow for a REIT. AFFO subtracts maintenance capital expenditures
from FFO to show how much cash the company is generating after running its
operations and investing enough capital to preserve what it already owns.
AFFO can be thought of as “Funds available for distribution” (FAD), and indeed
some REITs actually call it that. The di erence between AFFO and true free cash
ow, as reported by regular corporations, is that free cash ow also includes
growth capex, or the money the company is investing to expand its operations.
Investors can retrieve these gures from the company they are interested in,
and they are also directly available on our website. You can see Realty Income's
(O) historical AFFO and AFFO payout ratios below.
Source: Simply Safe Dividends
In addition to the unique non-GAAP gures reported by REITs, investors need to

be aware that these companies rely on issuing debt and equity to keep their
businesses running.
REITs Depend Heavily on Capital Markets

for Growth
Since REITs are legally only allowed to retain a maximum of 10% of taxable
income, they must use debt and sell additional shares to fund acquisitions of
new properties or improving existing ones.
As a result, the balance sheet of REITs will naturally show higher debt levels than
most other sectors of the market. In addition, the share count will tend to rise
over time as management sells new shares to fund the company’s growth.
For example, Realty Income (O) has seen its diluted shares outstanding more
than triple from 80 million shares in 2005 to 274 million shares in 2017.
While a rising share count means that existing investors are getting diluted,
unlike regular companies, this isn’t necessarily a bad thing. That’s because, as
long as the additional money raised by selling new shares or taking on new debt
results in AFFO per share growing over time, the capital raise is accretive (value
increases).
In other words, the increase in AFFO is greater than the rise in share count,
resulting in AFFO per share rising over time. That not only makes the existing
dividend more secure, but it also allows for dividend growth, which causes the
yield to rise, attracting new investors who bid the share price up.
In this way, quality REITs can grow over many decades, generating rising income
streams and creating substantial shareholder value along the way.
Other Key Di erences between REITs and

Corporations
There are two other key things to remember about REITs that are slightly
di erent than most other dividend-paying corporations.
First, due to how they structured for tax purposes, REIT dividends are
unquali ed, meaning they are taxed as regular income and thus at your top
marginal income tax rate. As a result, REITs are typically great candidates for tax-
sheltered accounts such as IRAs.
A second important factor is to know whether or not the REIT is internally or

externally managed. Most of the bigger, more popular REITs such as Realty
Income (O) or Welltower (WELL) are internally managed, and this is generally
preferable to an externally managed structure for two reasons.
First, externally managed REITs, in which management doesn’t work for the REIT
directly but is an external adviser that operates and manages the REIT’s assets,
have higher operating costs. Typically the manager charges a xed fee, a
percentage of assets, for its services. There is also a performance incentive
based on the growth of net asset value (NAV) above a certain hurdle rate. In
other words, externally managed REITs are the real estate version of a private
equity rm, and high fees can eat into long-term investor returns.
Not only does that lead to higher operating costs, and thus lower pro tability,
(which can make dividend growth harder), but it can also result in con icts of
interest between shareholders and management. That’s because if
management is paid based on the size of a REIT’s assets, then it has an incentive
to grow the REIT as large as possible, in order to maximize its own pay.
This can result in a REIT chasing after “growth at any price”, meaning buying
poorer quality properties at in ated prices, funded by excessive shareholder
dilution. You can see this with some of the lower quality REITs in which the share
count rises high enough over time to make the NAV per share (the equivalent of
tangible book value per share) stagnate or even decline.
That being said, some externally managed REITs can make good investments,
but you have to be very selective and make sure that management’s interests
are aligned with shareholders.
Why would anyone take the added risks of owning an externally managed REIT?
Well, the best ones are managed by large asset management rms with massive
scale, experience, and an army of high quality employees. They are able to make
deals that smaller, internally managed REITs might not know about or be able to
go after.
Regardless of whether an investor is buying shares of a corporation or a REIT, it

is important to remain aware of an asset’s sensitivity to the economy. Let’s take

a look at how REITs fared during the Great Recession.
Best Types of REITs for Recessions

Many dividend investors are conservative by nature. They aren’t worried about
trying to beat the market but are instead focused on generating safe, growing
income while preserving their capital. For this reason, they like to focus on
companies that have reliably grown their dividends over time.
The nancial crisis decimated many retirement accounts and was lled with
shocks. Many iconic dividend growth stocks proved to be vulnerable. From
General Electric to Bank of America, there was no shortage of surprises.
During recessions, some businesses perform much worse than others because
demand for their products and services is primarily driven by the health of the
economy. Unfortunately, many economy-sensitive businesses happen to be
major tenants for certain REITs.
Real estate took a big hit during the nancial crisis, and many REITs were
clobbered. However, some performed better than others and nicely preserved
investors’ capital while continuing to provide safe dividends.
The chart below shows the total return of each REIT group in 2007, 2008, and
2009. REITs with more cyclical tenants, such as hotels, experienced a 22% loss in
2007 and a whopping 60% drawdown in 2008. While they did rebound 67% in
2009, this type of volatility isn’t exactly what every retired income investor
dreams of.
Mortgage REITs were also walloped with losses in excess of 30% in 2007 and
2008, and industrial and retail REITs weren’t much better.
Fortunately, several types of REITs were not as impacted by the recession.

Health care REITs were up 2% in 2007 and recorded a more modest loss of 12%
in 2008. They also participated in the market’s rebound in 2009 with a 25%
return. People continue to need many health care services regardless of how
the economy is doing, which can make for more stable occupancy levels and
rental rates for these REITs.
Self storage REITs lost 25% in 2007 but held their ground very well in 2008 with a
5% return. It is a pain to move things in and out of storage. Items are usually
stored for a reason, and storage companies usually have an easier time raising
prices on their customers. This, in turn, makes them more reliable businesses
with fairly predictable demand.
Source: Simply Safe Dividends, REIT.com
In addition to the drop in many REITs’ stock prices, dividends also proved to be
quite vulnerable during the recession.
From May 2008 through March 2009, approximately 30% of all REITs suspended,
cut, or switched to paying part of their dividend in company stock, according to

The Wall Street Journal.
REITs’ relatively high payout ratios and dependence on raising equity and debt
to fund their business needs got them into trouble during the credit crisis when
a ordable capital was hard to come by.
While no one can predict when the next recession will occur, many investors are
feeling cautious about another risk – rising interest rates.
Interest Rates Can Impact Real Estate

Investment Trusts
A key detail to keep in mind when considering investing in REITs, especially
today with global interest rates remain near historic lows, is that REITs can be
highly sensitive to changes in interest rates for two primary reasons.
First, because of their business model, in which most growth capital comes from
raising debt or issuing equity, higher interest rates mean higher borrowing
costs. That’s either from taking on new loans, or merely rolling over (i.e.
re nancing existing debt).
This is why investors need to carefully watch a REIT’s balance sheet over time to
make sure its leverage ratios don’t get too high. Typically the best REITs are run
by conservative management teams that avoid overextending themselves when
it comes to debt.
Rising rates can a ect property values as well. Fortunately, cap rates (net
operating income / the cost of a property) remain well above the 10-year
Treasury yield. This healthy spread provides some cushion for commercial real
estate prices if interest rates continue rising.
Source: REIT.com
However, another reason REITs are interest rate sensitive is because many
investors are yield-starved by low bond rates. Thus, REITs, especially blue chip
names such as National Retail Properties (NNN) or Ventas (VTR), are seen as
safe, higher-yielding bond alternatives.
This partially explains why REITs have done so stunningly well over the past
decade, as income investors have bid up their prices due to their generous
payouts and stellar track record of consistent dividend growth over time.
However, the Federal Reserve is attempting to gradually end its ultra-loose

monetary policy by raising the short-term Federal Funds rate. While short-term
and long-term interest rates aren’t precisely correlated, they generally rise and
fall together.
Today, many high-quality REITs yield between 4% and 6%. If the risk-free rate of
return (i.e. the 10-year Treasury bond yield) rises high enough, then the same
group of investors that have piled into REITs over the last few years could
reverse course and send share prices much lower. This intuitively makes sense,
because any individual stock is naturally much riskier than U.S. Treasuries, even
the highest quality REITs.
Thus, investors will demand a risk premium in the form of a higher yield to own
such stocks, and since yields and share prices are inversely correlated, the rise
in yields means a fall in price.
Not only does a potentially falling share price represent a risk that investors
need to keep in mind (especially if you will need to sell shares to nance
medium-term goals such as retirement living expenses), but share prices can
have a direct impact on how quickly a REIT can grow.
Remember that REITs are periodically raising growth capital by selling new
shares. So if the share price falls too low, it can become harder to grow because
the cost of that capital might get too high.
Think of it this way. If a REIT is currently selling at X and yields 4%, then any new
shares it sells also yield 4% and act as a kind of perpetual bond given the
ongoing dividend payments required. And that dividend will hopefully rise over
time.
If the share price then falls to 0.5X, and the yield rises to 8%, then management
will need to sell twice as many shares to raise the same amount of funds. This
means more dilution to existing investors and a higher future dividend cost for
the company. As a result, the AFFO payout ratio will rise, dividend security will
fall, and future dividend growth might be harder to come by.
In comparison, most corporations, such as Pepsico (PEP) or 3M (MMM), generate

su cient cash ow to fund their growth internally. They only issue more shares
in the form of stock-based compensation to employees or to make large
acquisitions.
But rising interest rates will not spell doom for the industry, far from it. After all,
REITs have been around since 1960, and the industry has managed to thrive
under interest rates as high as 21%.
Indeed, REIT.com noted that REITs outperformed the S&P 500 with a total
cumulative return of approximately 80% while the Fed raised rates from 2004-
2006. Nareit's John Worth also noted that REITs have recorded positive total
returns in 87% of prior periods of rising interest rates, outperforming the S&P
500 in more than half of those times.
Standard and Poor's published a study analyzing the impact of rising interest
rates on REITs as well. The company noted that “when expectations about future
interest rates change suddenly, REITs have often experienced high volatility and
rapid price changes.”
However, the rm made the following conclusion:
“Ultimately, whether interest rates are rising or falling does not seem to be
the key driver of REIT performance over medium- and long-term periods.
Rather, the more important dynamics to address are the underlying factors
that drive rates higher. If interest rates are rising due to strength in the
underlying economy and in ationary activity, stronger REIT fundamentals
may very well outweigh any negative impact caused by rising rates.”
REIT management teams have had years to prepare for their businesses for the
prospect of higher interest rates. As of the fourth quarter of 2017, REITs have
clearly taken a number of actions to shore up their balance sheets and lower
their exposure to interest rates. Compared to the pre- nancial crisis period, they
appear to be in great shape.
Source: REIT.com
With that said, base rates have never been this low for this long. Unusually
strong price volatility could ripple across the REIT sector if the Fed continues
raising rates at a brisk pace over the coming years, and investors need to be
mentally and nancially prepared.
Focusing on REITs with experienced management teams, ones that have a
proven track record of generating strong shareholder value and rising dividends,
is all the more important in higher interest rate environments.
Closing Thoughts on Investing in REITs

Despite their unquali ed dividend status and interest rate sensitivity, REITs have
proven to be a solid long-term asset class over time. REITs can be especially
appealing for investors who seek high current income, dividend growth that can
beat in ation, and stocks that provide some unique diversi cation bene ts.
However, as with all investments, moderation is key to long-term success. The

Real Estate sector only accounts for around 3% of the S&P 500 Index, and REITs
possess a number of unique risk factors: interest rate sensitivity (especially
given the unprecedented era of low rates we have been living in), a need to
access debt and equity markets to raise capital, high payout ratios, unique tax
treatment, etc.
Therefore, it seems most prudent to limit a portfolio's REIT exposure to no more

than 15% to 20% of its overall value. If you are selective in which REITs you
invest in, focus on the most important industry-speci c metrics such as AFFO,
and remain properly diversi ed, this sector can make a solid addition for many
dividend portfolios.

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6/6/2019 A Guide to Investing in REITs - Intelligent Income by Simply Safe Dividends

However, REITs have a number of complexities and risks that should be

Furthermore, real estate is usually a predictable and cash-rich business thanks

Fortunately, there is a much simpler way for long-term income investors to

What are Real Estate Investment Trusts?

REITs: A Proven Long-term, High-yield,

$7,000 in 2018, representing compound annual growth of about 10%.

Source: Simply Safe Dividends, REIT.com

increase diversi cation and provide a source of income."

even more popular and liquid asset class.

There are Many Di erent Types of REITs

mREITs are based entirely on buying and selling mortgage-backed securities,

Important REIT Financial Metrics

That’s because under generally accepted accounting practices (GAAP) a

REIT’s ability to cover its dividend or grow it over time.

Source: Simply Safe Dividends

In addition to the unique non-GAAP gures reported by REITs, investors need to

REITs Depend Heavily on Capital Markets

Other Key Di erences between REITs and

A second important factor is to know whether or not the REIT is internally or

Regardless of whether an investor is buying shares of a corporation or a REIT, it

is important to remain aware of an asset’s sensitivity to the economy. Let’s take

Best Types of REITs for Recessions

Fortunately, several types of REITs were not as impacted by the recession.

Source: Simply Safe Dividends, REIT.com

cut, or switched to paying part of their dividend in company stock, according to

Interest Rates Can Impact Real Estate

However, the Federal Reserve is attempting to gradually end its ultra-loose

In comparison, most corporations, such as Pepsico (PEP) or 3M (MMM), generate

However, the rm made the following conclusion:

Focusing on REITs with experienced management teams, ones that have a

Closing Thoughts on Investing in REITs

However, as with all investments, moderation is key to long-term success. The

Therefore, it seems most prudent to limit a portfolio's REIT exposure to no more

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