PUBLICLY TRADED EQUITY REITS
3.5 Equity REITs: Property Subtypes
Equity REITs, the predominant form of REITs, are actively managed enterprises seeking to maximize the returns from their property portfolios by applying management skills in operations and finance. For this reason, most REITs focus on a particular property type, striving to excel in operating efficiency and growth while still being mindful of risk- reducing strategies, including diversification by geography and by the number and quality of properties and tenants. The analysis of equity REITs is conducted along the same lines as that of publicly traded equities in general: commencing with industry analysis, followed by company analysis, and then equity valuation. Certain specific economic value determinants, investment characteristics, risks, and areas for analysis and due diligence, apply to each property subtype of REITs shown in Exhibit 5.
Exhibit 5 Global REITs by Property Type Held
Property Type Percentage of Total
Shopping center/Retail 23.3
Office 14.5
Residential 11.3
Healthcare 6.8
Hotel/Resort 2.7
Industrial 4.2
Industrial/Office 1.0
Self- storage 2.6
Diversified 33.6
The following sections discuss these property types in more detail.
3.5.1 Shopping Center/Retail REITs
Shopping center or retail REITs invest in such retail properties as regional shopping malls, community/neighborhood shopping centers, and to a lesser degree, premium retail space in leading cities.
Regional shopping malls are large spaces, often enclosed, in which retailing tends to be in higher- priced discretionary goods (e.g., fashionable clothing). Tenants’ leases in regional malls usually have terms of 3–10 years and typically require tenants—except for the largest “anchor” retailers—to pay the greater of a fixed- minimum rental rate and a percentage of their sales. “Anchor” retailers, however, have very long- term, fixed- rent leases or own their premises. As part of their total rent under typical net leases, tenants pay a net rent, all of which goes to the landlord, plus a share of the common area costs of the mall based on their proportionate share of the space leased. Despite the link between tenants’ sales and rent, revenue streams are relatively stable because of high levels of minimum rent that often represent well over 90 percent of revenue.
Community shopping centers—consisting of stores linked by open- air walkways or, in the case of so- called “power centers” or “big- box centers,” linked by parking lots—
generally provide such basic necessity goods and services as food and groceries, home furnishings, hardware, discount merchandise, fast food, and banking, with similar lease maturities but non- participatory rents that are usually subject to periodic increases.
For shopping center REITs, analysts often analyze such factors as rental rates and sales per square foot/meter for the rental property portfolio, dividing them into same portfolio and new space addition components.
3.5.2 Office REITs
Office REITs invest in and manage multi- tenanted office properties in central business districts of cities and suburban markets. Lease terms are typically long (5–25 years) with contractual base rents that are fixed and adjust upward (typically every 5–10 years). In addition to base rents, tenants pay their proportionate share of operating expenses, common area costs, and property taxes. Rental income tends to be stable year- to- year, but over the longer term (5–10 years) it can be affected by changes in office market vacancy and rental rates that characterize the office industry cycle. This cycle arises because of long office tower construction and interior finishing periods (three or more years ) and the willingness of developers to build large buildings in which only a portion of the space has been preleased. These factors result in the commencement of construction of new space during periods of strong economic growth and the completion of new space potentially during economic downturns when tenant demand is low.
Analysts of office REITs pay particular attention to new space under construction in a REIT’s local market, to site locations and access to public transportation and high- ways, and to business conditions for a REIT’s principal tenants. Analysts also focus on the quality of a REIT’s office space, focusing on such factor as location, convenience, utilitarian and architectural appeal, and the age and durability of the building.
3.5.3 Industrial REITs
Industrial REITs hold portfolios of single- tenant or multi- tenant industrial properties that are used as warehouses, distribution centers, light manufacturing facilities, and small office or “flex” space for sales, administrative, or related functions.
Industrial property and industrial REITs are less cyclical than some other property/
REIT types including hotel, health care, and storage. The long- term net leases (5–25 years) that pertain to industrial space, the short time required to build industrial build- ings (usually well under a year), and the tendency to build and prelease and/or build space to suit particular tenants dampen any rapid change of rental income and values.
Analysts pay particular attention to trends in tenants’ requirements and the impact these can have on the obsolescence of existing space and the need for new types of space. Strategic property locations—such as near a port, airport, or highway—are important positive considerations. Shifts in the composition of national and local
industrial bases and trade play important roles in this regard and can sometimes be difficult to detect and forecast. Trends in new supply and demand in the local market are closely scrutinized.
3.5.4 Multi- family/Residential REITs
Multi- family/residential REITs invest in and manage rental apartments for lease to individual tenants, typically using one- year leases. Rental apartment demand tends to be relatively stable, but fluctuations in rental income can occur as a result of com- petition from condominium construction, tenant (move- in) inducements, regional economic strengths and weaknesses, the effects of inflation on such operating costs as energy and other utility costs, and taxes and maintenance costs (because apartment leases often tend to be gross leases under which many or all of such costs are paid for by the landlord).
Analysts pay particular attention to local demographics and income trends, age and competitive appeal, cost and availability of homeownership in local markets, and the degree of government control of local residential rents. Fuel and energy costs receive particular attention because properties are usually leased under gross leases that require landlords to pay for part or all of the building operating costs.
3.5.5 Storage REITs
Storage REITs own and operate self- storage properties, sometimes referred to as mini- warehouse facilities. Space in these facilities is rented under gross leases (i.e., no additional payments are due for operating costs or property taxes), usually on a monthly basis by individuals for storing personal items and by small businesses. Ease of entry into this growing field has led to periods of overbuilding.
Analysts pay special attention to the rate of construction of new competitive facilities, trends in housing sales activity that can affect the demand for temporary storage, local demographic trends, new business start- up activity, and seasonal trends in demand for storage facilities that can be significant in some markets.
3.5.6 Health Care REITs
Health care REITs invest in skilled nursing facilities (nursing homes), assisted living and independent residential facilities for retired persons, hospitals, medical office buildings, and rehabilitation centers. In many countries, REITs are not permitted to operate these facilities themselves if they wish to maintain their REIT status and must lease them to health care providers; these leases are usually net leases. REITs may jeopardize their tax status (no tax at trust level) if they are found to be operating a business in violation of their passive investment restriction. Although largely resistant to the effects of economic recessions, health care REITs are exposed to the effects of population demographics, government funding programs for health care, construction cycles, the financial condition of health care facilities operators/lessees, and any costs arising from litigation by residents.
Analysts scrutinize operating trends in facilities, in government funding, in litiga- tion settlements, and insurance costs. Amounts of competitors’ new facilities under construction in relation to prospective demand and prospects for acquisitions are also key points of focus.
3.5.7 Hotel REITs
Hotel REITs own hotel properties but, similar to health care REITs, in many countries they must refrain from operating their properties themselves to maintain their tax- advantaged REIT status. Hotel REITs typically lease all their properties to taxable REIT subsidiaries (or to third- party lessees) who operate them ensuring the hotel REIT parent receives passive rental income. This rental income typically accounts
for the major portion of a hotel’s net operating cash flow. Management of the hotel is usually turned over to hotel management companies, many of which own widely recognized hotel brands. The net effect of this structure is that although the hotel REIT is tax exempt to the extent that it meets its income distribution and other REIT requirements, a minor portion of net operating cash flow from hotel properties may be subject to income taxation. The hotel sector is cyclical because it is not protected by long- term leases and is thus exposed to business- cycle driven short- term changes in regional, national, and international business and leisure travel. Exposure to travel disruptions also increases revenue volatility.
Analysts examine trends in occupancies, average room rates, and operating profit margins by hotel type and geographic location; statistics are compared with industry averages published by government and private- sector hotel industry statistics providers.
Revenue per available room (RevPAR), the product of average room rate by average occupancy, is a widely monitored barometer of the hotel business. Attention is also paid to trends in hotel room forward bookings by category (individual, corporate, group, and convention), in food and beverage and banqueting sales, and in margins.
Expenditures on maintaining and improving property, plant, and equipment are scrutinized, and the rates of new room construction and completion in local markets are watched very closely in view of the cyclicality of demand and the long duration of hotel construction (typically 1.5 to 3 years). Because income is so variable in this sector, analysts need to be wary of hotel REITs that use high financial leverage.
3.5.8 Diversified REITs
Diversified REITs own and operate in more than one type of property and are more common in Europe and Asia than in the United States. Some investors favor the reduced risk and wider opportunities that come from diversification. An analysis of management’s experience with each property type and degree of local market presence are obviously important in reviewing diversified REITs.