Top Down Vs. Bottom Up
When picking stocks, you sometimes hear of top-down versus bottom-up analysis. Top-down starts with an economic perspective and bets on themes or sectors (for example, an aging demographic may favor drug companies). Bottom-up focuses on the fundamentals of specific companies. REIT stocks require both top-down and bottom-up analysis.
From a top-down perspective, REITs can be affected by anything that impacts the supply of and demand for property. Population and job growth tend to be favorable for all REIT types. Interest rates are, in brief, a mixed bag. A rise in interest rates usually signifies an improving economy, which is good for REITs as people are spending and businesses are renting more space. Rising interest rates tend to be good for apartment REITs as people prefer to remain, renters, rather than purchase new homes. On the other hand, REITs can often take advantage of lower interest rates by reducing their interest expenses and thereby increasing their profitability.
Capital market conditions are also critical, namely the institutional demand for REIT equities. In the short run, this demand can overwhelm fundamentals. For example, REIT stocks did quite well in 2001 and the first half of 2002 despite lackluster fundamentals, because money was flowing into the entire asset class.
At the individual REIT level, you want to see strong prospects for growth in revenue, such as rental income, related service income, and FFO. You want to see if the REIT has a unique strategy for improving occupancy and raising its rents. REITs typically seek growth through acquisitions, and further aim to realize economies of scale by assimilating inefficiently run properties. Economies of scale would accomplish by a reduction in operating expenses as a percentage of revenue. But acquisitions are a double-edged sword. If a REIT cannot improve occupancy rates and raise rents, it may force into ill-considered purchases to fuel growth.
As mortgage debt plays a significant role in equity value, it is worth looking at the balance sheet. Some recommend looking at leverage, such as the debt-to-equity ration. But in practice, it is difficult to tell when advantage has become excessive. It is more important to weigh the proportion of fixed versus floating-rate debt. In the current low-interest rate environment, a REIT that uses only floating-rate debt will hurt if interest rates rise.
The Bottom Line
REITs are real estate companies that must pay out high dividends to enjoy the tax benefits of REIT status. Stable income that can exceed Treasury yields combines with price volatility to offer a total return potential that rivals small capitalization stocks. Analyzing a REIT requires understanding the accounting distortions caused by depreciation and paying careful attention to macroeconomic influences.
