Learn · Lessons

REITs: the landlord's share.

A real estate investment trust owns buildings and pays most of the rent it collects to its shareholders. You get the landlord's income without fixing a single roof. Here is how the rent reaches you, how the buildings are valued, and why REITs care so much about interest rates.

Concepts in this lesson
REIT
A company that owns or finances income-producing property and must pay at least 90% of taxable income as dividends.
Cap rate (capitalization rate)
A property's yearly net operating income divided by its value or price.
Funds from operations
The REIT version of earnings: net income with property depreciation added back and property-sale gains removed.
Every term in Table Talk

01Owning the building

Buying an apartment block takes millions, a mortgage and a phone that rings at 2 a.m. when the boiler fails. A REIT lets you own a slice of hundreds of buildings for the price of one share: offices, warehouses, apartments, shopping malls, data centers, cell towers. The REIT's managers deal with the tenants and the boilers.

Most REITs own property and collect rent (equity REITs). A smaller group lends money against property and collects interest (mortgage REITs), which behaves more like a leveraged bond fund.

02From rent to dividend

In the US, a company qualifies as a REIT only if it pays out at least 90% of its taxable income to shareholders each year. In return, it pays no corporate income tax on what it distributes. The rent flows through the REIT and arrives in your account as a dividend, which is why REIT yields are usually well above the stock market's. A yield far above other REITs', though, is usually the market pricing in a dividend cut, not a gift.

The chain runs: rent, minus the costs of running the buildings, gives net operating income (NOI); minus interest and overheads, gives the cash available for dividends.

03Why REITs report FFO

US accounting rules make a REIT write down its buildings every year as depreciation, as if they were wearing out like machines. Well-kept buildings often hold or gain value, so that charge makes a REIT's reported profit look smaller than the cash it brings in. REITs therefore report funds from operations (FFO): net income with property depreciation added back and gains or losses from property sales taken out.

Investors value REITs on price-to-FFO rather than P/E; our Simon Property Group report works one through.

04What the buildings are worth

Commercial property is valued much like a bond: by the income it produces and the yield buyers demand on it. That yield is the capitalization rate, or cap rate.

Cap rateproperty value = net operating income ÷ cap rate
Worked example: a REIT with one big building

The building earns $1 million a year in NOI. At a 5% cap rate it is worth $1M ÷ 0.05 = $20 million. The REIT owes $12 million and has 1 million shares, so each share's slice of the equity is ($20M − $12M) ÷ 1M = $8.00.

If buyers start demanding a 5.5% cap rate, the building is worth $18.18 million and each share $6.18: down 23%, from a half-point move. At 4.5% the shares are worth $10.22. The debt doesn't change, so every move in the building's value lands on the shareholders, magnified. Set the debt to $6 million in the box below and the same half-point move costs 13%, not 23%: the borrowing does about half the damage.

One thing the formula holds still that the real world doesn't: the income. Leases roll over, rents tend to rise with inflation, and a REIT whose NOI grows a few percent a year can outrun a good deal of cap-rate drift. That growth is what separates a REIT from a bond, and it is the reason to take a REIT's yield over a bond's.

Try it: cap rates and share value

With JavaScript on, this box shows a REIT's equity value per share at every cap rate from 3% to 10%, as you change its income, debt and share count.

Equity value per shareZero: the debt equals the property's value

05Why rates matter so much

Cap rates tend to rise and fall with interest rates. When bonds pay more, property buyers demand more from buildings too, so cap rates rise and property values fall, as in the example. Higher rates also raise what a REIT pays on new debt, and make its dividend look less attractive next to a safe bond. That's why REIT shares often fall when interest rates jump, even when the buildings are full and the rent is coming in.

At the table

Owning a REIT is owning a seat that pays a steady hourly rake-back. When the other rooms in town start paying players more to sit (rates rise), your seat still pays the same, but what someone will pay you for it drops. The rent didn't change; what a buyer demands for it did.

06What can go wrong

  • Rising rates push cap rates up and values down, as shown.
  • Leverage magnifies every change in property values.
  • Tenants leave: empty offices or failing retailers cut the rent.
  • Dividend cuts when income falls, and in the US the dividends are usually taxed as ordinary income, not at the lower rate many stock dividends get.
  • Property types fall out of favor: the shift to remote work hit office buildings; online shopping hit malls.
The fine print, lesson edition. This page explains how REITs work. It is education, not advice to buy or sell any security. The income, debt and cap rates in the examples are round numbers for the arithmetic, not any REIT's actual figures. Tax treatment depends on where you live and the account you hold them in.