Most people associate the words "real estate" with lost weekends filled with sandpaper, paint, drills, and perhaps a few expletives. Or, worse yet, they associate real estate with mortgages.
While real estate can be a hassle in our lives, real estate securities can be important tools in our investment portfolios.
This lesson will examine the different types of real estate securities, how and why they perform the way they do, and how you might use these investments in your portfolio.
Types of real estate securities
You can invest in real estate securities via real estate stocks directly or through funds that specialise in real estate securities.
The most common type of real estate stock is a real estate investment trust, or REIT. A REIT owns a collection of properties. Its primary source of revenue is from leases. That's different from a typical stock, which generates its revenues by selling goods or services. And unlike other stocks, REITs are required to pay almost all of their revenues to shareholders in the form of dividends.
Then, there are real estate operating companies (REOCs). Unlike REITs, these securities aren't required to pay out dividends from their revenues. Instead, they can reinvest them to expand the business. They therefore offer more growth potential than REITs.
Funds that specialise in real estate securities generally invest in REITs, though some also invest in REOCs.
How real estate securities behave
REITs and REOCs, like most companies, ultimately depend on the strength of the economy for their success. But because their revenues spring from different sources, the stocks of real estate companies can move counter to the broader stock market. Thus, the returns of real estate stocks haven't behaved much like leading indices and because shareholders receive their dividends whether the REIT's stock price goes up or down, REITs are often seen to be safe havens. But there is no guarantee that REITs will never take a breather. As many will know only too well, they got slammed in 2007 and 2008 as the financial crisis took hold, putting an end to their torrid multiyear run. However, just because REITs go through up and down periods doesn't mean they can't serve as good diversifiers in a portfolio over the long term.
Finally, financial pros often refer to real estate securities as inflation hedges. That's because during periods of inflation, investors have historically flocked to tangible assets, including real estate.
Evaluating REITs: ROEs out, FFOs in
Evaluating real estate companies really is a whole different ball game compared to evaluating equities. For example, don't rely on returns on capital for much information: Almost all property companies earn pitifully low returns on capital.
The way earnings are calculated for real estate companies holds down returns on capital, too. Crack open the annual report of a property company and you'll find FFO, or funds from operations. Technically, FFO is net income excluding gains or losses from debt restructuring, sales of property, or extraordinary items, plus real estate depreciation and amortisation, and after adjustments for minority interests and income from nonconsolidated joint ventures.
Real estate companies place a lot of emphasis on this FFO--which is really another form of cash flow--and de-emphasise earnings. And for good reason.
The net earnings of real estate companies jump around a lot because of debt restructurings and property sales. That makes it tough for investors to unearth the underlying trends in corporate growth. Plus, depreciation of real estate assets is a large component of the reported costs of property companies, but that's a noncash charge that may not have much relation with the real deterioration of a company's properties. By examining FFO, you can better judge underlying trends and more accurately make comparisons across companies.
Two caveats, though. First, focus on FFO on a per-share basis. REITs tend to issue a lot of stock to fund their expansion, so raw numbers--whether sales, net income, or FFO--can make a firm's growth appear misleadingly rapid. Second, depreciation may be a noncash charge, but it does represent a real erosion of assets. Apartments and shopping centres become run down over time, so focusing exclusively on FFO ignores a very real cost. Don't ignore noncash charges.
So return on capital and earnings are out; FFO is in.
Other measures
What else do investors need to think about when analysing real estate stocks? Property markets go through their ups and downs like the rest of the economy, and different companies have widely varying exposure to this cyclicality. Get a handle on this exposure by focusing on the following:
Financial leverage: Property companies need the financial muscle to withstand slumps, so favour those with balance sheets that are low on debt and high on equity.
Geographical spread: The less spread out a real estate company's portfolio, the more exposed it is to weakness in the local economy or the local property market.
Type of property: Different types of property carry inherently different levels of risk. Companies that own apartments would see occupancy rates drop in a slump, but probably not enough to cause any serious damage to long-term health. Shopping-centre operators are more vulnerable: Should shoppers cut back on their visits, the profits of the owners could fall dramatically.
Aggressiveness of spending: Real estate companies spend large sums to add to their portfolios. In many cases free cash flow (the amount of cash flow left over after capital spending) is sharply negative. When conditions in the property market worsen, the aggressive spenders find themselves in the most trouble.
Management matters: At Morningstar, we've found that REIT managers can boost the overall value of their firms through a variety of mechanisms. For example, REITs can focus on boosting earnings from their existing portfolios or increasing their portfolios externally, often through "capital recycling." This can be accomplished by purchasing undervalued properties that can be developed or redeveloped into a higher-productivity asset. REITs can also boost value by expanding into property asset management, usually through joint ventures, with the REIT pocketing a stream of high-margin fees, with little capital requirements, to manage the assets. A final way that REITs can add value for shareholders is to retain earnings and reinvest the funds at above-average returns. Just as investors can look at the track records of fund managers to gauge their investment success, so too can REIT investors consider managers' track records at investing in good, high-return projects.
How to evaluate real estate funds
If you'd rather let a professional money manager manoeuvre the real estate market for you, go with a real estate fund.
Here, you want to examine a few things. Begin with the types of properties the fund owns. Some funds will focus on REITs that favour office properties, others on hotels, still others on retail and shopping centres. Find out which types of real estate stocks a fund owns and you'll get a feel for how vulnerable the fund will be in different economic scenarios.
Then, try to determine how aggressive the fund's REITs are. What's true in the bond market is often true in real estate: The higher a REIT's yield, the more aggressive the company.
Finally, find out whether the fund owns REOCs in addition to REITs. Remember, REOCs don't pay out dividends from their revenues. They therefore offer more growth potential than REITs--and more volatility, too. After all, there's no dividend buffer for a REOC to fall back on.
How to use real estate securities in your portfolio
Even though these securities may help diversify your portfolio, they're by no means low-volatility options and probably should take up no more than 5% or 10% of your portfolio.
So, who might consider these investments? Income seekers, for starters. If you're mostly looking for a steady dividend to supplement your income, REITs and real estate funds offer healthy yields. (Because of their dividends, however, neither REITs nor real estate funds are good investments for taxable accounts.)
Diversifiers may be drawn to real estate securities, too. REITs provide diversification away from stocks, particularly those in growth-oriented sectors.
If you have a portfolio that includes funds, you may already have some exposure to real estate securities. REITs appear in many value funds, in particular. To find out how much real estate exposure you have, examine your portfolio using an online tool such as Morningstar’s Instant X-Ray. Check your portfolio's weighting in financials, the sector into which REITs fall. If you find that you have a substantial position in financials, investigate further. Check your funds' shareholder reports to find out if these financials are, in fact, real estate stocks. Or look for the information on the fund family's website.
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