The financial positions of REITs are generally very straightforward. They have the assets that are being rented out the tenants, they have an occupancy rate, they have the debt and equity load that is being used to the support the asset itself, and then they will have a small pocket of additional costs that will be supporting the company’s overall operations. Because of this simplicity, it can be somewhat difficult for investors to evaluate the opportunities associated with the company itself.
Specifically, investors need to be able to take a look at the qualitative aspects surrounding the investment opportunity to make their decisions in this sector. Aspects such as managerial expertise, asset quality, and tenant quality are all integral to determining the ability of the company to continue churning out distributions, and keeping its asset base well maintained. The trick is to then be able to look at a company’s financial statements and managerial discussions to gain some insights about these aspects, and therefore gain an informational advantage.
An easy way to start evaluating the quality of the assets under a REIT’s management is to start by looking at how depreciation is building up across the various properties. In general, REITs will tend to overstate their depreciation. By digging into the notes that discuss the company’s policies on handling depreciation, an investor can also determine the maintenance schedule that the company has in place to ensure that the property remains functional.
More importantly, we can then look to see if there is any indication of major maintenance projects going forward at the current time, which might indicate impairment of an asset. Lastly, because of the way in which depreciation is a reported expense, investors should keep an eye out for accrued or deferred tax expenses and liabilities, which might indicate that the company has been shuffling its tax obligations into the future, which will hit their cash reserves going forward.
Upon determining the quality of the underlying asset base of a REIT, investors can then start to look at exactly what kind of clientele are renting space from the company, and determine their quality. For example, a residential REIT might be located in a transient neighborhood, indicated by a high maintenance expense and turnover rate on tenants. Alternatively, a healthcare REIT might have a higher quality of tenant, in that they tend to remain for several years, and do not cause significant damage to the property. Lastly, these healthcare REITs will also demonstrate a high-quality tenant in the way that they are willing to pay a premium for the incremental services that are provided at the facility.
It’s easy for investors to track down the clients of commercial REITs to determine the quality of companies that are leasing units. For example, a commercial REIT that has leased a large space to Walmart is likely to have some good stability from that particular unit, as Walmart stores tend to be popular. Alternatively, a commercial REIT leasing out spaces to many small professional practices might see a higher turnover, which implies greater overall income risk.
The last step to take as an investor is to evaluate the capital structure associated with the trust. Specifically, because of the way in which a REIT’s cost of equity will generally be tax exempt, an investor will want to make sure that the trust is balancing its structuring in an effective manor with tax adjustments made against both equity and debt calculations.
From there, the only trick is to make sure that the company is not over-leveraging itself in a way that might result in an unintended foreclosure (ie. the property value of a given asset declines below its loan amount, so much so that the bank calls in its loan. A very rare circumstance, but possible, depending on the kind of debt issued against the asset in question).