REITs are also often more indebted than other companies because to their capital-intensive properties. In reality, interest costs typically account for the majority of their entire costs.
Why do REITs use leverage?
When investors consider risk/reward considerations, the efficiency with which a REIT uses debt is a critical factor. When debt is used wisely, it boosts returns and aids growth. If debt is underutilized, a REIT’s profits and growth potential would be limited. Overuse of debt can result in a REIT’s credit rating being lowered, which raises the cost of financing and the danger of insolvency. We’ll look at two major REIT leverage indicators in this article: the debt/asset ratio and the debt/equity ratio. We’ll start by contrasting debt vs. equity funding for REITs.
What is the typical leverage for a REIT?
The first is that, in terms of Debt Ratio, REIT properties are far less indebted than the average home. Typical values range from 20% to 40%, which is less than half of the average home mortgage.
How is leverage calculated for REITs?
A REIT’s gearing ratio, also known as aggregated leverage, is the proportion of total debt to total assets. Investors keep a tight eye on this indicator, which is used to assess a Reit’s financial leverage. A low gearing ratio may indicate a higher ability to take on more debt for future acquisitions, but a high gearing ratio may indicate credit issues, particularly during economic downturns.
The Monetary Authority of Singapore has imposed a leverage limit of 50% on S-Reits in Singapore (MAS). This restriction was raised from 45 percent in April 2020 to give S-Reits more flexibility in managing their capital structure in the face of the Covid-19 pandemic’s tough environment.
S-Reits have maintained an average gearing ratio of 36.8% thanks to diligent capital management by Reit managers, according to the most recent business filings, which were extracted on January 31, 2021.
Why do REITs use debt?
The second most influential determinant is operating risk, which means that REITs with more fluctuating cash flows are more likely to use debt financing to minimize the risks of additional stock, such as misvaluation or investor reaction to equity issue announcements.
Do REITs hold debt?
Many financial consultants advise clients to retain varied sources of income in retirement, regardless of the size of their nest egg, according to Forbes. Retirees often live on a fixed income that is supplemented by investment income and principal withdrawals.
Investing in Real Estate Investment Trusts (REITs) can give high returns, diversification, and a prospective income stream to retirees and others with similar goals. Retirees are frequently dividend investors with conservative investment objectives. They may not be concerned with outperforming the market, but rather with creating and growing income while safeguarding and protecting their assets.
According to CNBC, retirees have traditionally focused on large cap equities and bonds as their primary source of investment income. Potential dividends from real estate could provide an alternate source of income for retirees. Equity REITs and debt REITs are examples of real estate that can be obtained through Real Estate Investment Trusts (REITs) (also known as mortgage REITs). We’ll go through some of the significant distinctions and similarities between the two types in the sections below.
Equity REITs and how they work
Equity REITs invest in and acquire properties across the commercial real estate spectrum, from shopping malls to hotels to office buildings to apartments. The rent they earn from tenants and businesses who lease the premises could be a source of cash for them. Furthermore, real estate ownership may result in price appreciation, resulting in an increase in the value of holdings.
Consider the case of Company A, which qualifies as a REIT. It raises capital from investors to buy an apartment building and leases out the space until it is fully occupied. This real estate property is currently owned and managed by Company A, which receives rent from its tenants on a monthly basis. Company A is a real estate investment trust (REIT).
Apartments, shopping complexes, office buildings, and self-storage facilities are examples of property types that equity REITs may specialize in holding. Some equity REITs are multi-asset and own a variety of properties.
Equity REITs must pay at least 90% of the income they collect to their shareholders in the form of dividends, which can be issued monthly or quarterly once a REIT has covered its selling, organizational, and operating costs involved with running its properties.
Debt or Mortgage REITs and how they work
Mortgage or debt REITs, unlike equity REITs, lend money to real estate buyers using debt or debt-like instruments such as first mortgages, mezzanine loans, and preferred equity structures. While rents are often the source of prospective income for equity REITs, interest generated on debt instruments is the source of revenue for debt REITs. Mortgage REITs, like equity REITs, must distribute at least 90% of their yearly taxable income to shareholders. Debt REITs, on the other hand, do not benefit from the property’s potential price appreciation, unlike equity REITs.
Consider Company B, which qualifies as a REIT and lends to a real estate sponsor. Unlike Company A, Company B has the ability to earn money from the interest on its loans. As a result, Company B is a debt REIT, or mortgage REIT.
Debt REITs invest in property mortgages rather than owning physical property. These REITs either lend money to real estate owners for mortgages or buy existing mortgages or mortgage-backed securities. The interest they get on the mortgage loans is the main source of their income.
Key similarities
Equity REITs and mortgage REITs can both be listed on major stock markets and be traded privately. Equity REITs are the more frequent of the two, according to NAREIT, accounting for the bulk of the US REIT industry. Equity REITs control more than $2 trillion in real estate assets in the United States, according to NAREIT, including over 200,000 properties in all 50 states and the District of Columbia. This means that there will be fewer mortgage REITs, which are backed by real estate but do not own or run the property.
Risks of investing in REITs
While REITs can provide diversification and attractive dividends, they also come with hazards. The majority of REITs do not trade on a public market, and those that do are considered illiquid investments. Investors who purchase non-listed REIT shares run the risk of not being able to sell them promptly or at their present value.
Furthermore, non-public REITs might be difficult to assess because valuations are not as regular as public REITs and are frequently reported quarterly rather than daily. Furthermore, many non-public REITs have significant upfront costs. As a result, before selecting to invest in a REIT, investors should examine all of the benefits and drawbacks.
Consider the “Risks” connected with each investment before making a decision. The official offering paperwork contain important information concerning risks, fees, and expenses. Illiquidity, full loss of cash, short operating experience, conflicts of interest, and blind pool risk are all hazards associated with investing in REIT common shares.
Benefits of investing in REITS
REITs have the advantage of paying big dividends since they are mandated by the IRS to distribute at least 90% of their annual taxable revenue to shareholders. This means REITs can’t keep the majority of their profits to fund their own expansion. As a result, they’re geared at investors looking for a steady stream of income.
Another advantage of REITs is that they are designed to provide some level of diversification. By purchasing REITs that are located in numerous locations and invested in a variety of property types, REIT investors can add real estate to their portfolios without the hassle of purchasing an actual property or group of properties.
Access to equity and debt REITs
On our platform, RealtyMogul offers both equity and debt REITs. Our non-traded REITs invest in commercial real estate portfolios around the United States, including:
MogulREIT I use debt and debt-like products to invest in a variety of commercial assets. MogulREIT I’s major goals are to deliver attractive and reliable cash distributions while also preserving, protecting, and growing an investor’s capital commitment.
MogulREIT II invests in multifamily apartment buildings in major areas in the United States, both in common and preferred shares. The major goals of MogulREIT II are to achieve long-term capital appreciation in the value of our investments and to provide shareholders attractive and reliable cash distributions.
Investing in REIT common shares is speculative and has significant risks. The offering circular’s “Risk Factors” section offers a full assessment of hazards that should be examined before investing. Illiquidity, full loss of capital, limited operating history, conflicts of interest, and blind pool risk are just a few of the concerns. Natural disasters, economic downturns, and competition from other properties pose additional risks to MogulREIT I’s investments, which may be limited in assets or concentrated in a geographic region. Changes in demographic or real estate market conditions, resident defaults, and competition from other multifamily buildings are all risks that MogulREIT II’s multifamily investments may face.
All material presented here is for educational purposes only and does not constitute an offer or solicitation of any specific stocks, investments, or investment strategies. Nothing in this publication should be construed as investment, legal, tax, or other advice, and it should not be used to make an investment decision. This could include forward-looking statements and forecasts based on current beliefs and assumptions that we feel are fair. With investing, there are dangers and uncertainties, and nothing is certain.
What metrics are most commonly used to evaluate REIT leverage?
For REITs, having too much debt can be a huge risk problem. The debt-to-EBITDA ratio is the most often used indicator to describe a REIT’s debt.
I like a debt-to-EBITDA ratio of less than 6:1, although this isn’t a hard and fast rule. To determine whether a REIT has an above- or below-average debt load, compare its debt-to-EBITDA ratio to that of its peers.
How much debt should a REIT have?
as an illustration ” I don’t have Duke’s phone number on my screen right now, but email me privately while we’re not live, and we’ll talk about Duke.” In terms of REIT debt versus cash, there are a few factors to keep in mind. For one, REITs often operate with more debt than other businesses, and they do it in a healthy fashion. Consider this: when you buy a house, you typically have 80 percent of the house in debt and just 20 percent in equity. While this isn’t exactly the same, a REIT functioning in a 50 percent equity, 50 percent debt capitalization is completely fair. Debt to EBITDA is a key measure for me. That one appeals to me; I prefer it to be under the age of six. In terms of cash, most REITs don’t keep a lot of cash on hand in regular times. REITs have taken down their credit lines to ensure they have adequate liquidity to go through whatever lies ahead, as you can see on one today. REITs don’t usually hold a lot of cash in normal times. It’s not a good business model to keep a lot more cash than you need, especially when almost all REITs, with the exception of the malls that recently went bankrupt, are quite cash flow positive in normal circumstances. As a result, they don’t need to store much cash in the bank.
How do you analyze REIT debt?
In order to fund and expand its activities, a REIT must take on debt. This is especially true because they must pay out at least 90% of their taxable profits as dividends, reducing the amount of capital available for acquisitions.
Debt, in addition to being a crucial instrument for growth, permits businesses to make a larger return than they would if they bought everything with cash. This is particularly true in real estate, where the cash-on-cash return on an investment is nearly always larger than the cap rate.
Too much debt, on the other hand, might be problematic for a REIT. The number of loan installments rises in tandem with the amount of debt owed. When a company’s debt payment is too expensive, it can be difficult to fund all of its expenses, pay dividends, or buy more real estate.
Debt to EBITDA Ratio
The debt to EBITDA ratio is one of the easiest and most effective measures to evaluate a REIT’s debt. Earnings before interest, taxes, depreciation, and amortization (EBITDA) is the acronym for earnings before interest, taxes, depreciation, and amortization.
This debt ratio is commonly calculated using the company’s net debt, which is total debt minus accessible cash. The EBITDA must also be annualized. The formula for calculating net debt to EBITDA is as follows:
A larger ratio indicates greater indebtedness and danger. Looking for a ratio between 4x and 6x is a reasonable rule of thumb.
A debt-to-equity ratio of more than 6x could suggest that the REIT has too much debt. A ratio of less than 4x could signal that the REIT is being too cautious with debt and spending more of its own money than necessary.
Debt Maturity Schedule
You should also look at the REIT’s debt maturity schedule in addition to the debt to EBITDA ratio. This will show how much debt will be due to mature each year over the next few years.
A well-staggered debt maturity schedule is desirable, since it ensures that the amount that must be paid off each year is stable. With a substantial amount of the overall debt due in the next few years, there’s a better probability the firm will issue new shares, diluting whatever stock you acquire, or they won’t be able to raise dividends. If the amount of debt owed is significant enough, dividends may be reduced.
When looking at Realty Income’s debt maturity calendar, you’ll notice that it’s reasonably well-spaced throughout the next five years, with pauses between major maturities.
Interest Rate
When examining a REIT’s debt profile, another factor to evaluate is the debt’s cost. For each form of loan, the company’s debt schedule will normally offer a weighted average interest rate.
When considering the risk based on the REIT’s debt to EBITDA ratio and loan maturity schedule, this factor comes into play. A substantial quantity of debt maturing in the coming year, for example, may be a good thing if the interest rate is higher than the REIT’s ability to refinance it.
You can also look at the interest coverage ratio of the company. The interest expenses of a REIT are calculated using this method and compared to its EBITDA. The formula is as follows:
The benchmark for many REIT investors and analysts is a 3x interest coverage ratio. The higher the ratio, the more capital available to meet interest expenses for the REIT. Anything less than 2.5x may suggest a significant level of danger.
Why are REITs a bad investment?
Real estate investment trusts (REITs) are not for everyone. This is the section for you if you’re wondering why REITs are a bad investment for you.
The major disadvantage of REITs is that they don’t provide much in the way of capital appreciation. This is because REITs must return 90 percent of their taxable income to investors, limiting their capacity to reinvest in properties to increase their value or acquire new holdings.
Another disadvantage is that REITs have very expensive management and transaction costs due to their structure.
REITs have also become increasingly connected with the larger stock market over time. As a result, one of the previous advantages has faded in value as your portfolio becomes more vulnerable to market fluctuations.
What is a good p FFO for a REIT?
The best tool for analyzing REITs is probably the price-to-funds-from-operations (P/FFO) ratio. P/FFOs have been in the high teens, with some going into the 20s, in the present interest rate environment. P/FFOs have been consistently low for various REITs, with some falling below 10.
Are REITs overvalued?
Some REITs have become overvalued, while others are still extremely profitable. We’ve sold a lot of our positions at High Yield Landlord, and we’ve made a lot of money.
