A real estate investment trust, or REIT, is a security that trades like a stock on the major exchanges and invests in real estate directly. Typical REITs might include a group of apartment buildings, hotels, commercial real estate, or timber holdings.
REITs receive special tax treatment and typically offer investors high yields, as well as a highly liquid (easily traded) method of investing in real estate. REITs have performed exceptionally well during the last several years. They have provided above-average yields in a historically low-interest-rate environment.
Investors have noticed the outstanding performance of REITs. In their quest for income, they have poured large amounts of cash into the REIT sector, prompting a continual increase in the overall stock price of these securities.
BWFA invests in REITs on behalf of many of its clients, but we are wary about the rising price of REITs, as well as a rush towards REIT conversions by non-traditional companies.
Wanting a piece of the action, many companies are considering a conversion to a REIT structure. These include companies that seem to be far from the real estate sector: data warehouses, private prisons, car dealerships, and healthcare facilities.
There are various criteria that must be satisfied in order to convert to a REIT, two of the main criteria being: a REIT must derive 75% of its revenue from rents and other direct real-estate activities, and it must pay out at least 90% of its profits to shareholders as dividends. In return, those profits are not taxed at the REIT-company level.
The 90% payout requirement is the reason why REIT securities are so attractive to investors seeking dividend income. Yet this same 90% payout requirement is precisely what can put a REIT into risky circumstances.
Because REITs cannot stockpile profits for the lean times, they are vulnerable to financial strain when their businesses or the larger economy hits a bump in the road. At those times, a REIT might have difficulty funding current operations.
In some cases, a REIT may have to borrow money in order to fund dividend distributions to shareholders.
In other cases, a REIT might need to sell additional equity or take on additional debt to meet capital needs.
In the short run, additional debt can represent great opportunity for the company, if it has good uses for the investment. But if the costs of borrowing start to overwhelm cash flow, the effects can be catastrophic for the REIT and its investors.
In other words, although a REIT conversion might be beneficial for a stock’s price in the short run, if it’s done for the wrong underlying reasons, it could backfire.
Our job is to diligently and thoroughly analyze these REIT conversions, while placing primary emphasis on the fundamental strength of company balance sheets, current and projected earnings, and cash flow data — making sure the right REIT securities are in your portfolio.