The Intelligent REIT Investor

The Intelligent REIT Investor is an introduction to investing in real estate investment trusts (REITs).

I found The Intelligent REIT Investor an informative book. As a newbie to the topic I appreciated the good overview it provides about the history of REITs, the terminology, and the different kinds of REITs and their characteristics. On the other hand, I wished there were some examples of how the authors analyse REITs in practice. Completely unnecessary are the about 30 pages of appendices with lists of all REITs, ordered by different criteria. Because all REITs are already listed when the different property types are discussed.

My notes

An Introduction to REITs

What Is a REIT

A real estate investment trust [...] is an entity that receives revenue through owning or financing income-producing property. [...] By being public, REITs are accessible to investors of all types, who can benefit from receiving real estate income without purchasing, managing, or financing property directly.

Publicly traded REITs can be bought or sold like the stock of any other public company. Unique to REITs, however, is their tax status. The Real Estate Investment Trust Act of 1960 legislation that created the REIT structure exempts companies that qualify as REITs from paying corporate income tax, provided they distribute their taxable income as dividends. To qualify as a REIT in the eyes of the Internal Revenue Service (IRS), a company must meet many specific criteria. The most widely known provision is that a REIT must pay shareholders a dividend equal to at least 90 percent of its otherwise taxable income.

Equity REITs derive the majority of their revenue from rents paid by tenants according to the terms of leases that exist between the REIT (the landlord or lessor) and its tenants (the lessees). These REITs usually have fee simple interest in their properties and use debt to finance a percentage of the purchase price. [...] Fee simple interest in real estate means the buyer receives title to the land and improvements, improvements being the building and any structure that exist on the land. The debt an equity REIT uses to finance a portion of a property can either be a mortgage (which is also called property-level debt) or corporate-level bonds (also called senior or unsecured debt).

Sometimes, equity REITs own properties according to a leasehold interest, which is also called a ground lease. In this case, the REIT does not own the land on which the building(s) sit(s). The REIT pays the landowner (or lessor) a monthly fee for an agreed-upon time period – usually several decades – in exchange for the right to use the land as needed to support the building's operations.

Mortgage REITs lend money to real estate owners directly, by issuing mortgages, or indirectly, by acquiring existing loans or mortgage-backed securities. Mortgage REITs, which are also referred to as mREITs, derive the majority of their revenues from interest received on commercial mortgage loans or from investments in residential- or commercial-based real estate instruments.

Every REIT can be broken down into three activities that support their financial results:

1. Internal growth generated by managing assets the REIT already owns; also sometimes called "organic" growth
2. External growth generated by acquiring or developing properties
3. Financing that growth through issuing new debt or equity, and/or by selling properties

Companies with lower costs of capital are able to grow faster and with higher quality investments than companies with higher, less competitive costs of capital.

Growing earnings by developing properties is riskier than acquiring assets that already exist, especially in property types that take a year or more to construct.

Acquiring assets bears more risk than managing properties a REIT already owns.

Regarding how a REIT pays for existing operations and any level of external growth, it is hard to find a REIT – or any company – that went bankrupt because it had too little debt. REITs are like any company in that more debt, which is also referred to as leverage, equates to higher risk and lower certainty of future earnings and cash flow.

Why Invest in REITs?

Investor total returns on any stock investment are calculated as the sum of dividends received plus any appreciation (or less any decline) in stock price during the time the stock is owned. Due in part to their attractive current yields, REITs have tended to deliver annualized total returns to investors of 10 to 12 percent over time.

Dividend income is one of the primary reasons to invest in REITs, in large part because their yields represent an attractive premium to yields offered by other investments.

REITs are an attractive investment for people seeking current income, provided that the REIT has a conservatively leveraged balance sheet and well-located assets that are competitively managed. When a REIT possesses these qualities, it generally can sustain – and preferably grow – the dividend it pays to shareholders.

Publicly traded REITs offer investors the ability to add real estate returns to their portfolios without incurring the liquidity risk that accompanies direct real estate investment.

Because real estate has its own unique drivers and cycle that are separate from that of other equities and bonds, real estate investments promote portfolio diversification.

The ability to pass along increases in operating costs enables REIT revenues to keep pace – albeit with some lag – with rising prices in times of inflation. The result is that REITs generate inflation-adjusted earnings, which makes their stocks attractive investments during times of inflation.

REIT Dividends

REIT yields may be attractive, but they are meaningless if the dividend behind them is not sustainable.

In a credit crisis, like the United States endured in 2007-2009 and in the savings-and-loan crisis of the late 1980s, many REIT boards of directors will elect to cut or even temporarily suspend dividend payments to preserve capital. To mitigate the risk of a dividend cut, invest in REITs with lower leverage levels than their peers.

A REIT's expected dividend payout ratio is calculated as its current annualized dividend, divided by an estimate of next year's expected funds from operation (FFO) per share. REITs use FFO to measure profitability instead of earnings per share (EPS). [...] The resulting dividend/FFO payout ratio (which is also referred to as an FFO payout ratio) gives a quick thumbnail sketch about a REIT's ability to pay its current dividend. An FFO payout ratio below 1.0 indicates that Wall Street expects that REIT to generate FFO sufficient to cover its current annualized dividend. By contrast, an FFO payout ratio above 1.0 should generate immediate concern and cause potential investors to dig deeper into a REIT's expected earnings ability.

Preferred stock is often viewed as a hybrid security in that it shares characteristics with debt and common stock investments. Like a bond, preferred shares are sold according to a face (or par) value, which, in the case of preferreds, is usually $25 per share. Unlike bonds, perpetual preferred stock has no maturity date. Typically, a REIT that issues preferred shares has the right to redeem (or call) those shares at par after five years; if the REIT can issue new preferred shares or debt that has a lower recurring payment than the old preferred shares, then management will likely call those preferred shares and issue lower-cost capital to pay for the redemption.

There are three risks investors need to keep in mind when investing in preferred shares for dividend income, each of which involves liquidity or lack thereof. First, the secondary market for REIT preferred stock is not as liquid as the market for common stock in the same company. This means that investors may have some difficulty selling (or even pricing) their preferred shares when they want or need their principal back. Second, it is important to read and understand the term sheet in the prospectus of each preferred stock issuance before investing. [...] there is no consistent underwriting standard to which issuers of preferred stock must conform. The difference that may exist between what preferred stock investors assume they are buying and the reality of what they actually bought can lead to unpleasant and costly surprises. For example, a REIT that pays a $0.75 per share annualized common dividend may issue a preferred stock that pays $1.00 per share each year. If that preferred stock does not contain a ratchet feature or some other covenant to protect the preferred yield relative to that of the common shares, the management team legally could increase the annual common dividend to be greater than $1.00 per share. If that happens, the preferred issuance will become illiquid, making it extremely difficult (or impossible) to sell the securities anywhere close to par. [...] The third level of liquidity risk relates to when there is a change in control at a REIT, such as when a private equity firm or competing REIT buys a REIT that has preferred shares outstanding. In all too many instances, the preferred equity investors of the acquired (or target REIT discover that the terms of their preferred stock allow an acquiring company to suspend their preferred dividend and/or that the acquiring entity has no obligation to "cash out" the target REIT's preferred shareholders.

Leases

A lease is a legal agreement between a landlord (the lessor, which is the REIT) and a tenant (the lessee) whereby the tenant agrees to pay rent for a defined period of time in exchange for the right to occupy the landlord's space.

Along with the length of each lease, which is usually expressed in months or years, different lease structures translate into different cash flow streams to a landlord. Tenants and landlords negotiate all aspects of a lease, including the length of time a property will be leased (lease length, term, or duration), who will pay for which operating expenses, and who will pay for improvements to the tenant's space. Each type of lease allocates different costs to the landlord or tenant and determines which person bears the risk of paying higher costs if utility or other expenses increase.

Base year is the 12 months of a lease or the period that ends with the first full calendar year of a lease. In the latter instance, the base year will be more than 12 months. It is often used to set the expense stop (defined below) in a full-service or modified gross lease.

Common area maintenance (CAM) are charges the landlord incurs to maintain areas of a multi-tenanted property (which simply is a building that has more than one tenant) that are accessible to all tenants, such as the landlord's property management fee, labor costs associated with the building's engineering team, lobbies, shared restrooms, and a parking area.

Escalation clauses, or escalators, are set future increases in rent that the tenant agrees to pay during the course of a lease.

Expense stops are most common in full-service and modified gross leases. The landlord will bear the operating expenses and CAM associated with the tenant's space up to the expense stop amount; the tenant will bear any expense overage.

Leasing commissions (LCs) are paid to real estate brokers who represent the tenant and/or landlord.

Operating expenses are costs associated with operating and maintaining the rented area of a building. Such costs include real estate taxes, property insurance, utilities, and janitorial services for tenant-specific areas [...]. Operating expenses do not include capital expenditures for structural maintenance of the building, and they do not include interest payments on any mortgage associated with the property being leased.

Total, base, gross, or contract rent are all ways of describing the amount of money a tenant will have to pay the landlord each period, as defined in the lease. It includes agreed-upon expense stops and reflects any rent escalations that have become effective.

Net rent is the amount of rent a landlord retains each period, after paying (or net of expenses associated with property operations and maintenance.

Effective rent is net rent, adjusted to reflect the cost of any concessions and leasing commissions the landlord has agreed to as part of the lease agreement.

Free rent is a period of time [...] during which a landlord grants the tenant occupancy rights to the rental space without requiring contract rent be paid. Free rent is a concession a landlord is willing to pay to entice a tenant to lease a space.

Market rent is the rental rate associated with comparable spaces in similar buildings and locations.

Gross square feet (or gross building area) measures a building's total constructed area to the outside of its walls. Gross square feet generally is not used for leasing purposes unless the tenant leases the entire building, in which case the gross square feet equals the rentable square feet.

Rentable square feet is the sum measurement of a tenant's useable area, plus that tenant's pro rata share of the building's common areas.

Useable square feet (or useable area) measures the amount of space that can be used by tenants within the walls defining the space they have rented.

Tenant improvement (TI) allowance is an amount of money the landlord is willing to spend on a space to retain an existing tenant or entice a new tenant to lease a space.

Gross lease – a lease in which the tenant pays the landlord a fixed monthly rent and the landlord assumes responsibility for paying all operating expenses, taxes, and insurance associated with the property. [...] Unsurprisingly, the gross lease is rarely (if ever) used, and often only for short periods of time and at lower-quality properties.

Net lease – a lease in which the tenant pays the landlord a fixed monthly rent and is also responsible for paying all or some of the expenses associated with operating, maintaining, and using the property.

Modified gross lease – [...] is one in which the tenant pays the rent plus the property taxes and insurance, and any increases in these items over the base year. The landlord pays the operating expenses and sometimes the maintenance associated with the property.

Full-service lease – a lease in which the tenant pays the landlord a fixed monthly rent that includes an expense stop calculated off the base year. The landlord pays all the monthly expenses associated with operating the property, including utilities, water, taxes, janitorial, trash collection and landscaping and charges the tenant in subsequent years to the extent operating expenses exceed the expense stop.

Leases between a REIT and a tenant are viewed by bankruptcy courts as operating expenses, which are senior to the bankrupt tenant's debt obligations to lenders. Accordingly, a tenant must continue to pay rent to their landlord (the REIT), even while going through bankruptcy.

Knowing the average lease length and the type of lease structure a REIT uses helps predict how its shares may trade during times of economic expansion and contraction.

Shorter leases translate into more volatile future earnings and, by extension, wider daily swings in price for those REITs' shares. In contrast, longer leases generate steady income that is similar to receiving interest payment from a bond.

REITs by Property Type

Diversified REITs are equity REITs that invest in two or more types of commercial property [...]. On the opposite end of the property spectrum are specialty REITs [...], which own only one type of highly specialized real estate, such as billboards, correctional facilities, or farmland.

[...] a triple-net lease is one in which the landlord collects a base rent that excludes – meaning it is net of – taxes, insurance, and maintenance expenses associated with occupying the property. These and other operating expenses are paid directly by the tenant to the various service providers. REITs that use triple-net leases typically lease their properties to a single tenant for 10 or more years.

During times of economic expansion, landlords that use long-term, triple-net leases do not profit as much as other landlords that use shorter-term, gross, or full-service leases because they cannot capture rising market rents. However, triple-net landlords do benefit from steady, bond-like cash flows generated by their leases. As a result, triple-net REITs are viewed as the most defensive, least volatile REITs and tend to outperform other REITs during times of economic uncertainty.

Health-care REITs receive their income primarily from leasing facilities to health-care providers, usually on a triple-net or modified-gross basis. [...] Property types include senior and assisted-living/rehabilitation facilities, medical clinics, medical office buildings (also referred to as MOBs), health-care laboratories, and hospitals.

Industrial properties are leased to businesses for a variety of purposes, including distribution warehousing, light manufacturing, and research and development (R&D). Industrial property is among the most stable, least-volatile asset classes in the United States. [...] The fact that supply of newly constructed industrial property tends to track demand for new facilities is one of the primary reasons behind the sector's stability.

Industrial properties are fairly simple to build, consisting essentially of four walls tilted up on a six-inch slab of concrete, with a roof that holds it all together. As such, it typically takes only six-to-nine months to construct an industrial property after breaking ground. Due to the relatively short development cycle, industrial property markets tend not to get overbuilt.

REITs generally own hotels branded under the most widely recognized flags, and tend to focus on the urban markets. [...] Hotels are frequently classified by the quality-level of guest services offered, such as luxury, upper-scale, upscale, midscale, or economy or by their location such as urban, suburban, resort, and airport.

Location and quality-levels is a key driver of a hotel's maximum revenue per available room (RevPAR), which is the product of a hotel's average daily room rate (ADR) and its occupancy rate.

Labor represents the most significant expense in hotel operations. As a result, hotels will have large fixed costs to operate the hotel since a minimum number of employees are required to open, run, and clean a hotel each day, regardless of occupancy levels.

Hotel REITs differ structurally from other equity REITs in that [...] hotel owners are not permitted to directly operate the properties they own. This is because earning profit from operating hotels is active and differs from the more passive business of collecting rent on hotels leased to third-party operators. As a result, hotel REITs must retain a third-party hotel manager to operate its hotels.

During times of strong economic growth, hotels can increase prices immediately; as a result, during certain points in the economic cycle, hotel REITs can achieve some of the highest annual total returns of any property type [...]. In addition, since the lease rate for hotel rooms can be reset daily, in a rising inflationary economy, hotel REITs have an advantage as they can reprice their "leases" daily. As a result, hotel REITs tend to be the least interest rate sensitive class of investment real estate.

Mortgage REITs originate residential and commercial mortgages, and they also invest in securities backed by residential mortgages (RMBS) and commercial mortgages (CMBS). A mortgage-backed security (MBS) is a bond-like investment, supported by interest income generated by an underlying mortgage or collection of mortgages.

Because mREITs lend money at one rate and borrow it at another, their profitability is affected by changes in the interest rate environment.

Because mREIT profitability can be challenged by any change in interest rates, investors are better served to invest in these REITs only when they feel confident that the interest rate environment will be stable during their investment period.

Office REITs own everything from high-rise buildings in major metropolitan areas such as New York City, to low- and mid-rise suburban office space in secondary office markets such as Charlotte, North Carolina.

Office buildings are also classified based on building quality (construction and materials), conditions of their mechanical and other internal systems, in-building amenities (such a gym or restaurant), and location. Newer buildings typically are deemed to be Class-A properties. Older buildings that have less efficient mechanical and electrical systems, or that are simply less aesthetically pleasing, tend to be classified as Class-B or Class-C.

Office leases typically are full-service leases with an initial term of five to seven years, plus one or more multi-year renewal options.

Office REIT returns are more cyclical than the average equity REIT's due to periodic overbuilding. [...] If demand for new space does not keep pace with the increase in supply, office vacancy in that market will rise and rental rates will decline. The office sector's longer building cycle is a primary contributing factor to historical overbuilding. During the two or more years it generally takes to complete an office tower, local demand for office space, which is a function of job growth and the local economy, can change materially and cause a building to sit vacant or mostly vacant until demand for office space recovers.

There are three subcategories of residential REITs: apartments (or multifamily), manufactured homes, and single-family homes.

Traditional apartment buildings are classified as either garden-style or high-rise buildings. Garden-style apartments contain multiple buildings that usually are one to four stories in height and are configured around the center of the community, typically a pool or other common area(s). [...] In both formats, apartment properties generally contain a mix of studio, one-, and two-bedroom apartment units. Properties also are classified as Class-A, B, or C. Class-A buildings include newer buildings in prime locations. Buildings in Class-B and C categories tend to be older, offer residents fewer amenities, and, perhaps, are located in less desirable locations.

Similar to office space, demand for apartments is highly correlated with employment trends. As employment in an area increases, demand for apartments to house new workers who in-migrate to that area also increases. In contrast to the office sector, demand for apartments also increases when employment decreases, as some former homeowners sell their houses and go back to renting.

Commonly known as mobile homes, manufactured housing communities are a lower-cost alternative to home ownership, which makes them popular among retirees and lower-income workers. REITs in this property niche own land that is rented to individuals pursuant to a ground lease. Tenants purchase prefabricated houses that are placed in an approved location within the community.

Initial lease terms to anchor tenants – the larger box tenants used to draw traffic to the retail center – generally are negotiated for 15 to 20 years. Inline tenants are the smaller shops in a center and generally lease their space for 5 to 10 years. Retail landlords typically employ net or modified gross leases [...]. Retail landlords also may receive percentage rents in addition to their face rents and CAM fees. Percentage rents are calculated as a portion (typically 1 to 2 percent) of revenue a tenant achieves in any given year above the base (or initial) year revenue.

During times of economic expansion, landlords can enhance the overall yield on their properties from percentage rents. When economic growth slows or contracts, however, the landlord may receive no percentage rents, which would represent downside risk to the retail REIT's earnings.

Similar to what drives the apartment sector, demand for self-storage units is driven by population growth, people moving locations for jobs or other reasons, as well as the urge many people have to archive things for future generations or the simple inability to throw anything away.

Property owners rarely depend on one customer for large portions of revenue because individual consumers (rather than businesses) represent the majority of self-storage users. The storage units themselves are simple structures located near busy roads in order to ensure visibility. They require little capital expenditures outside of roof or parking lot/pavement repairs.

Investing in REITs

Getting Technical

Prior to 1992, equity REITs owned their commercial properties directly or through joint ventures. [...] So with a traditional REIT structure [...], shareholders essentially owned a portion of the REIT's business enterprise, prorated according to how many shares they owned of the REIT as a percentage of total shares outstanding.

Beginning in 1992, the REIT corporate ownership structure underwent a radical change with the introduction of the Operating Partnership Unit (OP unit) and the Umbrella Partnership REIT (UPREIT) structure. [...] UPREITs differ from traditional REITs in two ways. First, [...] in the UPREIT structure, the REIT does not own its properties directly. Instead, the REIT owns (usually a great majority of) units in a limited partnership called an operating partnership (OP), which in turn owns and operates the properties. [...] When an UPREIT sells common shares or issues debt to the investors, it contributes the proceeds raised to its OP in exchange for additional OP units. The OP technically is the legal entity that buys and/or develops properties and operates them. From the money it earns from operating the properties, it "dividends" money back to the UPREIT, which pays dividends to the investors. [...] Second, UPREITs have an additional currency besides cash and common stock with which its management team can acquire properties: the OP unit.

[...] the operating partnership of an UPREIT can issue OP units to the seller of property as a form of consideration, similar to issuing common shares. OP units are economically the same as shares of common stock in that the OP unit holders receive the same distributions per unit as the UPREIT's stockholders receive on their common shares. Unlike common stock, OP units are not publicly traded and the owner cannot vote regarding UPREIT corporate governance matters. In nearly every instance, OP unit holders can convert each unit on a one-for-one basis into common stock of the UPREIT or for cash (at the UPREIT's option).

Generally, the IRS views the contribution of limited partnership units of real property in exchange for partnership interests, including OP units, as a nontaxable event. As a result, the party that contributed real estate in exchange for OP units may be able to defer the recognition of capital gains (and the associated taxes) until such time as they convert their OP units into shares of the UPREIT or cash.

Investors in PNLRs [public nonlisted REIT] and private REITs often cite the lack of daily price changes (or volatility) among the benefits of investing in these entities. They like the fact that they do not have to worry about the daily price movements in their investments, as do shareholders in publicly traded REITs. However, this semblance of stability comes at the steep price of not having liquidity. Shareholders of publicly traded REITs own liquid investments that can be sold instantly in the stock market. It can take weeks or months to redeem in investment in a private REIT or PNLR [...].

Publicly traded REITs and PNLRs must file quarterly and annual periodic statements with the SEC. [...] In contrast, private REITs do not have to disclose their financial statements.

REIT Performance

Although current stock prices reflect investor expectations about future company earnings, the fundamental laws of supply and demand also matter. Because the REIT industry is small relative to other industries, REIT returns can be negatively affected when too many REITs issue too many new shares, creating a temporary market situation of oversupply.

If a credit crisis is possible, stocks associated with real estate, such as REITs, are likely to underperform the broader market due to investor fears – real and imagined – about the sustainability of corporate dividends and the risk of defaulting on loans scheduled to mature in the near term.

Each REIT in every property sector is governed by three broad forces that affect their performance, both on an absolute basis and relative to other REITs: real estate fundamentals, lease structure and duration, and cost of capital. Real estate fundamentals, and especially the degree to which demand for a property type is consistent throughout different phases of the economic cycle, affect a REIT's profitability over the long term.

Supply of and demand for commercial space, which are the two primary real estate fundamentals, affect REITs' longer-term operating performance and, by extension, returns for shareholders. When a property market is inundated with too much new construction (supply), vacancy rates increase and landlords decrease rental rates in an attempt to keep existing tenants in their spaces. Whether landlords experience increases in vacancy or declines in rental rates (or both), their profit margins decline.

By understanding how the real property cycle interacts with the economic cycle, it is possible to make smart and timely REIT investments. The property cycle encompasses how occupancies and rents in a market fluctuate, and whether new construction "makes sense".

1. Recovery – After the economy emerges from recession, the recovery period for real estate is characterized by a lack of new construction because rental rates are not improved enough, generally, to merit the cost of new development. [...] Because demand for space is recovering without the addition of new supply, occupancies rise. REITs with cash on hand (or low levels of debt) are able to buy assets at attractive discounts to replacement cost, enabling them to deliver outsized returns on their investment.
2. Expansion – During an economic expansion, occupancy continues to increase but at a decreasing rate from prior periods. Landlords are able to push for higher rents on new leasing to the point that assets can no longer be purchased at discounts to replacement costs. As rental rates rise, new construction begins to become profitable again.
3. Supply-and-Demand Equilibrium – This is a state of commercial property nirvana that is rarely achieved, in large part because private developers tend to overbuild their markets (at least slightly) during each cycle.
4. Oversupply or Lack of Demand – As the economy begins to slow, property markets continue to add new supply, albeit at a reduced pace. This is because new construction started during the late phase of the economic expansion frequently is delivered into a softening economy. [...] During periods of oversupply or declining demand, vacancies increase. However, rents may still increase for a period of time because not all tenants' business will feel the effects of a slowing economy at the same time.
5. Recession – An extension of the oversupply phase, property markets can slip into recession if too much supply is delivered into an economy that is in recession. The lack of demand for space, compounded by the new square feet coming onto the market initially, causes some tenants to sublease their unused space. Investors should watch for signs of increasing levels of subleased space, also called "shadow supply", to signal a market's decline. Then direct vacancies begin to rise as tenants choose not to renew some or all of their previously leased space. In such an environment, landlords will offer concessions and lower rental rates to maintain as much occupancy as possible.

Real estate performance lags economic conditions, depending on the leases in place. The longer the lease length, the longer the property's cash flow takes to reflect what's happening in the economy. Knowing the average lease length and the type of lease structure a REIT employs helps predict how a REIT's shares may trade during times of economic expansion and contraction.

Shares of REITs that own properties with shorter-term leases tend to trade with more volatility than those with longer lease lengths.

One of the main reasons why REITs with more highly leveraged balance sheets tend to underperform is that they miss opportunities to acquire assets at deeply discounted prices during times of market dislocation [...]. REITs with too much debt going into a recession or market crisis simply don't have the financial flexibility to capitalize on market opportunities.

Analyzing REITs

Net operating income, or NOI, is similar to an operating company's gross profit margin. [...] NOI equals the sum of rental revenues from properties plus any tenant reimbursement revenue, less all property operating expenses, including fees paid to any third-party property managers, taxes, and insurance. [...] Said another way, NOI measures the property-level profit on a stand-alone basis, excluding the REIT's corporate overhead or the effects of financing.

Borrowed from the retail industry, the term same-store generally refers to revenues, operating expenses, and net operating income from assets the REIT has owned and operated for 12 or more months. Isolating the profitability of assets owned for at least 12 months from earnings generated by recently acquired or developed properties enables investors to gauge how competent the REIT management team is at operating their properties.

Unlike C-corporations, whose growth is measured as a change in earnings per share (EPS), REITs' growth is measured by the year-over-year change in funds from operations (FFO).

[...] FFO equals:

• Net income, as computed in accordance with GAAP, excluding:
  • Real estate depreciation and amortization
  • Gains (or losses) on the sales of previously depreciated operating properties
  • Impairment write-offs on previously depreciated operating properties
• Adjust to include the REITs share of FFO (or losses) in unconsolidated entities

If a REIT's yield looks too good to be true, it probably is.

One way to assess if the managers of a REIT are prudent allocators of shareholder capital is to observe the investment tactics they use when their stock is trading significantly above or below net asset value (NAV). NAV estimates the current market value of a REIT's properties, net of other non-real estate assets and liabilities. [...] REITs whose shares trade at a premium to NAV have a cost of capital advantage and should continue buying and/or developing to grow their portfolios [...]. In contrast, if a REIT's shares are trading at a significant discount to NAV, management should shrink its portfolio by selling the lowest performing or lowest growth assets and use the proceeds to pay down debt (or redeem any callable preferred shares). If the discount persists for several quarters, management should also consider buying back common stock – but only if they can do so without increasing their total debt.

Capitalization rates (or more commonly, cap rates) are a measure of the expected unleveraged return on assets. Another way to think about cap rates is that they are the inverse of a P/E ratio, where "price" is the fair market value (or purchase price) of the asset, and "earnings" are the property's cash NOI.

Conclusion

Ultimately, the most sound investment strategy for investing in REITs is to go for quality: quality real estate, quality balance sheet, and quality management.