Dividend income from bricks and mortar – the lowdown on Real Estate Investment Trusts (REITs)

What is a REIT?

A Real Estate Investment Trust (REIT) is a property investment company. Unlike lots of other property investments, it can be easily traded on the stock market – exactly the same as any other share.

This can make it an attractive way for ordinary investors to invest in property. You can invest a small amount, rather than the tens of thousands needed to buy a property outright. And you can get your money back at any time – although as with any investment, you could back less than you originally put in.

To qualify as a REIT, at least 75% of profits must come from property rental and 75% of the company’s assets must be involved in the rental business. REITs must also pay out 90% of their rental income to investors.

In exchange for operating within these relatively strict rules, and to encourage investment in UK real estate, REITs don’t pay corporation or capital gains tax on their property investments.

What are the advantages for income investors?

Having to pay out 90% of rental income as dividends can make REITs an attractive option for investors looking for an income. The special tax arrangements also mean dividends are only assessed for tax once – when they reach investors.

Lots of REITs have long-term lease agreements with their tenants, which helps to make rental income and dividends relatively reliable, though of course there are no guarantees. Those who are able to impose regular rent reviews on occupiers should also enjoy a steady income growth.

This article isn’t advice. If you’re not sure what’s right for you seek advice. Investments rise and fall in value, so you could get back less than you invest. Income is variable and not guaranteed.

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Evaluating REITs

Net asset value (NAV)

REIT returns to investors come in two parts – dividends and changes in Net Asset Value (NAV).

NAV represents the value of all the assets owned by the REIT. For example, if the assets owned by the REIT, less any debt, are worth £1m and there are one million shares in issue, the NAV per share is £1. If the value of the properties increases, either through market movements or development activity, the REIT’s NAV will grow.

Premiums and discounts

If a REIT, or the sector in which it invests, is particularly popular, demand might push the share price up. The share price can rise above the NAV. The same process in reverse might push the REIT to a discount.

REITs with a long track record of growing NAV per share often trade at a greater premium – and are worth extra attention from investors. As a general rule though, REIT share prices have tended to move in line with the NAV.

Debt and LTV

Since REITs have to pay out most of their income to investors, it’s hard for them to build up enough capital to reinvest in new properties from their own profits. For companies looking to expand, that leaves two main means of funding growth – selling new shares or taking on debt.

The level of debt in a REIT is something investors should keep a close eye on. REIT debt is usually measured in relation to the NAV through what’s called loan-to-value (LTV), the proportion of the property portfolio that is funded by borrowings. A higher ratio means more leverage.

Using debt can stop investors having to stump up more cash or risk being diluted, as they would be if the company chose to sell new shares. However, it does bring extra risk.

Because property prices are cyclical, property values can change quickly. A REIT with a high level of debt can quickly find itself in trouble as LTV shoots up – especially if a downturn also hits rental income. It can reduce its ability to service or repay debt.

Different REITs can afford different levels of debt, depending on how reliable their rental income is. However, we tend to think that LTVs of more than 40% are comparatively high and should be avoided in normal times.

Specialist versus general REITs

There are over 50 REITs listed on the London Stock Exchange, collectively worth over $70bn. However, they’re not all alike.

As well as bigger companies with a wide range of properties, there are a number of specialist REITs that focus on particular types of real estate. Healthcare, residential, logistics and retail are all examples.

List of FTSE 100 and FTSE 250 REITs

Investing in individual companies isn’t right for everyone – it’s higher risk as your investment is dependent on the fate of that company. If a company fails, you risk losing your whole investment. You should make sure you understand the companies you’re investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

There are advantages and disadvantages to both general and specialist approaches.

A diverse tenant base should mean generalist REITs avoid catastrophic collapses in rental revenue if conditions shift in any particular industry. Since rental revenues need to be paid out to shareholders, that feeds through to dividends too.

However, a large, diversified portfolio can be unwieldy, making management more difficult and possibly making managers less nimble when it comes to buying and selling assets. That could hold back NAV growth over the long term.

By comparison, specialist REITs are more exposed to specific market conditions and that can make them more volatile. In the last 18 months we’ve seen specialist retail REITs come under extreme pressure as tenants either couldn’t or wouldn’t pay rents over lockdown, whereas Healthcare REITs have boomed. Clearly specialist REITs can be riskier. Remember past performance isn’t a guide to the future.

However, a more focused portfolio does have advantages. With fewer factors affecting performance, investment cases are clearer and arguably more compelling. Managers are specialists in their sector, making asset management more effective and often allowing teams to buy new properties ‘off-market’. ‘Off-market’ sales are where properties are bought without being offered for general sale. They can come at a lower price, boosting rental yields and scope for future NAV growth.

Both types of REITs have their attractions. Which is most appropriate for you will depend on your specific circumstances.

We will shortly be publishing and overview of current conditions across the various property sectors and looking at the prospects for affected REITs. Those interested in reading that article and more can sign up to our weekly share insight article, and get it delivered straight to their inbox.

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