How to Evaluate a REIT
REITs are a popular investment for Self Directed IRAs. They are usually not accessible from standard brokerage platforms, yet they provide a more structured venue for real estate investing. For investors who want to get into real estate but don’t necessarily want to personally manage a property, a REIT can be the perfect option.
For an introduction to investing in REITs with a Self Directed IRA, please read here. Once you understand the different kinds of REITs and retirement accounts, it’s time to get real. How do you evaluate a specific REIT and decide if it's a good option for your Self Directed IRA?
Analyzing a REIT Balance Sheet
REITs use a unique balance sheet. It has a lot of terminology and categories that don’t apply to the broader world of investing. The result is that even if your Self Directed IRA has extensively invested in other kinds of assets, you will still need to get educated on REIT-specific terminology. Let’s start with defining the most common terms and concepts.
- Equity REIT – The two most common form of REITS are equity REITs and mortgage REITs. Equity REITs will typically buy an income producing property and collect rent, while a mortgage REIT makes loans secured by property. Most investors who want to invest in a REIT have in mind an equity REIT.
- Depreciation – This is an accounting metric. Rather than listing the purchase price of the asset in one lump sum, the price is spread out over the years that the asset is expected to be active (useful life). Depreciation is similar to amortization with the one key difference that depreciation is limited to physical tangible assets.
- Net Assets – The value or purchase price of the property minus the accumulated depreciation.
- Net Income – The simple calculation of revenue minus expenses. Net income takes into account depreciation.
- Funds From Operations (FFO) - This is similar to net income but with two major modifications. Net income takes into account both depreciation and property sales. However, these two factors don’t have an appreciable effect on the REITs dividend paying capability. To give a better analysis of the dividend picture, FFO adds depreciation back in and deducts any property sales.
- Adjusted Funds From Operations (AFFO) - The AFFO metric adds another number to calculate a REIT’s value potential: capital expenditures. These are any expenses that go into the maintenance of the real estate. Since this number can be significant, and it can definitely impact profits, it’s important to know how it fits into the total package. The AFFO is a good indicator of the true cash flow of the REIT and its ability to pay dividends.
- Capitalization (Cap) Rate – The ratio of the price of the property in relation to its expected annual income.
- Net Asset Value (NAV) - This is a metric that is meant to give the total value of the properties held, and, when done properly, will take into account rental income and true depreciation. This is an inexact number (due to inherent unknowns in the system,) but a fairly standard indicator. To get a simplified NAV, first calculate the total asset value. This is done by adding the value of the property itself plus cash plus any other assets. Then deduct the liabilities. This gives you the NAV. Then calculate the NAV per share by dividing the NAV by the number of shares outstanding. With the NAV per share, you can then compare it to the offering price to see if it's being sold at a discount or a premium. Another standard way to calculate the NAV is to multiply Net Operating Income by the Cap Rate, and then divide the whole thing by any liabilities (e.g. mortgage payments.)
- Payout Ratio - The percentage of earnings that go to the dividend payment.
- Debt-to-EBITDA Ratio - Ratio of total debt to pre-tax earnings
REIT Questions To Ask
In addition to the past performance of the REIT, there are a number of data points that can influence your investing decision. When placing a REIT in a Self Directed IRA, it is always better to be fully informed to make sure you maximize your retirement assets.
- What is the outlook for raising rents in the near future? - If the properties are in a hot area, it’s possible that rents can jump and positively affect the dividend payment. Conversely, in rent-controlled areas or neighborhoods with slumping real estate, the opposite could be true.
- Will occupancy rates go up? - Are the properties currently rented to near capacity? Or is there the possibility of a savvy business team coming in and jumpstarting a middling rate?
- Is the REIT interested in external growth? - Is the current property set expected to remain stable? Or does the REIT have a successful history of cutting underperforming properties and acquiring those with better potential?
When your Self Directed IRA looks to invest in a REIT, it should request the company’s key documents. These can either be found on the company website or on the SEC Edgar database.
- SEC reports – This includes the 10-K and 10-Q. They detail quarterly and annual financial results for the REIT.
- Real Estate Portfolio – A comprehensive listing of the company’s real estate holdings. This will include a listing of major tenants. Tenants are often an important indicator as to ongoing stability.
- Press Releases – Press releases are often good sources of information to find out the future direction that a REIT is planning on taking.
This is often an overlooked element of REIT research. If your close friend wanted your Self Directed IRA to invest in his business, you would certainly be interested in how he was running the business. This should be no less true when your Self Directed IRA invests in a REIT. Research the management team by looking into previous ventures they have overseen. Sometimes a new addition to the management team can have a significant influence. For instance, if an established REIT is having problems with high credit ratios, a CFO who is known for their experience in lowering credit liabilities may be a key acquisition. Conversely, if the REIT’s management is just being outsourced to a third-party team, that could be a red flag. Also, be cautious of any conflicts of interest that may be present for key executives.
Moving Forward With a Self Directed IRA
Would you like to talk out a potential REIT investment with a Madison specialist? They can help you understand the process and whether or not your specific REIT is a good fit for a Self Directed IRA. You can schedule a call here.