Commercial Properties REITs
Refers to an investment trust comprised of only commercial real estate.
What are Commercial Properties REITs?
REIT is an abbreviation for Real Estate Investment Trust. "Commercial Properties REIT" (CPR) essentially refers to an investment trust comprised of only commercial real estate.
It is a pool of funds from multiple entities invested in high-value commercial property.
These are like mutual funds, where the underlying asset is real estate and whose growth drivers are primarily rental yield and capital appreciation.
These are also traded in an open share market.
There are two main types:
- Equity
- Mortgage
As of the 2nd quarter of 2021, REITs have outperformed US stocks if we look at the last 10- and 20-year historic rolling data regarding both returns and volatility.
However, there is a caveat: the analysis undertook the collective value of all the REIT types (discussed later in this article). As a result, certain kinds of REITs have performed differently.
What qualifies as a REIT?
Not just any fund can qualify as a REIT. However, some general requirements are essential for a trust to be classified.
- Net Asset Value (NAV) must be declared twice every financial year.
- 90% of the income (primarily rental yield and capital appreciation) must be distributed to investors as dividends.
- A board of directors or trustees.
- Five or fewer individuals may hold no more than 50% of its shares.
- 80% of funds must be invested in properties capable of generating revenues.
- It would help if you were an entity that would be taxable as a corporation.
- At least 75% of revenues must be generated from passive channels, such as rent, interest, etc.
How Do Commercial Properties REITs Work?
Commercial REITs work in a somewhat similar way to mutual funds.
The commercial property REIT industry offers a diverse range of properties at diverse locations with various strategic advantages.
CPRs also provide liquidity, which can convert any investments in any CPR into cash in the short term.
CPRs expose their investors to real estate by putting bets on properties like offices, restaurants, shopping centers, condominiums, and hotels.
Primarily, these trusts profit from their investors through rental yield and capital appreciation property.
These typically have two general categories of growth:
- First, internal growth refers to the development of revenues through an existing asset base, such as by increasing rents.
- External growth can be attributed to the asset base of the REIT, which occurs when, for example, buying new real estate.
Because REITs have to pay the majority of revenue to shareholders, they usually fund through external sources, such as issuing new shares or raising debt.
Keeping this in mind, even though it's far easier for a REIT to offer shares and raise funds, an investor or analyst needs to ensure that the REIT is performing reasonably on a per-share basis.
How to Invest in Commercial Property REITs?
Let's understand this with the help of an example,
Let's say you have a spare $25 and want to grow it in the capital markets. So you give this money to a fund manager through the equity markets using a Demat account with an authorized broker.
Alternatively, you could invest an amount as low as $25 into real estate assets through REITs in a similar method as a mutual fund.
With a mutual fund, the money you invest is kept in the pool of funds by the fund manager. The fund manager will evaluate the best stocks and invest the collection of funds in those stocks.
Similarly, A REIT manager will look for the best property/properties (in the context of this article, commercial property) and invest the pool of funds into it.
Investors are not responsible for any legal or tax-related formality. Also, the maintenance, collection of rentals, and other responsibilities are not supposed to be taken care of by investors.
Hence, the procedure for investing in REITs is as transparent and straightforward as investing in the stock market.
What are the types?
There are several types of REITs:
- Office
- Timberland
- Retail
- Lodging
- Datacenter
- Healthcare
- Self-storage
- Infrastructure
- Diversified
- Specialty
- Residential
- Industrial
- Mortgage
However, the top CPRs invest in the following:
- Office buildings
- Hotels
- Industrial buildings
- Retail stores
- Specialty property
Assessing commercial Property REITs
Today, as an investor or analysts, we have multiple metrics and formulas to evaluate a company's stock. Similarly, the following are some essential and popular metrics to assess a REIT.
1. FFO
This is the primary metric used to assess.
FFO stands for Funds from Operations, and it is an important metric when it comes to evaluating real estate companies. It indicates the net income or loss the firm makes from its operations.
The formula for FFO:
Funds From Operations = Net Income + Depreciation and Amortization + Losses on Property Sales - Gains on Property Sales - Interest Income.
To better understand this metric, refer to the hyperlink and check out Page 57-59 in this 10-K filing from Tanger Outlets (one of the REITs Warren Buffet invested in).
2. Credit Rating
Below is the screenshot of Store Capital, another company in which Warren Buffet is invested. To find the credit rating of any company, log into Moody's website and search.
Source: Moody's.com
A credit rating essentially represents the ability of an entity to pay off a loan on time. It is used when deciding whether an entity should get a loan and at what interest rate.
A company with a high credit rating can take out debt swiftly and at a low-interest rate, allowing for business expansions whenever required. That is why it is a notable metric to assess any REIT.
3. Adjusted EBITDA, EBITDAre, Adjusted EBITDAre
EBITDA stands for Earning before Interest, Taxes, Depreciation, and Amortization. EBITDAre and adjusted EBITDAre are the modified versions of the EBITDA metric.
EBITDAre stands for Earnings Before Interest, Taxes, Depreciation, and Amortization for real estate.
The two metrics suit the evaluation methods applied to REITs and the real estate industry.
For a better understanding of these metrics, please refer to the hyperlink and check out Page 62-63 in this 10-K filing from Tanger Outlets
Commercial Property REITs Advantages and Disadvantages
Some of the advantages and disadvantages are listed below. These factors should all be considered when investing in one of these trusts.
Advantages are:
- They provide a convenient and affordable way for individuals to make real estate investments.
- They provide an easy exit for investors, i.e., they are liquid assets.
- The system to invest in them is transparent and easy to use.
- They have a comparatively higher rate of return; as stated above, REITs are legally bound to distribute 90% of profits to shareholders.
- Investors do not have to deal with the general management of properties, legal issues, taxation, and other formalities.
- They provide exposure to properties of different natures, locations, etc.
Disadvantages are:
- They are highly dependent on the economy. For example, recently, because of COVID-19, when the world went to work from home, the value of some commercial REITs plummeted.
- They are somewhat dependent on the infrastructure policies of the owned real estate nations.
- The dividend taxation levied on unitholders/investors is comparatively higher than the average investment vehicle available in the market.
- The fund manager's commission is also higher than the average investment vehicle available in the market.
- Its dependency on the economy makes it difficult for management to control market performance. Many publicly-listed companies aren't nearly as exposed to economic downturns.
Commercial Properties vs. Residential Properties
Let's understand the difference by taking a look at the table below:
| Metric | Commercial Properties | Residential Properties |
|---|---|---|
| Returns | These properties generate higher returns in comparison to residential properties. | These properties generate lower returns |
| Acquiring Cost | Higher cost of acquiring | Lower cost of acquiring comparatively |
| Rental Income | It generates a higher rental income. | It generates a lower rental income comparatively. |
| Leasing Terms | More flexible, usually standardized | Less flexible, usually non-variable |
| Examples | Office buildings, shopping centers, warehouses, etc | Condominiums, multi-family homes, etc. |
Commercial REITs vs. Direct Investment in commercial real estate
Some of the notable differences are:
| Metric | Direct Investment | Commercial REITs |
|---|---|---|
| Returns | Higher | Lower comparatively |
| Safety | Less safety in terms of return and market risks | More safety in terms of return and market risks |
| Scope of Diversify | Less scope of diversification for investors | High scope of diversification for investors |
| Investment Entry Amount | Usually highest in comparison to all investment vehicles available | Very Low |
| Value Fluctuations | Less, as it is a real asset that has real intrinsic value | Higher |
| Control | Control over market fluctuation and performance is higher | Control over market fluctuation and performance is lower |
| Liquidity | Less flexibility in terms of exit | More flexibility in terms of exit |
| Responsibilities and Liabilities | A lot of legal, tax-related, and maintenance liabilities | No liabilities in comparison to direct investment |
| Tax Benefits | No notable tax benefits | Reasonable tax benefits are available |
| Example | Buying an office in New York | Buying a unit of the Tanger Outlet REIT |
Difference Between REITs and Real Estate Mutual Funds
The differences are:
| Metric | Real Estate Mutual Funds | Commercial REITs |
|---|---|---|
| Diversification | Better diversification than REITs based on investment strategy | Less diversification comparatively |
| Dividend | Lower dividend comparatively | Higher dividend every year to shareholders |
| Inflation | Lower returns comparatively | Better returns when property prices rise |
| Liquidity | Similar liquidity | Similar liquidity |
| Management | Experts and professionals manage the portfolio | Usually self-managed until some professional is hired/appointed |
| Example | HDFC Realty, Piramal Real Estate, etc. | Tanger Outlet REIT, Store Capital, etc. |
Commercial Property REITs FAQs
90% of the income (primarily rental yield + capital appreciation) must be distributed to investors as dividends to qualify as a REIT.
REITs make profits primarily through the property's rental yield and capital appreciation.
Investing in REITs is similar to how we invest in the stock of a company listed on NASDAQ. It can be bought/sold through a Demat account in an open security market.
FFO, funds from operations, credit ratings, EBITDA, EBITDAre, NAV, etc.
Rental yield is the percentage of the property value received over a year through rental income from the property.
Some primary advantages are:
- Liquidity provides an easy exit
- Low ticket price, investment can be as low as $25
- Diversification, investors can put their money into different types of properties for different kinds of locations
- No responsibilities for unitholders regarding legal formalities, taxation, and maintenance for
- Tax benefits
EBITDA stands for Earnings Before Interest, Tax, Depreciation, and Amortization. It is essentially an indicator of a company's overall financial performance.
NAV stands for Net Asset Value. It is calculated by adding what a REIT owns and subtracting what it owes.
The formula is:
EBITDA = Net Income + Taxes + Interest Expense + Depreciation and Amortization
Or, EBITDA = Operating Income + Depreciation & Amortization
The formula is:
NAV = [(Assets - Liabilities)/ Total Number of Outstanding Shares]
Capital Appreciation refers to an increase in an asset's market price value. The formula for capital appreciation is as follows:
Capital appreciation = Selling Price of Asset - Purchase Price of Asset.
Credit rating essentially refers to an entity's score; it denotes the entity's credibility to procure a loan and at what possible interest rate. The higher the score, the higher the likelihood of repaying the debt, and the lower the interest rate
FFO stands for Funds From Operations. This metric is frequently used when assessing REITs.
The formula is:
FFO = [(Net Income + Depreciation + Amortization + Losses on Sale of Property) - (Gains on Sale of Property - Interest Income)]
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