What it means
The structure exists to solve a simple problem: property is a good income asset but a terrible one to buy in small pieces. A REIT pools investors' money, buys shopping centres, warehouses, flats, offices or data centres, collects the rent and passes the bulk of it through.
To qualify, a REIT must hold most of its assets in property, earn most of its income from rent, and distribute at least 90% of its taxable income each year. REITs come in flavours worth distinguishing.
Equity REITs own buildings and collect rent; mortgage REITs lend against property and earn interest instead, which makes them behave far more like bond funds and far more sensitive to interest rate movements. Most of the market by value is made up of equity REITs.
Ordinary earnings per share is a poor measure for a REIT, because accounting depreciation assumes buildings steadily lose value while well maintained property often does the opposite. Analysts therefore use funds from operations, which adds depreciation back to net income and strips out one-off gains on property sales.
The mandatory payout is a double-edged feature. It gives investors a reliable income stream, but it also means a REIT retains almost no cash, so growth has to be funded by issuing new shares or taking on debt.
That reliance on capital markets makes REIT share prices unusually sensitive to interest rates. Managers outside the property world meet REITs most often as landlords.
If your office, warehouse or shop is owned by one, its need for predictable distributable income shapes how it negotiates rent reviews, lease lengths and tenant incentives.
In practice
Real-world examples.
Example
A pension fund wants property exposure without the cost of managing buildings, so it buys shares in three listed REITs covering logistics, healthcare and residential assets. It gains diversified rental income and can sell the position in a day, which would be impossible with a directly owned office block.
Example
A retail chain sells the 40 stores it owns to a REIT for $310,000,000 and leases them back on 15 year terms. The chain converts property equity into cash for expansion while the REIT gains a long, predictable income stream from a single tenant.
Example
An income-focused investor compares two REITs with the same dividend yield and finds one pays 90% of FFO while the other pays 118%. The second is funding its dividend from asset sales and borrowing, which signals that a cut may be coming.
Think of it
“REIT is a real estate company that avoids corporate taxes by paying out most income.
Formula
Calculation
Funds from operations (FFO) = net income + real estate depreciation - gains on property sales
Price to FFO = share price / FFO per share
A listed industrial REIT reports net income of $40,000,000, property depreciation of $55,000,000, and a $12,000,000 gain from selling a warehouse. FFO = $40,000,000 + $55,000,000 - $12,000,000 = $83,000,000.
The REIT has 41,500,000 shares in issue, so FFO per share = $83,000,000 / 41,500,000 = $2.00. With the shares trading at $24, the price to FFO multiple is $24 / $2.00 = 12 times. The declared dividend of $1.80 per share costs 41,500,000 x $1.80 = $74,700,000 and represents $1.80 / $2.00 = 90% of FFO, comfortably meeting the distribution requirement while leaving a small cushion.Case study
Seen in the real world.
The following is an illustrative and entirely fictional scenario. Cobblestone Yards REIT, an invented owner of suburban retail parks, reported growing earnings per share for four straight years and its board pointed to the record as evidence of a strong business.
An illustrative analyst looked instead at funds from operations and found the picture reversed. Rental income had been flat, and the earnings growth came almost entirely from gains on selling three sites, which FFO strips out. Once those gains were removed, FFO per share had fallen from $2.20 to $1.85 while the dividend had risen to $1.95.
Cobblestone Yards was paying out more than it generated and funding the gap by selling the very assets that produced its rent. In this fictional account the board cut the dividend to $1.55 the following year and redirected the difference into refurbishing its remaining parks.
Watch out
Common mistakes.
- Judging a REIT on earnings per share rather than funds from operations, which makes depreciation-heavy property companies look far less profitable than they are.
- Assuming a high dividend yield always signals a good investment, when it often reflects a share price that has fallen because the market doubts the payout is sustainable.
- Treating mortgage REITs and equity REITs as one category, despite the fact that one owns buildings and the other owns loans.
Questions
People also ask.
Are REIT dividends tax free?
No, the REIT avoids tax at company level but shareholders normally pay income tax on the distributions they receive.
Why do REIT share prices fall when interest rates rise?
Higher rates raise borrowing costs and make bond income more competitive with rental income, so buyers pay less for the same dividend stream.
Can a REIT keep any of its profit?
Yes, it can retain the portion above the required distribution and any capital gains it chooses to reinvest, though the retained amount is usually small.
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