Real estate and REITs

Level 1 Plain words

For every reader: the idea in plain words, no formulas.

Owning property for its rent

Buy an apartment building and you collect rent from the tenants. Out of that rent you pay property taxes, insurance, repairs and a manager. What is left, before any mortgage payments, is the building's net operating income, or NOI. Investors value the building by asking how much they would pay for that stream of income.

The answer depends on two things: how large and how secure the income is, and what return buyers demand on their money. If buyers want 5 % a year from a building that earns $1 million of NOI, they pay $20 million for it. If they start wanting 6 %, the same building is worth less, because the same income now has to cover a higher required return.

What a REIT is

A real estate investment trust, or REIT, is a company that owns income-producing property and passes most of its income to shareholders. Congress created REITs in 1960 so that ordinary savers could own large commercial property through shares, the way a mutual fund lets them own many stocks. In return for paying out at least 90 % of its taxable income each year, a REIT pays no corporate income tax on what it distributes.

Most REIT shares trade on stock exchanges, so an investor can buy a slice of office towers, warehouses, apartments or cell towers as easily as a share of any company. Some REITs are not listed and trade rarely; their values come from appraisals and change slowly.

What moves property values

Real estate prices respond to interest rates, because buyers compare a building's yield with what bonds pay. They respond to rents and occupancy, which set the income. Debt magnifies every gain and loss, because most buyers borrow a large part of the price. And the economy feeds through tenants: firms that lose business stop paying, shed space or leave. Level 4 has an example of each.

Real estate differs from stocks and bonds in one more way. A building is a single, large, unique asset that can take months to sell. Its price is an estimate until it changes hands. Listed REITs fix that by trading every day, at the cost of moving with the stock market in the short run. Over long periods their returns have followed the buildings they own; over a few months they have often followed stocks.

Level 2 How it works

For readers who want the mechanism, with the diagrams.

Beginner path stops here

Net operating income and the cap rate

The cap rate, short for capitalisation rate, is NOI divided by the property's value. It plays the part of a yield. A cap rate of 5 % means the building returns 5 % a year in operating income on its price, before debt and before any growth in rents.

Cap rates differ by property type and place. Buyers accept low cap rates for buildings with long leases to strong tenants in growing cities, and demand high ones for buildings with short leases, weak tenants or shrinking markets. Over time cap rates move with interest rates, though with a lag and with wide variation. Subtract the 10-year Treasury yield from a cap rate and you get the property market's risk premium: what buyers ask for owning a building rather than a government bond.

How a REIT works

A REIT collects rent, pays its operating costs and the interest on its debt, and pays most of what remains to shareholders as dividends. To keep its tax status it must meet tests on what it owns and earns: at least 75 % of its assets in real estate, cash or government securities, at least 75 % of its gross income from rents, mortgage interest or property sales, and distributions of at least 90 % of taxable income.

Because a REIT pays out most of its income, it keeps little cash to grow. To buy new buildings it issues new shares or borrows. That makes REITs dependent on capital markets: when share prices are high and credit is cheap they grow fast, and when both close at once they can be forced to sell buildings or issue shares at low prices.

REIT dividends are mostly taxed as ordinary income, not at the lower rate for qualified dividends, which is one reason many investors hold REITs in tax-deferred accounts (Chapter 22).

Equity REITs and mortgage REITs

Most REITs are equity REITs, which own buildings. Mortgage REITs own property loans or mortgage bonds instead, and earn the gap between what those pay and what the REIT pays to borrow. Mortgage REITs behave more like leveraged bond funds than like landlords, so they suffer when short-term borrowing costs rise or when mortgage bonds fall in price. This chapter is about equity REITs unless it says otherwise.

Property types and their drivers

Different kinds of property respond to different forces. Apartments depend on household formation and local wages, and their one-year leases let rents adjust fast to inflation. Office buildings depend on employment in offices and, since 2020, on how many days people come in. Warehouses grew with online shopping. Shopping centres shrank with it. Data centres and cell towers have leases that behave more like infrastructure contracts. Hotels have no leases at all; they reprice every night, which makes them the most cyclical.

Lease length decides how fast a property's income responds to inflation. Long leases with fixed rents behave like bonds: steady income, and value that falls when rates rise. Short leases let the landlord raise rents when prices rise, which helps against inflation and hurts in a slump.

Level 3 The math

For Series 65 and CFA readers: formulas and worked examples.

Series 65 path stops here

Cap rate valuation

The value of a property follows from its NOI and the cap rate $c$.

In words, a property's value equals its net operating income divided by the cap rate.

The cap rate as a required return less growth

If NOI grows at a steady rate $g$ and buyers want a total return $r$, the Gordon model of Chapter 10 applies to buildings too: $V = \text{NOI}_1 / (r - g)$, so the cap rate equals $r - g$.

In words, a cap rate equals the total return buyers require less the growth rate they expect for the building's income.

With $r = 8\%$ and $g = 3\%$ the cap rate is 5.0 %. This form explains why cap rates and interest rates do not move one for one. If inflation pushes the required return up to 9.5 % but also lifts expected rent growth to 4 %, the cap rate rises only to 5.5 %. Property whose rents keep pace with inflation is partly protected; property on long fixed leases is not.

Leverage and the equity holder

Most property carries debt. Against a value $V$ and debt $D$, the loan-to-value ratio is $D/V$, and the investor's equity is $V - D$. A change in value lands entirely on the equity.

In words, the percentage change in the investor's equity equals the percentage change in the property's value times the value divided by the equity.

FFO and AFFO

Accounting rules make a REIT deduct depreciation on its buildings, as if they lost value steadily. Well-kept buildings in good places often gain value instead, so net income understates the cash a REIT generates. The industry measure is funds from operations, FFO.

In words, funds from operations is net income with property depreciation added back and one-off gains from selling buildings taken out.

Adjusted FFO, or AFFO, then subtracts the recurring capital spending a building needs to keep its tenants: new roofs, lobby upgrades, leasing commissions.

Debt service coverage and refinancing

Lenders watch the debt service coverage ratio: NOI divided by the year's interest and principal payments. Below about 1.2 or 1.25, many lenders refuse to refinance.

In words, debt service coverage is the property's operating income divided by what the borrower must pay the lender each year.

A building with $1 million of NOI and a $12 million interest-only loan at 4 % has a DSCR of 2.08. When the loan comes due and rates have risen to 7 %, the same loan would cost enough to cut coverage to 1.19. If NOI has also fallen 15 %, coverage drops to 1.01, and the borrower must put in more equity, sell, or hand the keys to the lender.

At a 5.5 % cap rate and a 4.5 % 10-year yield, property offers a spread over Treasuries of 100 bp. When that spread narrows, buyers are being paid little extra for owning buildings over bonds.

Level 4 History, analysed

For readers who want past episodes run through the Level 3 math.

2008: leverage and the closed credit market

Most of the 2008 losses came from debt, and less from rents, which fell only slowly. Many REITs had borrowed heavily in 2005 to 2007, often with loans due in a few years. When credit markets froze, they could not refinance at any reasonable price. Some sold buildings into a falling market, and many issued new shares at low prices in 2009 to pay down debt, which diluted their existing owners at the bottom. The leverage formula shows the mechanics: with 60 % debt, a fall of −16.7 % in property values cuts equity by −41.7 %, and a firm that must also sell shares at that low price locks the loss in. REITs that came into the crisis with low debt and long-dated loans recovered much faster.

2022: the cap rate meets the bond market

In 2022 rents for most property types were still rising, so the loss came almost entirely from the cap rate. We can ask what cap rate change the loss implies. If a portfolio was priced at a 4.5 % cap rate and its NOI did not change, a loss of −24.9 % means buyers now applied a cap rate of about 6.0 %. That is a rise of about one and a half points, a little less than the 10-year yield's rise of 2.4 points, which fits the $c = r - g$ form: higher inflation also raised expected rent growth, so the cap rate rose less than the bond yield.

Private property funds, valued by appraisals, reported gains or small losses for 2022 (Gaps). The buildings were similar; the measurement differed. Listed REITs reprice every second, while appraisals follow sales, and sales dried up as buyers and sellers disagreed on price. Over the following years the appraised values fell too. For an investor, the smooth line of an appraisal-based fund does not mean lower risk; it means the risk shows up later.

Office after 2020: income and cap rate together

Office buildings were hit by both terms of the cap-rate formula at once. Suppose a building's NOI falls 15 % as tenants shrink their space and the cap rate buyers demand rises from 5 % to 7 %, because rates rose and the future of offices looked uncertain. Its value falls −39.3 %, from $100m to $60.7m. An investor who bought with 60 % debt sees the equity fall −98 %: loan-to-value has risen to 99 %, and the equity is nearly gone.

The refinancing arithmetic of Level 3 finishes the story. The building's coverage at the old 4 % loan rate was comfortable; at 7 % with NOI down 15 % it falls to 1.01, far below what a lender will accept. Borrowers in that position have often stopped paying and handed buildings back to lenders, which is why office loans became a worry for regional banks and for holders of commercial mortgage bonds.

What the three cases share

In each case the cap-rate formula and the leverage formula, taken together, explain most of the loss. Rising required returns cut values even when rents held (2022). Falling income cut values further when it came too (office). Debt turned moderate falls in property value into severe losses for owners, and debt coming due in a closed market forced sales at the worst time (2008). Property is a real asset with rents that can rise with inflation, and that helps over long periods. Over a few years its price behaves much like a long bond's, with leverage added.

For an investor choosing between listed REITs and a private property fund, the cases point to the questions worth asking. How much debt does the portfolio carry, and when does it come due? How long are the leases, and do the rents adjust with inflation? What cap rate does the price imply, and how far is that above the 10-year Treasury yield? A portfolio with low debt, staggered maturities and a wide spread over Treasuries can ride out a bad year. One with heavy debt due soon, priced at a thin spread, depends on rates staying low.