Real Estate Investment Trusts (REITs) were created by the United States Congress in the 1960s, giving individuals the opportunity to invest in large property businesses. There are currently more than 150 publicly traded REITs in America. Since 2001, REITs have resided in the Standard & Poor’s 500 index, gaining in popularity with individual and institutional investors.

Some regulations, as outlined by the Internal Revenue Service, apply to these investments. Prominently, REITs must invest at least 75% of their assets in real estate and distribute 90% or more of annual taxable profits, as dividends, to shareholders. These equities serve as good current income investments, given their high yields and relatively stable share prices.

Many REITs invest in different types of properties, offering investors a fair degree of diversity. A trust’s area of concentration can be determined from the Business Description in the Value Line report. REITs invest in categories, such as shopping centers, office buildings, or apartment units. However, some have specialized portfolios, which may entail, for example, healthcare facilities, industrial properties, hotels, and self-storage buildings. A prudent investment strategy is to purchase several REITs dealing in different business categories.

Revenue/Rental Income

Unlike industrial companies, which post “Sales” on their profit-and-loss statements, REITs report “Revenues” or “Rental Income”, largely consisting of rental proceeds from wholly owned properties. From one year to the next, rental revenue usually remains steady, thanks to long-term leases. Revenue levels largely reflect the supply and demand situation in a given location and, indirectly, the health of the regional economy. Most important, a REIT’s revenue is dependent on its occupancy rates and ability to raise rents. Revenue may include management revenue and/or fee income related to development efforts. Investors should note that during a difficult demand period, competition among landlords can lead to the granting of costly concessions, such as free rent and space improvements.

Rental revenue does not advance quickly, since low tenant turnover and rate-hike limitations temper the pace. Nonetheless, renovations and upgrades can attract well-heeled tenants. Also, many REITs expand the top line via acquisitions or development efforts. A crucial consideration for prospective investors is a trust’s ability to effectively manage its construction pipeline. Indeed, poorly managed REITs have suffered project delays that have hurt revenue and net profit. The “Loans & Real Estate” line in the Statistical Array on the Value Line report is a rough indicator of a trust’s expansion and revenue growth potential.

Profitability

REITs have relatively fixed operating expenses, including maintenance, insurance, property tax, and general outlays. Expenses will increase markedly, however, when large properties are acquired. It’s true that rising utility costs sometimes present a challenge, but they are most often easily passed on to tenants. The two largest expenses for REITs, which are not included on the “Operating Margin” line, are depreciation and interest. These items tend to rise dramatically with financed expansion. If not managed properly these expenses can measurably reduce reported net income and GAAP earnings per share.

Financing

REITs use considerable leverage for property development and purchases. Debt-to-total capital ratios above 50% are common. The trusts take advantage of equity financing, as well, but this can be quite dilutive to share earnings if acquired assets or new projects do not quickly generate returns. Some REITs reduce their risk exposure by tapping third-party equity financing to form stand-alone entities. These unconsolidated enterprises, though, sometimes lack transparency. In periods of stress, tangible assets are a safety net for REITs, in that they can be sold to raise capital. Only in the most challenging of times, would a trust consider reducing or eliminating its dividend, a move that sends stockholders running to the exits.

REIT Valuation

In an attempt to assign a value to a REIT, one might consider the market prices for assets similar to what the trust holds. Historical “Book Value per share” offers a similar approach to pricing a REIT stock. In overheated or tepid property markets, however, these methods can be misleading, resulting in extreme highs or lows for share prices.

REITs may also be valued by income, using “Funds from Operations per share” (FFO). This measure is a REIT’s net income, excluding gains or losses from asset sales, plus depreciation & amortization. Additionally, “Dividends Declared to FFO” gives an indication of how much flexibility a trust has in hiking the annual distribution. This payout ratio is typically in the 50% to 80% range. A level of 100% or higher would suggest that the dividend is in danger.

It’s worth noting that in the wake of the recession at the end of the previous decade, many REITs under Value Line coverage, including some of the industry’s largest and most prominent operators, were forced to substantially reduce their dividend payouts to conserve capital. Although payout ratios are once again approaching normal levels, companies—chastened by the most recent downturn—are liable to be more cautious about increasing their distributions in the future.

Value Line REIT price charts feature a “Dividend” plot, as opposed to a “Cash Flow” line. The Dividend plot is based on the 10-year Treasury Note Rate, an appropriate benchmark for income-producing securities. When a REIT trades at a price above the plot, this suggests that it is overvalued. Conversely, when the REIT’s share price is below the line, the stock may be considered undervalued. The share price generally hews close to the plot. Most REIT issues have near-market betas and above-average Stock Price Stability. Safety ranks are typically 3 (Average) or better. REITs are suitable holdings for most conservative investors.