Value Investing With Real Estate Investment Trusts – Analysis and Evaluation Techniques

Real Estate Investment Trusts (REITs) are considered excellent long-term investments. There are two underlying reasons. First, under the Internal Revenue Code, they are considered income tax free investments. To comply, the REIT must distribute at least 90% of all net income earned to shareholders. The shareholders pay income tax on those dividends received. Because of the dividend distribution requirement, REITs have excellent dividend yields. This is why REITs are considered perfect investments for widow and orphan funds whereby cash is necessary to fund the monthly payments to annuitants. Secondly, similar to any real estate investment, time is beneficial to the overall value of the REIT’s fixed assets. No differently than owning a home, time allows the underlying asset to increase in value. Thus, the normal pattern for a REIT’s market price should be a slow and continuously positive increase over time. Long-term resale of the stock should provide capital gains for the investor. Putting the two financial benefits together creates an excellent long-term return on one’s investment in the stock.

With value investing, the concept is to own quality stocks at good prices. This matches the primary tenet of business – ‘Buy Low, Sell High’. When the price returns to normal, proceed to sell the stock and continue the pattern. The long-term outcome is significantly greater returns than many of the common market indicators (DOW Jones Industrial Average, S&P 500, Russell 2000, etc.).

REIT’s are generally high quality investments. Their financial statements are moderately difficult to read due to two uncommon financial measurement indicators of 1) funds from operations (FFO) and 2) normalized funds from operations. However, with an understanding of basic accounting reporting information and how FFO is quantified, a reader of REIT financial reports can quickly ascertain overall performance of the entity.

Analyzing and evaluating REITs is similar to owning residential property as a landlord. However, the scale is exponentially greater; practically eliminating variances. In effect, there is improved predictability and reliance on the information provided. With REITs, investors look for three key financial indicators of performance. First, is the dividend yield percentage. This matches the landlord’s desire for cash flow from their investment in real estate. Secondly, holders of rental property desire positive net income in order to assure adequate proceeds to make the principal payments on any mortgages associated with the property. Finally, landlords want to ensure that their rents charged mirror the economic conditions of the property’s location. With publicly traded REITs, this is evaluated with the fixed assets turnover ratio.

The following sections cover the three basic principle indicators of value and describe evaluation techniques for each. The overall goal is to identify long-term trends of each indicator and weigh them appropriately for a general sense of REIT performance. Using this information, a value investor can then easily identify opportunities, set buy/sell trigger points and take action. The end result is outstanding returns well in excess of the various market yields.