NEW YORK – March 16, 2015 – With the economy gaining strength, this is a good time to consider investing in commercial real estate. You can do that via real estate investment trusts (REITs).
REITs trade like regular stocks, but they don’t pay U.S. federal income taxes as long as they pay out at least 90 percent of their taxable income to shareholders. On the downside, REIT dividends are mostly taxed as regular income instead of the lower 155/20 percent capital gains rates. So it’s best to keep REITs in tax-sheltered accounts.
There are two basic types of REITs: property REITs and mortgage REITs.
Property REITs own commercial real estate properties, such as apartment complexes, office buildings or shopping centers. Mortgage REITs don’t own properties; instead, they invest in mortgages backed by real estate, typically single-family residential properties.
Most REIT share prices got hit recently on fears that rising interest rates would reduce the value of these high-dividend payers. My research (Harry Domash) has found that those concerns are well founded for mortgage REITs, which usually do underperform in a rising interest rate environment.
However, that is not the case for property REITs. They typically experience strong cash flow growth, which in turn, drives dividend growth in a fast growing economy, which is what drives interest rates up. So, today, we’ll focus on property REITs.
Property REITs provide the customary management services associated with leasing properties such as apartment buildings, shopping centers and office buildings. But they can’t operate properties requiring a high degree of personal service, such as hotels and healthcare facilities. Instead, they must lease those properties out to third party operators.
The depreciation effect
You can’t use earnings per share (EPS) to analyze property REITs. Here’s why:
Accounting rules require property REITs to depreciate the value of any improvements (buildings, etc.), over a fixed period, typically 30 years. For example, if a building cost $30 million to construct, the property owner would typically deduct $1 million per year from annual earnings, even if, in fact, the property was appreciating in value. Thus, reported earnings figures do not reflect the real cash flow generated by the properties.
For that reason, the REIT trade association (NAREIT) created a measure called funds from operations (FFO), which reflects the cash flow generated by a property REIT’s operations. Interestingly, the EPS forecasts that you see posted for property REITs on most financial websites are, in fact, per-share FFO forecasts.
Most analysts group property REITs into these categories: retail, healthcare, lodging, industrial, office, mixed industrial/office, residential, specialty, and diversified, which includes REITs that that own properties in multiple categories.
Currently, healthcare and lodging REITs have the best outlooks.
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