What it means
A real estate investment trust, or REIT, is a special tax status rather than a type of business. In exchange for holding mostly property, earning mostly rent and distributing the large majority of taxable income, the company avoids being taxed at corporate level, so profits are effectively taxed once in the shareholder's hands.
Equity REITs make their money as landlords. They buy offices, warehouses, shopping centres, flats, hotels, data centres or healthcare facilities, collect rent, manage the buildings and recycle capital by selling assets and buying better ones.
For investors, the appeal is liquidity and income. Property is normally slow and expensive to trade, but REIT shares can be bought and sold in seconds, and the distribution requirement means the dividend yield is usually well above that of the wider market.
The trade off is that share prices move with the stock market as well as the property market, so a REIT can fall sharply on a bad day even if its buildings are fully let. REITs are also sensitive to interest rates, because higher rates raise their borrowing costs and make the yield on their shares less attractive against bonds.
Accounting profit is a poor guide to a REIT's performance because depreciation charges are enormous while well maintained buildings often hold or gain value. The sector therefore reports funds from operations, which adds depreciation back to net income and strips out gains on property sales.
In practice
Real-world examples
Example 1
A pension scheme wants property exposure but cannot tie up money for years. It buys shares in three equity REITs covering logistics, healthcare and residential property, achieving diversification across sectors that would be impossible with direct purchases.
Example 2
A retail focused equity REIT sees occupancy fall from 96% to 88% as tenants fail. Rental income drops, funds from operations fall by a fifth, and the board cuts the dividend to stay within its distribution policy rather than borrowing to maintain it.
Example 3
An analyst compares two office REITs trading at similar dividend yields. One has debt at 30% of asset value on fixed rates for eight years, the other at 55% on floating rates, and she rates the first far more highly despite the identical yield.
Think of it
Equity REIT owns actual properties-buildings and land, not loans.
Formula
Calculation
Funds from operations (FFO) = net income + depreciation and amortisation on property - gains on property sales
A warehouse focused equity REIT reports net income of $30,000,000 for the year. It charged $45,000,000 of depreciation on its buildings and booked a $5,000,000 gain on selling an older estate. FFO = $30,000,000 + $45,000,000 - $5,000,000 = $70,000,000.
With 50,000,000 shares in issue, FFO per share is $70,000,000 / 50,000,000 = $1.40, against reported earnings per share of just $30,000,000 / 50,000,000 = $0.60. If the REIT pays a dividend of $1.19 per share, the payout represents $1.19 / $1.40 = 85% of FFO, a level the market would read as generous but sustainable. Separately, if the REIT bought a warehouse for $80,000,000 that produces net operating income of $5,600,000 a year, the capitalisation rate on that purchase is $5,600,000 / $80,000,000 = 7%.Case study
Seen in the real world
This is an illustrative and clearly fictional example. Longmoor Industrial Trust, an invented equity REIT, owned 120 distribution warehouses and had built a reputation for a steadily rising dividend covered comfortably by funds from operations. Around 80% of its debt was fixed for an average of seven years.
When market interest rates rose sharply, its share price fell 30% along with the rest of the sector, and nervous private investors sold. Underlying trading told a different story: occupancy stayed above 97%, rents on renewal were rising with inflation, and the fixed rate debt meant interest costs barely moved for three years.
Longmoor's fictional management used the period to buy two estates from a rival forced to sell, funded by an equity raise at a modest discount. By the time rates settled, funds from operations per share were higher than before the sell off, illustrating that a REIT's share price and its rental economics can move in opposite directions for years.
Watch out
Common mistakes
- Judging a REIT on earnings per share, when heavy property depreciation makes accounting profit a poor guide to what the buildings actually earn.
- Buying purely for a high dividend yield, which is often high precisely because the market expects the dividend to be cut.
- Assuming REIT shares behave like direct property, when they trade with the stock market day to day and can swing far more violently.
Questions
People also ask
What is the difference between an equity REIT and a mortgage REIT?
An equity REIT owns buildings and collects rent, while a mortgage REIT lends money against property and earns interest, which makes it far more sensitive to interest rate movements.
Why do REITs pay such large dividends?
Because keeping their tax status depends on distributing the large majority of taxable income, typically at least 90%, rather than retaining it.
How should the dividend be assessed for safety?
Compare it with funds from operations rather than net income, and treat a payout comfortably below 100% of FFO as the healthier position.