Real Estate Investment Trusts: What Equity Investors Need to Know

REITs trade like stocks but behave like bonds with equity upside—you collect yield (averaging 4-5% historically), you get property appreciation (tied to real assets), and you absorb interest rate risk (because leverage and duration matter). In real portfolio data, REITs have delivered 9.7% annualized returns since 1972, outperforming the broader S&P 500 by roughly 0.5% annually with a correlation of just 0.56 (NAREIT, 2023). The practical insight isn't treating REITs as "alternative investments." It's understanding that REITs are income vehicles with real estate characteristics—and valuing them requires different metrics than standard P/E ratios.

The 90% Rule (Why REITs Pay High Dividends)

REITs exist because of a tax bargain. To qualify as a REIT, a company must distribute at least 90% of taxable income as dividends to shareholders. In exchange, the REIT pays no corporate income tax on distributed earnings.

The structure:

• Must derive 75%+ of income from real estate sources
• Must invest 75%+ of assets in real estate
• Must have 100+ shareholders (no closely held ownership)
• Must distribute 90%+ of taxable income annually

Why this matters for you: REITs can't retain earnings the way a tech company can. Growth requires either issuing new shares (dilution), taking on debt (leverage), or asset appreciation (market-dependent). When you buy a REIT, you're buying an income stream with limited internal reinvestment capacity.

The yield comparison (December 2024):

• Average equity REIT yield: 4.2%
• S&P 500 dividend yield: 1.3%
• 10-year Treasury yield: 4.3%

The point is: REIT yields compete directly with bonds. When Treasury yields rise, REIT prices often fall—not because the properties are worth less, but because the income stream is worth less relative to risk-free alternatives.

FFO and AFFO (Why Earnings Don't Work)

Standard earnings (net income) are misleading for REITs because of depreciation. Accounting rules require depreciating buildings over 27.5-39 years, but well-maintained real estate often appreciates rather than depreciates. Net income understates actual cash generation.

Funds From Operations (FFO):

The calculation: FFO = Net Income + Depreciation + Amortization - Gains on Property Sales

Example (Prologis, PLD, 2023):

• Net Income: $3.0 billion
• Add back depreciation: $2.1 billion
• Subtract property sale gains: $0.4 billion
• FFO: $4.7 billion
• FFO per share: $5.10 (vs. reported EPS of $3.24)

Adjusted FFO (AFFO): Takes FFO and subtracts recurring capital expenditures needed to maintain properties:

AFFO = FFO - Maintenance CapEx - Straight-line Rent Adjustments

AFFO is closer to "true" cash available for dividends. The dividend coverage ratio that matters is Dividend / AFFO—if this exceeds 90%, the REIT has limited cushion.

Practical interpretation:

• AFFO payout ratio below 75%: Conservative (room for dividend growth)
• AFFO payout ratio 75-85%: Moderate (sustainable but limited growth)
• AFFO payout ratio above 85%: Stretched (vulnerable to cuts if income drops)

NAV (What the Properties Are Actually Worth)

Net Asset Value attempts to value a REIT based on the market value of its underlying real estate minus liabilities.

The calculation: NAV = (Market Value of Properties - Total Debt) / Shares Outstanding

Example (simplified, Realty Income, O):

• 13,100 properties
• Estimated market value: $58 billion
• Total debt: $24 billion
• Net asset value: $34 billion
• Shares outstanding: 600 million
• NAV per share: ~$57
• Current stock price: $55
• Premium/Discount: -3.5% (trading at discount)

Why NAV matters: A REIT trading at a 20% discount to NAV might be undervalued—or might signal that the market believes property values will decline. Premium to NAV can indicate either market overvaluation or justified confidence in management's ability to grow.

The durable lesson: NAV is a floor estimate, not a precise number. Cap rate assumptions (more below) drive the calculation, and small changes in cap rates produce large NAV swings.

Cap Rates (The Real Estate Yield Metric)

Capitalization rate is the real estate equivalent of earnings yield—it shows the unleveraged return on property value.

The calculation: Cap Rate = Net Operating Income (NOI) / Property Value

Example:

• Office building generating $2 million NOI annually
• Property valued at $25 million
• Cap Rate: 8%

Interpreting cap rates by sector (late 2024):

The point is: Lower cap rates mean higher valuations. Industrial REITs trade at low cap rates because e-commerce growth drives sustained demand. Office REITs trade at high cap rates because remote work creates structural oversupply concerns.

Property Types (Sector Matters Enormously)

REIT performance varies wildly by property type. Choosing "real estate exposure" without considering sector is like choosing "equity exposure" without considering whether you want tech or utilities.

Residential (multifamily apartments):

• Lease terms: 12 months (quick repricing to inflation)
• Demand driver: Household formation, housing affordability
• Key risk: Local rent control regulations
• Major REITs: AvalonBay (AVB), Equity Residential (EQR), Mid-America (MAA)

Industrial (warehouses, logistics):

• Lease terms: 5-10 years (NNN leases—tenant pays expenses)
• Demand driver: E-commerce fulfillment, reshoring
• Key risk: Overbuilding in secondary markets
• Major REITs: Prologis (PLD), Duke Realty, Rexford (REXR)

Office:

• Lease terms: 5-15 years (long but declining occupancy)
• Demand driver: Employment growth, return-to-office policies
• Key risk: Remote work structural shift
• Major REITs: Boston Properties (BXP), SL Green (SLG), Kilroy (KRC)

Retail:

• Lease terms: 5-10 years (varies by tenant quality)
• Demand driver: Consumer spending, foot traffic
• Key risk: E-commerce substitution, tenant bankruptcies
• Major REITs: Simon Property (SPG), Realty Income (O), Regency Centers (REG)

Data Centers:

• Lease terms: 5-15 years (power-intensive, sticky tenants)
• Demand driver: Cloud computing, AI infrastructure
• Key risk: Technology obsolescence, power costs
• Major REITs: Equinix (EQIX), Digital Realty (DLR)

Performance divergence (2019-2024 cumulative returns):

• Industrial REITs: +62%
• Data Center REITs: +54%
• Multifamily REITs: +18%
• Retail REITs: +8%
• Office REITs: -38%

The practical point: Sector selection within REITs has driven more return variance than the decision to own REITs at all.

Interest Rate Sensitivity (The Duration Problem)

REITs behave like long-duration bonds in many market environments. Rising rates hurt through three channels:

Channel 1: Discount rate effect. Higher rates increase the discount rate applied to future cash flows. A property generating $1 million NOI forever is worth $20 million at 5% cap rate but only $12.5 million at 8%.

Channel 2: Relative yield competition. When Treasuries yield 5%, REIT yields must rise to remain competitive. Yields rise through price declines.

Channel 3: Borrowing cost increase. REITs typically carry 30-50% debt-to-assets. Higher rates directly reduce profitability as debt refinances at higher costs.

Quantified impact (2022):

• Fed funds rate increased from 0.25% to 4.25%
• REIT index declined -28% (vs. S&P 500 down 18%)
• Worst performers: Office (-42%), Healthcare (-35%)
• Best performers: Industrial (-15%), Self-storage (-12%)

The durable lesson: When rates rise quickly, REITs underperform. When rates fall or stabilize, REITs often recover sharply as yield-seeking capital returns.

Mitigation Checklist (Evaluating REITs)

Essential (high ROI)

These 4 metrics prevent most REIT selection errors:

• AFFO payout ratio below 85% (dividend sustainability)
• Debt-to-EBITDA below 6x (leverage safety)
• Weighted average lease term 5+ years (income stability)
• Sector with secular tailwinds (not office without thesis)

High-impact (deeper analysis)

For investors building dedicated REIT allocations:

• NAV premium/discount vs. historical range
• Variable vs. fixed rate debt mix
• Lease expiration schedule (concentrated = risk)
• Same-store NOI growth trend

Optional (for active sector rotation)

If you're timing REIT entry/exit:

• Monitor 10-year Treasury direction (rates falling = REIT tailwind)
• Track sector-specific supply pipelines (construction starts)
• Watch for M&A activity (privatizations signal undervaluation)

Next Step (Put This Into Practice)

Pull up a REIT you own or are considering and calculate its AFFO payout ratio.

How to do it:

1. Find FFO per share in the most recent earnings release (always reported for REITs)
2. Find maintenance CapEx per share (usually disclosed or estimable as 5-10% of FFO)
3. Calculate AFFO = FFO - Maintenance CapEx
4. Divide annual dividend by AFFO

Interpretation:

• Below 75%: Strong coverage, room for dividend growth
• 75-85%: Adequate coverage, sustainable
• Above 85%: Limited cushion, watch for headwinds
• Above 100%: Dividend exceeds cash flow—unsustainable without asset sales

Action: If payout exceeds 90%, dig into the debt maturity schedule. Refinancing at higher rates could force a dividend cut—exactly when you least expect it.