Real estate sector and REITs: how they work and what to watch

The real estate sector is made up mostly of real estate investment trusts, or REITs: companies that own, and usually operate, income-producing property such as apartments, warehouses, offices, shopping centers and data centers. A REIT collects rent and passes most of its taxable income to shareholders as dividends. Because depreciation distorts reported earnings for property owners, the usual profit metrics need adjusting before they tell you much.

What is in the sector

Real estate became its own sector in the Global Industry Classification Standard in 2016, after being part of financials (see GICS sectors explained). It has two groups: equity REITs, which own property, and real estate management and development companies, such as brokerages and developers. Mortgage REITs, which hold mortgage loans instead of buildings, are classified within financials rather than real estate.

Equity REITs are usually grouped by property type:

Each type has different lease lengths, customers and economic sensitivity. Apartment leases are short and reset quickly, while an office or industrial lease might run for many years.

How a REIT works

To qualify as a REIT in the United States, a company must follow rules such as holding most of its assets in real estate and earning most of its income from property. It must also distribute at least 90% of its taxable income to shareholders each year. In return, the REIT generally pays little or no corporate income tax on the income it distributes. Since so much cash leaves as dividends, REITs often rely on borrowing and issuing new shares to buy more property, which makes their financing costs and share price important to growth.

Why earnings per share falls short

Accounting rules make a company depreciate buildings every year even though well-maintained property often holds its value or rises. That non-cash charge cuts net income. So REITs commonly report funds from operations (FFO):

FFO  =  net income  +  real estate depreciation and amortization
        -  gains on property sales  (+ impairment charges)

Adjusted funds from operations (AFFO) goes further by subtracting recurring spending needed to keep the properties competitive, such as leasing costs and maintenance capital, and sometimes making other adjustments. Unlike FFO, there is no single standard definition of AFFO, so two companies' figures may not be comparable. See depreciation and amortization for why this charge matters.

Example (illustrative numbers)

A REIT reports net income of $40 million, real estate depreciation of $60 million and a gain of $10 million from selling a building. FFO is $40 million + $60 million - $10 million = $90 million. If recurring maintenance and leasing spending is $20 million, a simple AFFO is $70 million. With 100 million shares, AFFO per share is $0.70. If the REIT pays $0.56 per share in dividends, the payout against AFFO is $0.56 / $0.70 = 80%.

That 80% looks very different from the payout against net income per share, which would be $0.56 / $0.40 = 140%. That is why payout ratio for a REIT should be measured against AFFO, not earnings per share.

What to watch

Occupancy and leasing. The share of space that is rented, the rent on new and renewed leases compared with expiring ones, and when large leases expire.

Same-property growth. Net operating income (rent minus property operating costs) from properties owned in both periods strips out the effect of buying or selling. It shows underlying performance.

Tenant quality and concentration. A few large tenants, or tenants in a struggling industry, raise risk.

Debt and maturities. Most REITs borrow heavily. Look at net debt to EBITDA (REITs often report a version adjusted for real estate), the share of debt at fixed rates, and when debt must be refinanced.

Interest rates. Higher rates raise borrowing costs and can lower what buyers will pay for property, shown in the capitalization rate, which is net operating income divided by property value. Falling property values can then pressure the share price. Interest rates and the Fed covers the backdrop. REIT shares are also compared with bonds by income-seeking investors, so yields on safer assets matter.

Asset value. Some investors compare a REIT's share price with the estimated value of its properties, often called net asset value. That estimate depends on cap rate assumptions and is sensitive to small changes.

Valuation basics

The standard multiples are price to FFO and price to AFFO, along with dividend yield. Rules of thumb: compare REITs within the same property type, because a warehouse owner and an office owner face different growth and risk, and compare against the company's own history. A low multiple may reflect weak prospects, not a bargain.

Common mistakes

• Using P/E and earnings per share. Depreciation makes both misleading for REITs.
• Chasing yield. A high yield can signal trouble in the property type, the tenants or the balance sheet.
• Ignoring debt. Leverage works in good years and hurts in bad ones.
• Forgetting the tax treatment. REIT dividends are often taxed differently from qualified dividends. Rules change, so check current rules or ask a tax professional.
• Mixing property types. Data centers, hotels and apartments have little in common.

Where to see it on StocksXray

You can browse the group on the Real Estate sector page. StocksXray ranks metrics within the sector, so a REIT is compared with other real estate companies, but remember that generic measures such as earnings per share can understate a REIT's cash earnings. Use the company's reported FFO and AFFO in its filings alongside the scores.

Key takeaways

• Most real estate stocks are REITs that collect rent and must distribute at least 90% of taxable income.
• Depreciation depresses net income, so FFO and AFFO are the standard profit measures.
• AFFO has no single definition, so check how each company defines it.
• Occupancy, lease expirations, same-property growth and debt maturities drive the story.
• Interest rates affect both borrowing costs and property values.