For income investors, Real Estate Investment Trusts (REITs) are a great vehicle to earn passive income. Why so?
The main reason is that REITs usually have high dividend yields. REITs are required by law to distribute at least 90% of their taxable income to shareholders in the form of dividends, making them an ideal choice for investors seeking regular income. For example, the iShares Core U.S. REIT ETF (USRT) has a current dividend yield of 3.5%. That’s more than double the S&P 500’s dividend yield.
Likewise, REITs tend to be less volatile than other types of investments and can offer stability and growth potential even during tough economic times. For example, investors looking for high yields have traditionally turned to sectors like utilities and telecoms. But with interest rates expected to rise in the coming years, these sectors could see their dividend yields decline. On the other hand, REITs are less sensitive to rising interest rates because they tend to have shorter-term leases with built-in rent increases.
So now it is apparent that REITs offer a high, predictable stream of passive income for investors, what are the most important factors you need to consider before you invest in any particular REIT?
Type of Industry
Not all REITs are made the equal. REITs generally fall into five broad categories: office, retail, residential, healthcare, and mortgage. Each industry has unique characteristics will alter the REIT’s growth, risk level, and performance.
For example, Boston Properties owns office buildings and receives rental income from tenants who have usually signed long-term leases. During a bull economy, many businesses do well, and demand for office space is high. This generates higher rents and higher property income for the REIT. However, during a recession, business segments fail, and companies go bust, which lowers the demand for office space and leads to lower property income for the REIT.
Equity Residential is a REIT that manage apartment complexes in major cities in United States such as Boston and New York City. Usually, the demand for their properties will depend on the inflow of people into New York and job availability in that area. A falling vacancy rate combined with rising rents signals this demand is increasing. To illustrate, at the height of the Covid pandemic, Equity Residential saw a decline in occupancy rate as more people moved out of New York.
Dividend Yield
The dividend yield is the first ratio most people look at when trying to find a good investment. While having a high dividend yield is great, it is also important to track other aspects of the company, such as its dividend track record. Growing dividends are not guaranteed, and REITs may reduce any time depending on their business performance.
A company’s dividend track record can give you an idea of how stable its dividends are. A REIT that’s able to steadily grow its income and dividend per share year after year is understandably a more attractive investment than a business with dividend payouts that fluctuate all the time.
A REIT with a higher dividend yield doesn’t necessarily mean it’s a better investment. For example, an office REIT usually has higher yields than other REITs. However, this doesn’t necessarily mean that it’s better. The reason is that the office sector is generally more volatile than other sectors. So, while the higher yield may look attractive, it comes with more risk.
Another thing to keep in mind is that a high dividend yield and a decline in stock price may also be a sign that the market is expecting the company to cut its dividends in the future. So, while a high yield may look attractive today, it could be significantly lower in the future if the company does indeed cut its dividends.
Property Yield
Property yield is the income a REIT can generate from a property. For example, if a property is worth 10 million dollars and earns $400K in rent yearly, the property yield would be 4%. Yields can vary greatly depending on the type of property and location. For instance, retail properties tend to have lower yields than office or industrial buildings due to their low risky nature and short leases.
One common way for a REIT to improve its property yield is to acquire yield-accretive properties. For example, if a REIT s property yield is 4% and it acquires a property with a 7%, the new portfolio yield will be 5%.
Another way to increase yields is through redeveloping or repositioning existing properties by making improvements to the property that make it more valuable or by changing its use. For example, a retail property could be converted into an apartment.
Gearing Ratio
A REIT’s gearing ratio is a key metric in determining the company’s financial health.
A high gearing ratio indicates that a REIT has a high debt relative to its total assets. This can be a cause for concern, as the REIT is more leveraged and at greater risk of defaulting on its debt obligations. However, a high gearing ratio is not necessarily bad, as it can also indicate that the REIT is well-positioned to grow its business.
Price to Book (P/B Ratio)
A REIT’s P/B ratio measures its share price against its net asset value (NAV) per share. Theoretically, a P/B ratio of 1 indicates a fair valuation. A higher percentage means the stock is overvalued, while a lower ratio indicates it is undervalued.
In practice, you shouldn’t simply rely on P/B alone to value a REIT. When evaluating a REIT’s P/B ratio, it is important to compare it to other similar companies in the same sector. This will give you a better idea of whether the stock is truly over or undervalued. Additionally, remember that the P/B ratio is just one metric to consider when making investment decisions. It should not be used in isolation but rather as part of a larger analysis.
Final Thoughts
REITs are a good investment for people looking for stable passive income. However, it is important to consider all aspects of the investment before making a decision. There are many factors to consider when investing in REITs, including the type of property, the location, the valuation and the financial stability of the company.