SPECIAL REPORT. The REIT Stuff INVESTING IN. REITs

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1 SPECIAL REPORT The REIT Stuff How to Get Started INVESTING IN REITs

2 Areal estate investment trust (REIT) is a company that owns or finances incomeproducing real estate. REITs provide investors with regular income streams and long-term capital gains. REITs have been part of the American landscape for well over a century, however it was not until 1960 that President Dwight D. Eisenhower signed into law the REIT tax provision contained in the Cigar Tax Excise Tax. This legislation changed the dynamics of the real estate industry and created a new approach to real estate investing. The new REIT legislation served as a vehicle to allow both equity and real estate investors to invest in large-scale, income-producing real estate through the purchase and sale of liquid real estate equities. Prior to the REIT law, access to the investment returns of commercial real estate equity, as a core asset, was available only to institutions and wealthy individuals having the financial wherewithal to undertake direct real estate investment. Thanks to the 55 year-old REIT legislation, investing in a diversified pool of real estate is as easy as buying shares of stock. By owning shares in a modest, but growing REIT, investors win two ways (if the dividends grow while you own a REIT): First, the higher payouts increase yield and, second, the dividend increase usually drives the share price higher. To find the REITs with the best dividend growth prospects, you must pinpoint those with the fastest expected funds from operations (FFO) growth. Because property owners must deduct non-cash depreciation expenses when calculating earnings, even if the property is, in fact, appreciating in value, reported income is unrealistically reduced by those charges and doesn t measure the actual cash flow generated by the properties. For that reason, the REIT trade association created a measure called funds from operations, which reflect the actual cash profits generated by a REIT s operations. As I said, depreciation is a non-cash charge therefore, you must add back the depreciation charge to net income in order to produce funds from operations. The concept is that depreciation unfairly reduces net income because a building doesn t necessarily lose value and by adding it back it fixes the distortion. (FFO also includes a few other adjustments, too.) The most important element is that FFO gets closer to cash flow than net income, but it s not precise. A more accurate analysis would incorporate capital expenditures. While there s no universal method to arrive at this more precise pure cash flow metric, most analysts and investors incorporate the adjusted funds from operations (AFFO) formula. That is generally equal to FFO with adjustments for recurring capital expenditures, straight-lining of rent, leasing costs, and other material factors. Regardless of how industry professionals choose to compute AFFO, it is considered a more accurate measure of residual cash flow for shareholders than simple FFO. This provides for a more accurate base number when estimating present values and a better predictor of the REIT's future ability to pay dividends. 2

3 How To Buy REITs Publicly traded real estate investment trusts trade just like stocks. For example, Essex Realty trades on the New York Stock Exchange under the ticker symbol ESS. There is no minimum investment for most REITs, although you may need to buy shares in even blocks of 10 or 100. REITs can be purchased through a securities dealer, including discount brokers. Usually you can purchase the common stock, preferred stock or debt security of a publicly traded REIT. Types of REITs The two main types of REITs are equity REITs and mortgage REITs. Equity REITs constitute the majority of today s REIT market. Equity REITs mostly own and operate income-producing real estate such as shopping centers, hotels, apartments, health care facilities and office buildings. In addition, there are a number of new categories that have been ruled real estate by the IRS, including cell towers, transmission lines, prisons, data storage, and even document storage (i.e. Iron Mountain). The majority of equity REIT revenue comes from their properties rent. Stock exchange-listed equity REITs account for around 70% of all U.S.-listed REIT assets, and 90% of the approximately $800 billion equity market capitalization of the listed REIT marketplace is represented by equity REITs. There are approximately 150 exchange-listed equity REITs, almost all of which are traded on the New York Stock Exchange. Listed equity REITs own more than $1 trillion of real estate assets in the U.S., including more than 40,000 properties in all 50 states and the District of Columbia. The assets of equity REITs account for an estimated 15% of total U.S. commercial real estate assets, and equity REITs directly or indirectly support some 1 million U.S jobs. Mortgage REITs deal in the investment and ownership of commercial and residential property mortgages. They earn their profit from the difference between the income they receive and their costs, including their funding costs to purchase mortgage investments. They have the same requirement as equity REITs to distribute the bulk of their income to their shareholders annually. There are around 40 mortgage REITs that have $40 billion of REIT capitalization. The U.S. was the pioneer of the securitized real estate sector but now close to 30 countries have adopted REIT-like laws. How to Value REITs It's important not to use P/E for REITs, or to compare a P/E for a REIT with the P/E of a non-reit stock. As noted above, FFO is a standardized metric, though not GAAP; AFFO is not standardized, and equity analysts have different ways of constructing it. Both of them are better than using earnings for valuing REITs. By utilizing price to FFO (P/FFO) valuation, analysts and investors can determine the trading history of each REIT by itself and relative to the entire REIT sector. Accordingly, payout ratios are based on adjusted funds from operations because it more accurately measures cash flow when compared to net income (due to depreciation), and given the contractual nature of lease payments today, earnings growth rates are higher than the S&P. 3

4 When evaluating REITs, you get a much better picture of the company by looking at FFO or AFFO rather than looking at net income. If you are seriously considering the investment, try to calculate adjusted funds from operations, which deducts the likely expenditures necessary to maintain the real estate portfolio. Also AFFO is a good measure of the REIT's dividend-paying capacity. Finally, the P/FFO and P/AFFO metrics are great tools for analyzing a REIT: look for a reasonable multiples combined with good prospects for growth in the underlying AFFO. What About Net Asset Value? Examining a potential investment based on its underlying valuation is a critical element for determining whether or not the subject security promises safety of principal and satisfactory return. It's that distinction between investment and speculation that lies at the heart of Benjamin Graham's investment philosophy and its primary impetus behind his development and promotion of the "margin of safety" principle. As Graham suggested, the value investor's purpose is to capitalize upon "a favorable difference between price on the one hand and indicated or appraised value on the other." That's why the margin of safety is the essence of value investing because it's the metric by which hazardous speculations are segregated from bona fide investment opportunities. As I explained above, I generally analyze a REIT security based upon historical earnings (or funds from operations) and dividend performance. For me, price-to-funds from operations is a relative valuation metric because it provides a clear picture of where the company has been, where it is now and where it's headed in the future. However, the other widely accepted REIT valuation metric is net asset value (NAV) an analysis of underlying real estate designed to asses valuation of any REIT relative to its sector-level peers. It's much more difficult for an investor or analyst to determine with accuracy the valuation of a company, since there are many variables involved. I typically don't focus on NAV-based pricing, since my preference is to focus on earnings trends. In addition, REITs are rarely liquidated, so the use of the NAV model is less meaningful for the average retail investor. Occasionally, I will refer to analyst s NAV estimates to provide me with a good benchmark, and occasionally I will provide my subscribers with more granular research if it s meaningful. The Primary Differentiator is Dividends Benjamin Graham, the legendary investor and author of The Intelligent Investor, was certainly intrigued by the notion that a defensive investor must confine himself to the shares of important companies with a long record of profitable operations and he believed that the most persuasive tests of high quality is an uninterrupted record of dividend payments going back over many years." As evidenced by Graham s fascination with dividend investing, he wrote the following: Paying out a dividend does not guarantee great results, but it does improve the return of the typical stock by yanking at least some cash out of the manager s hands before they squander it or squirrel it away. Because REIT shareholders are legally entitled to 90% of the REIT s taxable income each year, the shareholders are allowed to participate in income reinvestment decisions. This more 4

5 disciplined approach in effect forces the REIT manager to payout substantially more income to investors and defend against squandering or squirreling it away. (Shareholders are responsible for paying taxes on the dividends and any capital gains they receive.) Although many academics claim that it shouldn t matter to shareholders how much of its net income a corporation pays out in dividends, many argue that dividends really do matter with respect to shareholders total returns. I am certain that Graham would have argued the point as he wrote (in The Intelligent Investor): One of the most persuasive tests of high-quality is an uninterrupted record of dividend payments going back over many years. To better understand the power of predictable dividend income, I reflect on the research of Harvard University Professor, Michael Jensen, who describes a free cash flow hypothesis, whereby a company with too much cash flow often results in internal insufficiency and waste of corporate resources, leading to added costs and burden on stockholder value creation. As Jensen wrote: Payouts to shareholders reduce the resources under managers' control, thereby reducing managers' power, and making it more likely they will incur the monitoring of the capital markets that occurs when the firm must obtain new capital. In other words, companies that payout a steady stream of dividends are forced to maintain discipline. Jensen's free cash flow hypothesis states that when a company has generated an excessive surplus of free cash flow and there are no profitable investment opportunities available, management tends to abuse the free cash flow in hand, which results in increased costs. Jensen makes the argument that dividend payments are the ultimate form of accounting transparency. He suggests that a low dividend tax rate lowers the effective tax rate on corporate earnings and that the low rate can influence managerial behaviors. Remembering that REITs must pay out at least 90% of taxable income by law so the REIT structure is in essence a much more disciplined vehicle and a primary reason that REITs have outperformed most other asset sectors over time Jensen went on to explain: Managers with substantial free cash flow can increase dividends or repurchase stock and thereby pay out current cash that would otherwise be invested in low-return projects or be wasted. Recently, Chinmoy Ghosh of UConn and Le Sun of Alliance Bernstein published an article in which they found that REITs that pay HIGHER dividends actually have LOWER cost of capital (both equity and debt) AND HIGHER growth. That's because capital providers know they're not likely to be wasting the capital. The academic experts explain: High dividends are associated with high growth in the REIT industry. Dividend payments have a significantly negative impact on the cost of equity and debt issued by REITs. Dividends serve a unique role in REITs because the mandatory high level of distribution limits the REIT managers' ability to build cash reserves. So, to support investment, REITs must raise capital from the market frequently, and at competitive rates. Dividend payment is effective in mitigating information asymmetry, and assuring suppliers of capital that management is not inclined to divert cash flow to enhance personal benefits. This reduces cost of capital and enhances growth. Brad Case, Ph.D., senior vice president of research at NAREIT, explains the value proposition that makes REITs a classic model of dividend discipline: Listed equity REITs have 5

6 returned 12% per year, on average, for nearly 43 years since we started collecting data in That's better than large-cap stocks, small-cap stocks, foreign stocks, bonds and commodities and every other asset class I know of. Why have they outperformed so consistently? I think a big part of the answer is that REITs don't waste their earnings they distribute earnings to shareholders, and then ask again for capital when they want to make investments. That's the REIT difference, and it has paid off for investors for a long, long time. What Are the Pitfalls? Last year REITs scored well with FTSE NAREIT s All-Equity REIT Index delivering 28% and through the end of January 2015 REITs have returned almost 6%. While Mr. Market maintains a high level of excitement for REITs, I would stay cautious and focus your efforts on valuation. One of the reasons that I commenced my newsletter, the Forbes Real Estate Investor, is to assist investors with finding a margin of safety in REIT stocks. While I do consider the overall U.S. real estate market to be healthy, it s important to seek the best bargains so that your hard earned capital can grow and prosper. I expect 2015 to be a solid year for REITs. However, it s critical to buy high-quality companies that have the best potential for long-term price appreciation. Also, stay away from sucker yields. This chase for yield in the stock market leads to the same thing that all such chasing leads to impulsively reacting to dividend quantity over dividend quality. A sucker-yield is based on quantifiable high yields, seemingly ridiculous, when the underlying security has a flawed or vulnerable business model. Companies that fall under the sucker-yield definition typically have unpredictable and unreliable earnings histories with unsafe dividend payouts. I always stress to investors that there can be a lot learned from a company s dividend history. For that reason, I spend a considerable amount of time researching and analyzing historical earnings. As a true measure of safety, it's critical that investors analyze the underlying safety of the dividend, the ability for the dividend to grow and the overall merit of the stock. It s also important to maintain adequate diversification. As much as I love REITs, I would never recommend that an investor put all of his or her eggs in one basket. Always maintain an adequate assortment of securities. I generally recommend between 10% to 20% depending on risk tolerance. How To Get Started? As I said earlier, REITs have been around more than 50 years so the idea of investing in this asset class is nothing new. In fact, it s time tested and that means that unlike some of the other high-yielding asset sectors, such as master limited partnerships and business development companies, REIT investors have more than five decades of data to rely on. Also, the U.S. real estate market is performing extremely well as evidenced by the improved operating fundamentals for most equity REITs. It s important to remember that rising occupancies, means rising rents. Accordingly, rising rents mean rising dividends. The best way to sum up my investment mantra is to help you sleep well at night. That s why I created a portfolio in my newsletter called the SWAN (acronym for sleep well at night). I look forward to helping you build a powerful portfolio of REIT dividends! 6