I want to retire early and as such, I invest in income producing assets to generate for myself a passive stream of income that, one day, will replace my job income.

While I could have invested in hard cold real estate buildings, I believe that with my limited net worth and capital, it would be too risky and all my money would be tied in a single investment (Dont put all your eggs in the same basket). Plus, Im not so tempted by the proverbial leaky toilet example and by managing tenants. I already own a house and I have to spend a lot of my free time on its maintenance. Its enough for me.

One of my friends owns 2 rental buildings and he recently had to pay 800$ to kill bed bugs brought in by one of his tenants No thanks!

Thats why I prefer investing in stocks. I can get a diversification among many sectors, many companies, many countries I actually select stocks of great company paying growing dividends year after year. This strategy is called dividend growth investing .

Though I dont invest directly in real estate, I recognize they are extraordinary wealth builders. Fortunately enough, with the dividend growth strategy I can get a great exposure as well as a great diversification in the real estate sector by buying REITs and you could too!

Heres how to analyze them :

But what is a REIT exactly?

REIT is the acronym of real estate investment trusts. Its a real estate company that usually invest in hard cold buildings generating income. There are also mortgage REITs but these do not fit my guidelines as they use complicated edging strategies and they dont own the underlying assets.

These trusts dont pay income taxes and to qualify they must return 90% (might vary from country to country) of their income to unitholders like me. Thats what makes them interesting on an investor standpoint!

Why invest in REIT?

Carefully selected REITs can offer interesting initial yield and dividend growth prospects and even though taxes might be a little complicated with REITs, usually part of the dividend is classified as a return on capital so it is tax-advantaged. In Canada, REITs can be held in a TFSA and as such, their distributions are tax-free and you can avoid the taxes headache.

I like quarterly dividends, but I love monthly dividends. Many REITs pay monthly dividends. Its fun to get this regular income deposited directly in your account every months.

In fact, REITs offer about the same kind of attractive prospects that utilities offer. Even though they are a little riskier and more cyclical, they are also more diversified. I believe that REITs should be part of a Dividend Growth Portfolio with a long-term approach because they provide a necessity of living (or doing business) and because historically, real estate has provided a good shelter against inflation.

You can find a lot of different kind of REITs specialized in. hotels, appartements, commercial offices, industrial facilities, health care, huge malls, small malls, storage facilities and even prisons. There is also another kind of REIT specialized in holding mortgages. I dont recommend that kind of REITs because they dont provide the same protection against inflation.

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What to look at when analyzing a REIT in a dividend growth investing strategy :

The price per unit vs the NAV

The price per unit should not be much higher than the net asset owned by the REITs (the NAV or net assets value). If the REIT had to sell every buildings today, youd want your capital to be covered by the assets. Makes sense? In practice some might argue that a greatly managed REIT with great dividend growth prospects might be sold at a premium and it often happens!

An economy in good shape

The investor needs to make sure the local economy where the REIT invests is in good shape or recovering. People want to rent in hot places and since the income comes from the rents, you must ensure that theres going to be some demand going forward.

Reasonable debt load

Debt shouldnt be more than 30%-40%. You want to make sure here that rents are going to cover debts even if the occupancy rate is low for a while or if rates are high for a long time.

Since REITs do not retain a lot of earnings, they usually need others sources of financing. The less debts they have, the better. But keep in mind that a rise in interests could affect a lot a REIT if the debt load is too high.

Do not rely on the P/E ratio get to know what is the FFO

The price/earning ratio cannot be used to analyze REITs. The investor must use the FFO (funds from operations). Lowell Miller, the author of the Single Best Investment. suggests it should be no more than 10-12 for an established REIT and 10-14 for a fast-growing REIT.

The FFO is basically a figure to define the cashflow from their operations. It is calculated by adding depreciation and amortization expenses to earnings. It is important to note that the funds from operations is not the same as the Cash from Operations.

When you analyze a REIT you want the FFO to be growing and the dividend to be growing as well. As the payout ratio is very high, without a growing FFO itll be next to impossible to grow the dividend

Dont chase the highest yield!

Yield should normally be average at the moment you invest. There are a lot of high yield REITs out there but very high yield often comes at the expense of low or no yield growth. While a high yield can be interesting for current income, over the long term high growth of yield is what we seek for in a dividend growth strategy.

The importance of management commitment

Warren Buffett likes to see managers who have a huge stake in the business they manage. Thats a nice thing to motivate them to make you make money. Make sure management hold at least 10-15% equity or more in the REIT to make sure that your success is also their success! Managers are usually highly motivated to make the business grow when a huge part of their net worth is at risk with yours.

Where Can I find the NAV and FFO of a REIT?

This is a tricky one! Dont search on Google Finance, Yahoo Finance, Morningstar You wont find the NAV and the FFO there. Instead, go directly to the website of the REIT you wish to analyze.

Realty Income (O). is an investor friendly REIT and they provide a lot of cool information to help the investor. As such, it makes a good example.

You could also download the REIT.com app which provide the FFO for many of the listed REITs, but not all of them.

Ultimately, you could calculate the FFO by yourself :

Funds from Operations (FFO) = Net income + Depreciation + Amortization Gains on sales of properties

For the NAV, things get even trickier.

Book value per share doesnt apply to REIT analysis. The NAV is an attempt to replace the book value by taking into consideration the market value of the buildings. The NAV is simply the market value of all the buildings less the mortgages. This gives you what we call the equity or net asset value (NAV).

MyOwnAdvisor has done a great job at explaining how to figure out the NAV. I suggest you take a deep look at his post.

What are the downsides of REITs?

Doing your taxes can definitely become a headache As a Canadian, I will hold my Canadian REITs in my tax free saving account. In this account, they are not taxable for now. My US REITs are hold into my RRSP account. They wont be taxable until I retire and then all of the income Im going to take out of my RRSP will be taxed as regular income. This is a good way to avoid the headache

A second downside is that REITs are exposed a lot to mortgage rate variations and as such, since we all know where the rates are at right now I guess they can only go up When? Who knows How fast? Who knows But this could potentially affect their capacity of paying rising or high dividends. But, Keith Park from DivHut.com, one of my fellow bloggers, has written a great post on that question recently and his conclusions are very interesting. The comments from the visitors are as interesting as his post. I suggest you go read that.

If youd like to learn more on the subject, I suggest you visit this website. REIT.com or you could also buy the following book which is, to my own belief, the best book about dividend growth investing. Its probably one of the best investments youll make in your life :