Loading...
 

With few exceptions, a real estate investment trust, or REIT, buys, sells, develops, and manages income-producing property. The type of REIT can run the gamut from apartment landlords such as AvalonBay Communities (AVB) and Equity Residential (EQR), to operators of retail outlets and self-storage facilities including Federal Realty (FRT) and Public Storage (PSA), to office tower developers such as Boston Properties (BXP) and Vornado (VNO). Healthcare and assisted living centers are a budding area, too, owing to the country’s aging Baby Boomer population, a trend on which HCP (HCP) and Healthcare Realty (HR) hope to capitalize. Our REIT coverage isn’t limited to property operators, with Annaly Capital Management (NLY), which owns and manages a portfolio of mortgage-backed securities, serving as a prime example.

But while the sphere of operation varies widely, all REITs have one thing in common: tax-exempt status. For a prospective REIT to qualify, and be exempt from corporate-level income taxes, no less than 75% of its assets must be real estate related, and at least 90% of its taxable income must be distributed to shareholders through dividends. Because of this structure, REIT stocks mainly appeal to investors stressing current income, since they generally have modest long-term upside potential, but offer substantial yields. In fact, the typical REIT issue under our review is expected to appreciate 40% in value over the next three to five years, well below the median for all equities in the Value Line universe. Conversely, the average dividend yield within our REIT industry is about 5%, more than double that of all the stocks we cover.

By offering a passive investment within the structured, highly-liquid confines of stock ownership, REITs removed three historical obstacles to real estate investment. First off, gone are the days when a significant amount of capital was required to purchase income-producing property, since investors can acquire as many, or as few, shares as their finances will allow. The relative illiquidity of real estate is also a thing of the past, since market participants are assured of their ability to buy or sell shares quickly and at fair market value. Finally, investors who may lack the time, interest, or wherewithal to take an active role in property management no longer need to, since the REIT acts as landlord and property manager on the shareholders’ behalf. Although REITs have been around since the early 1970s, the format didn’t gain in popularity until the 1990s when property values increased sharply and investors sought a way to capitalize on that phenomenon.

One of the main attractions of real estate ownership is the ability to generate cash flow, referred to as funds from operations, or FFO, within the context of REITs. Typically defined as net income plus noncash charges (namely depreciation), FFO is almost universally used as a stand-in for earnings. Consequently, when considering a REIT stock for a potential investment, a primary concern is the company’s ability to generate FFO, since it is the firm’s funds from operations that will ultimately support the dividend. Most areas of the Value Line page—such as the Capital Structure and Funds Flow boxes, or the Statistical Array—should be examined with that in mind.

Despite the real estate market’s roller-coaster ride of the past few years, operating performance is usually steady from one reporting period to the next. This is largely due to the long-term nature of leases, which generally extend several years into the future, and in some cases can run upwards of a decade at a time. Thus, Timeliness is rarely a factor here, since most REIT stocks under our review are usually expected to mirror the broader market averages over the near term.

Special attention should be paid to the Capital Structure box, which gives a glimpse at the condition of the company’s balance sheet. Too much debt (relative to its peers) can place an undue burden on FFO, since interest expense is typically the largest non-operating expense a real estate firm encounters. However, too little debt might mean the company is not taking full advantage of financial leverage, which can, if used judiciously, amplify returns on capital. A similar examination should be applied to interest coverage, which demonstrates the company’s ability to meet its debt obligations.

The next stop down is the Funds Flow box, which illustrates how much capital the company has coming in and going out, as well as its sources of funding. Generally speaking, net profit plus noncash charges (i.e. FFO) in excess of dividends declared would be a positive sign, indicating that a company is covering its payout through its cash flow from operations, instead of borrowing or selling properties to appease shareholders. Investments funded exceeding investments repaid would also be encouraging, since it shows that a company is laying the groundwork for the future, as opposed to liquidating productive assets to generate short-term gains.

With respect to the Statistical Array, although each measure provides an important detail about the company’s operation, three lines should be of particular interest: Funds from operations; dividends declared; and dividends declared to FFO. At the end of the day, REIT stocks are dividend vehicles. Tracing the relationship between the funds a company is generating through its core operations, and the percentage of those funds being distributed to shareholders, is of utmost importance while weighing an investment in a real estate investment trust. Consideration should also be given to the strength and persistence of that relationship over time, since a history demonstrating a steady, upward trajectory would be an encouraging sign for future payouts.

In all, REIT stocks are unlikely to stand out for short- or long-term price appreciation potential, although there are a few notable exceptions. Hotel developer FelCor Lodging (FCH), distribution center operator ProLogis Trust (PLD), as well as mall owners Developers Diversified (DDR) and Pennsylvania REIT (PEI), all break the mold in that regard. However, their considerable recovery potential is more attributable to steep share price declines over the past few years, than to their stellar long-term prospects. By and large, REIT stocks offer above-average yields, led by Annaly Capital and hotel owner Hospitality Properties Trust (HPT), and have a good track record for generating current income, while gradually increasing their payouts over time.