There is one pocket of the public equity markets that is a little different from the rest: the REITs. Short for “real estate investment trust,” REITs are popular for a few reasons amongst investors in good times, but they fall steeply in troubled times and have been hit rather hard in 2015 with fears that rising interest rates will hurt the sector.
What is a REIT
To understand what a REIT is, we should first think about the classic mutual fund. Mutual funds were first designed to fund large enterprises—many investors would pool together their cash and that pooled cash would go towards a particular venture. In the 17th century that meant a ship would sail to the new world looking for wealth; in the 21st century that could mean buying shares in a sector of the U.S. equity markets. The idea is that a bunch of people bring their cash together to make an investment that would be impossible to do on a smaller scale.
REITs are no different, except they are limited to real estate. The idea with a REIT is that many investors will entrust their capital to a firm that will use that capital to invest in money-making real estate opportunities.
Because real estate is an alternative market to equity markets, buying REITs can be a way to diversify away from equities and debt. It is also an opportunity to provide income; most REITs are required to return most of their income in the form of dividends to shareholders. There are complex tax implications to this structure, but for an analyst seeking a strong return and an income stream, the sector has value.
Classic Public REITs
To understand what REITs offer, let’s take a look at three classic examples: Realty Income Corp (O), Omega Healthcare Investors Inc (OHI), and Ventas, Inc. (VTR). These three REITs have been around for over a decade, and have provided a consistent positive return for most of that time:
The capital gains are nice, but most REIT holders are interested in the income these companies provide. O and VTR pay about 5% in dividends and OHI pays over 6% at current prices—and each of the three companies have history of dividend increases. For dividend growth investors, these REITs have been an addition to classic dividend aristocrats like Proctor and Gamble (PG) and AT&T (T).
Downsides and the REIT Purpose
There are risks, of course. The fall in 2008 is obvious; the fall in 2013 and again now is also distressing—and both are for the same reason (a fear of rising interest rates cutting into demand for these names). None of these names are at all-time highs, and only one (O) has outperformed the S&P 500 over the last 20 years.
This tells us that the purpose of a REIT is complex. It provides exposure to real estate, it provides income, and it provides exposure to some of the things that impact bonds. At the same time, it is not a “flight to safety” asset, so it can go down with stocks as well. Determining where it fights into a profile is somewhat complicated. Additionally, the metrics that are used to value REITs are very different from the metrics used for equities (things like EPS and P/E ratio are worthless here—funds from operation, or FFO, is key).
There is a learning curve with REITs, but when they are learned an analyst can provide an additional dimension to his or her stock picks and approach to the market, providing one more important tool in the toolbox for delivering alpha.