A Real Estate Investment Trust, or REIT, is a real estate company that is modeled after the mutual fund market. REITs were first created in 1960 by the U.S. Congress in order to offer all Americans, regardless of their income level, the opportunity to invest their funds into income-producing real estate in a similar fashion to investors who invest in stocks via mutual funds.

Any land with income-producing improvements made to it, such as apartments, shopping malls, hotels, or offices, is considered income-producing real estate. REITs can invest directly in a property and generate income through rent payments, or they may choose to invest their funds in mortgage securities, generating interest income through financing the properties.

REITs provide anyone with the opportunity to invest in large-scale property portfolios much like they would invest in any other industry through the purchase of stock. Much like shareholders benefit from owning stocks in corporations, REIT stockholders are able to earn a share of the income created by an income-producing real estate investment, without having to actually finance, build, and manage a property.

Examples of REITs

REITs exist everywhere. In fact, most of the shopping malls, homes, hotels, apartment complexes, medical facilities, office buildings, and cell phone towers are owned by REITs. REIT properties are located in countries all over the world, and produce millions in investment income each year.

Pennsylvania Real Estate Investment Trust (PREIT) is a well-performing REIT that has provided investors with tremendous value. Between October 14, 2011 and October 12, 2012, Pennsylvania R.E.I.T. experienced a roughly 127% appreciation in share value.

Even more impressive, Sovran Self Storage Inc (SSS) has consistently appreciated since 2009. So far this year, shares of Sovran Self Storage Inc have climbed approximately 25 percent.

That’s not to say that every REIT is a guaranteed to be a winner. While REITs have tremendous growth potential, they are not without risk. One example of a REIT that lost investors a lot of money was American Capital Agency Corp. (AGNC). which experienced an approximately 37 percent depreciation in share value between April 26, 2013 and July 5, 2013.

Another example of a poor performing REIT is Arbor Realty Trust, Inc. (ABR). which experienced substantial depreciation since its share value peaked at $34.05 on February 16, 2007.

Are REITs Only Available in the U.S.?

They may have originated in the U.S. but REITs are now a global investment vehicle. Nearly 30 countries have adapted different versions of the REIT model found across the pond. Today, people all around the world can invest in REITs.

Characteristics of REITs

Investors often benefit from the diverse profiles of the REIT industry. Despite the diversity of REITs, they are typically classified as being mortgage REITs or equity REITs. Equity REITs invest in properties that produce most of their income from rental payments. Mortgage REITs receive most of their income from interest earned on mortgage investments or mortgage-backed securities. Currently, 90 percent of all REITS are equity REITs, and the remaining 10 percent of REITs are mortgage REITs.

How to Qualify as a REIT

There are a myriad of restrictions and qualifying factors that a company must meet in order to qualify as an REIT, including the following:

• Invest 75 percent or more of its total assets into the real estate market.
• Receive at least 75 percent of its income from real estate sales, rent derived from real property, or finance interest on mortgages.
• Payout 90 percent or more of its taxable income to its shareholders in the form of dividends.
• Be a taxable corporation.
• Managed by a board of trustees or directors.
• Have at least 100 shareholders and have no more than half of its shares held by a handful of individuals.

Advantages of REITs

There are numerous advantages associated with investing in REITs. Let’s take a look at some specific benefits that more and more investors are experiencing:

• Diversification – REITs invest in a multitude of property types in countries around the world, bringing both geographic and property diversification to a person’s portfolio.
• Dividends – Given the fact that REITs must pay out at least 90 percent of their income in the form of shareholder dividends, REIT investors regularly receive sizable dividend payments. In fact, $29 billion in dividends were paid out to REIT investors in 2012 alone.
• Liquidity – Individuals can easily purchase and sell REIT shares, and there are more than 160 publicly traded REITs on the world’s major stock exchanges.
• Performance – REITs have been outperforming the major stock indices, including the NASDAQ Composite, S&P 500, and Dow Jones Industrial Average, for over 30 years now.
• Growth – During long holding periods, returns on REITs have outpaced inflation, allowing investors to hedge their portfolio’s purchasing power.

With dozens of consistently high-performing REITs to choose from, regular dividend payments, and portfolio diversification, it is not surprising that REITs are more popular now than ever before.

Risks of REITs

Like all investment vehicles, there are certain risks inherent in investing in REITs. Below are some of the risks you should be cognizant of when considering a REIT:

• Interest rates – REITs are often highly leveraged and heavily depend on the banks and credit markets for refinancing activities. In particular, dividends paid by mortgage REITs are volatile and are often cut when interest rates or mortgage defaults rise.
• Legislation – The Great Recession prompted regulators to consider removing the minimum mandatory dividend payout ratio of REITs in order to spur their recovery. While the legislation was not passed, similar legislation could affect investor returns in the future.
• Capital Dependency – By virtue of their business model, REITs have to pay out 90% of their taxable income to shareholders, leaving them unable to retain earnings for future growth. This requires REITs to be heavily dependent on the capital market for equity or debt refinancing.
• Tenant Risk – Prolonged economic stagnation inevitably leads tenants to default on payments or vacate their rental space, which can profoundly impact the performance of a REIT.

How to Evaluate a REIT

Before an investor allocates his funds into a REIT, it is important for him to understand its relative value. Unfortunately, many of the common metrics investors use to value common stocks, such as earnings-per-share (EPS), are not useful for valuing a REIT.

These three factors allow investors to approximate the value of a REIT:

1. Net asset value (NAV)
2. Funds from operations (FFO)
3. Adjusted funds from operations (AFFO)

We shall examine each of these in the subsections below.

NAV  The NAV of a company is the difference between its assets and its liabilities — in other words, the owner’s capital account. (In bookkeeping, assets and liabilities go on the left side, capital on the right.) It may or may not be equal to the equity value of the business. Normally, NAV is given as “per investment unit” — in other words, the gross asset value is divided by the total number of outstanding investment units. The resulting figure is thus a reflection of the market values of every piece of real estate that the REIT holds. By looking at the amount of premium or discount on the price of each property unit, and comparing it with the NAV, one can get assess the REIT accurately.

A closely-related figure is called the adjusted price-to-book ratio, which is the ratio of the current market value of a company to its book value, either as reflected on the balance sheet or as divided by the total number of outstanding shares in the business. This ratio reflects factors that the NAV does not, such as brand values or unrealized gains or losses on properties.

FFO  The FFO is equal to the sum of earnings to expenses from depreciation and amortization. It is to REITs what EPS (earnings per share — the total number of earnings divided by the number of outstanding shares) is to other forms of investment, and like NAV it can also be calculated on a per share basis. It is important to note, that you should really focus on FFO on a per-share basis because REITs tend to issue large amounts of stock to finance their expansion, which often makes their growth appear misleadingly rapid.

The reason why this special formula is used for REITs is because real estate is not subject to depreciation in the way that many other types of plant assets are. It thus avoids the distortions that would occur if depreciation were included, and makes other adjustments as well. All companies are required to reconcile their FFOs to their net income for the purposes of taxation.

AFFO  FFO gets closer to cash flow than does net income, but it does not capture the former amount, nor does it make the deductions for capital expenditures which are required for the business to maintain its present portfolio of properties. Another figure, called AFFO, is therefore focused on by professionals as a more accurate way of measuring residual cash flow after all the expenses and expenditures have been deduced.

There is no uniformly accepted definition of AFFO, but a common way of calculating it is to subtract capital expenditures from FFO. The resulting figure can be said to represent the residual cash flow that is available to shareholders in the corporation, and is also an accurate measure of the future capacity of that entity to pay dividends.

Other Subjective Metrics

Aside from NAV, FFO, and AFFO, there are other more subjective indicators investors should think about when analyzing REITS.

Financial Leverage  Property companies operate in a very volatile financial environment, and any successful REIT should have the financial reserves to withstand sluggish periods. You should favor REITs with balance sheets that exhibit low debt and high equity. Highly leveraged REITs carry higher risk and should largely be avoided unless you are a very adept investor.

Geographical Spread  REITs that have real estate portfolios spread across a greater geographic region are less exposed to risk. For example, if a REIT had a large portion of its property holdings within a community, if that community had a natural disaster, the REIT would be heavily affected.

Type of Property Different properties entail varying degrees of risk – during an economic downturn, apartments are unlikely to lose as much long-term value as luxury summer homes. Consequently, you should look for REITs that diversify the type of their property holdings.

Concluding Thoughts

REITs are a financial innovation that has afforded many casual investors the ability to invest in large-scale real estate developments. Many REITs have performed well over the last decade, especially in 2011 and 2012. Unfortunately, many novice investors value REITs using traditional equity metrics, such as EPS, which do not properly capture the true value of these investment vehicles. By using NAV, FFO, and AFFO, as well as other subjective indicators, investors can properly value REITs and hopefully avoid making questionable investment decisions.

This was a guest article by Michael Lord. a content writer at Penny Stocks Lab. which is a website focused on educating investors about penny stocks as well as other general investing topics.