REITs – An Industry Introduction to Real Estate Investment Trusts

Industry Definition

Real Estate Investment Trust (REIT) – A legal entity that uses pooled investor capital to purchase and manage income property or mortgage loans. Most REITs operate using a straight forward business model by leasing space and collecting rent on its real estate in order to generate income which is then paid out to shareholders in the form of dividends. To qualify as a REIT, the entity must distribute at least 90.0% of taxable income.

Main Activities

The two main types of REITs are equity REITs and mortgage REITs (mREITs), which are mostly traded on major stock exchanges, but there are also public non-listed and private REITs.

Equity REITs

A company that owns or operates income-producing real estate.

Mortgage REITs

Mortgage REITs provide financing for income-producing real estate by purchasing or originating mortgages and mortgage-backed securities and earning income from the interest on these investments.

Public Non-Listed REITs

PLNRs are registered with the SEC but do not trade on national stock exchanges.

Private REITs

Private REITs are offerings that are exempt from SEC registration and whose shares do not trade on national stock exchanges.

Majority of REITs fall within these types of real estate property types: residential, retail, office, industrial, healthcare, self-storage, specialty, data center, timberland, infrastructure, and lodging (hotels and resorts) REITs. The REIT companies will manage and rent out to tenants their real estate investments.

Similar Industries

Real Estate Sales & Brokerage in the US

Operators in this industry primarily act as intermediaries during various real estate transactions, including buying, selling and renting real estate.

Apartment/Offices/Retail Centers/Hotel Rental and Management

Operators in this industry primarily act as lessors of multiunit buildings used as residences or dwellings, such as apartment complexes, retirement villages, malls, hotels, and mix-use properties and townhomes.

Timberland Real Estate

Operators in this industry harvest and sell timber.

Mutual Funds – Operators in this industry manage a portfolio of stocks and/or bonds like REITs do with real estate. Income for investors is earned from dividends and capital gains.

Charlie Izaguirre contributed to this report.

Buy-Side Strategies

Attractive Opportunities in 2018

At the sector level, there has been certain private health care players under margin pressure, which has increased the number of REITs actively acquiring assets on the private side. Medical offices should continue to be active and stay a fragmented sector, and there will be a continuation of hospital systems and private-side owners of office assets that will continue to test the waters as potential sellers of real estate.

Vertical M&A

A vertical M&A is a merger between two companies that operate at separate stages of the production process for a specific finished product. If a company wanted to offer not only income-producing properties, but also mortgages to full be able to capture the different stages of REITs it could go out and seek a mortgage REIT. This would allow it to offer the two aspects of REITs that they are involved in.

Horizontal M&A

A horizontal M&A is when business consolidation occurs between from that operate in the same space, as competition tends to be higher and the synergies and potential gains in market share are much greater for merging firm in such an industry. An example would be retail and apartments. If two firms thought they could gain market share from merging they could do a horizontal merger in which they both would gain from the expansion. The firms would combine to have more apartment buildings or retail space that could lead to more profits.

Market share competition

The REITs industry covers a large sector of the economy but most companies that operate in the REITs industry are diverse and only operate in a select few segments of REITs (e.g. offices, apartment buildings, warehouses, retail centers, medical facilities, data counters, cell towers, infrastructure and hotels). At the end of 2017 there was 222 total REITs in the FTSE Nareit all REITs index and the equity market capitalization for all REITs was $1.134 trillion. The NYSE traded 188 REITs, which equaled a market capitalization of $1.020 trillion.

It is difficult for any one company to attain a significant share of revenue across the industry as a whole because of the specialization of the firms. However, some can gain market share within one of the segments of REITs.

Key Success Factors

Market environment

The real estate market depends a lot on a good market environment ranging from wages, inflation, interest rates, high mortgage prices and market volatility. A good market environment always helps to lead to successful real estate environment.

Superior financial management

A significant amount of capital and debt is used to finance property acquisitions. Therefore, companies must be able to properly manage cash flows, reserves and debt levels to grow and effectively manage property portfolios.

Maintenance of excellent customer relations

Understanding the needs of, and having good relationships with existing and prospective clients can assist operators in gaining new business and retaining existing customers.

Proximity to key locations

Tenants pay a premium for buildings located near business centers, transportation hubs and entertainment venues. Buildings in metropolitan areas usually have higher rental income and less vacancies.

Access to highly skilled workforce

Real estate firms that employ highly skilled staff with specialized knowledge can develop a reputation for quality service and increase their bargaining power.

Cost Structure Benchmarks

Cost structure may vary depending on the segment in the REITs industry.

Profits

EBIT (earnings before interest and taxes) varies for firms in different segments of the REITs industry. Probability has been recovering, since the subprime crisis, in property values and construction projects. Interest expense makes up a large portion of the real estate holdings after EBIT as companies attempt to raise capital for developments and acquisitions.

Purchases

The largest of the purchases are associated with contracting and acquiring properties, which can be also financed with debt. Because some form of debt is typically used in the purchases of properties most firms will have fairly high interest expenses or the gradual elimination of liability, such as loan, from a company’s balance sheet. Another major purchase incurred is construction materials for development projects. Construction materials will vary depending on commodity prices, as most costs are related to concrete, glass, structural steel, concrete panels, panels, structural timber, metal cladding, aluminum fitting, electrical power, fuels and lubricants.

Other Costs

Depreciation and amortization usually accounts for a large portion of the REITs costs. REIT properties experience annual wear and tear or loss of utility, so companies depreciate real estate assets over time to account for this deduction. Selling, general, administration and development also make up a decent amount of expenses incurred throughout the year for firms.

Basis of Competition

Competition within the REITs industry is primarily on income properties and mortgage loans. The income properties are highly competitive, as property owners compete for tenants on location, rental rates, amenities and design. Property purchases competition arises where land is scarce or the demand is high.

REIT Services

Most REIT services are tailored to a specific sector within the industry. This makes it competitive because most established firms specialize in a certain area of real estate. Their location in an important factor as companies try to gain and retain customers trust and a competitive advantage over other firms.

Prices for REITs are always a major factor as REIT companies try to get the best price whether through acquisition or development. Their ability to lower costs and increase revenues is always an ongoing competition between firms.

The mortgage loan industry has seen slowing demand and increasing competition from other lenders. Demand is down for all three types of mortgages GES Eligible, Non-GSE Eligible and Government.

External Competition

External Competition has come from the ability to work remotely, videoconferencing, space sharing offices and e-commerce. Companies have downsized office space, which has allowed them to decrease the amount of space necessary for their businesses. E-commerce has also had an effect on the retail space because they don’t need to have stores everywhere to offer their products. Companies can have a few spaces throughout the U.S. and still be able to offer their products nationally.

Barriers to entry

Barriers to entry vary depending on the sector within REITs. Most REITs will have a medium to high barrier to entry because of the capital necessary to acquire, develop and maintain properties. The storage rental REITs have a lower barrier to entry because of the smaller amount of capital needed to construct a storage facility. That being said, there are many factors that increase the barrier to entry such as lower vacancy rates, new entrants being prohibited from entering a real estate market due to permit requirements, various local, state and federal regulations, and zoning, ordinances, and licensing requirements. Overall it is difficult to establish a solid foothold in the real estate markets because smaller companies will have smaller portfolios due to capital requirements needed to grow.

Industry Globalization

Industry globalization is low because the REITs industry is vast and requires knowledge of local markets and trends. Most equity REITs that are located in U.S. have a large portion of their real estate in the U.S. but also have properties abroad. The industry does have large firms; however, these firms usually specialize in a certain sector within REITs whether it is offices, apartment buildings, warehouses, retail centers, medical facilities, data counters, cell towers, infrastructure and hotels. REIT firms are expected to continue to expand domestically and overseas in an attempt to grow revenue and diversify risk through real estate developments and acquisitions.

 

 

Charlie Izaguirre contributed to this report. For a detailed list of sources, click here.

Nate Nead
Nate Nead
Nate Nead is a licensed investment banker with Four Points Capital Partners, LLC and Principal at Nead, LLC. Nate works with middle-market corporate clients looking to acquire, sell, divest or raise growth capital from qualified buyers and institutional investors. Four Points Capital Partners, LLC is a member of FINRA and SIPC and registered with the SEC.