A complete guide to commercial REITs

Getting your feet wet with commercial real estate investing can be daunting. The good news is that you can invest in commercial real estate without buying and running a property on your own. You can invest in a real estate investment trust, also known as a REIT, which is a trust that pools money from multiple investors to buy, develop, and operate commercial properties that can generate income.

What is a REIT?

Many REITs are registered with and regulated by the U.S. Securities and Exchange Commission. Some that are registered with the SEC are publicly traded, while others are private.  

One thing to keep in mind: To qualify as a REIT, a company must check off the following boxes:

• Distribute at least 90% of its taxable income to shareholders annually.
• Be an entity that would be taxable as a corporation but for its REIT status.
• Invest at least 75% of assets in real estate.
• Have a board of directors or trustees.
• Have shares that are fully transferable.
• Have a minimum of 100 shareholders after its first year as a REIT.
• Have no more than 50% of its shares held by five or fewer individuals.
• Invest at least 75% of its total assets in real estate assets and cash.
• Get at least 75% of its gross income from real estate-related sources.
• Get at least 95% of its gross income from real estate-related sources and dividends and income from any source.
• Have no more than 25% of its assets made up of nonqualifying securities or stock in taxable REIT subsidiaries.

What are commercial REITs?

Commercial REITs invest in commercial properties. As with stocks, investing in a REIT means you buy shares of ownership in the asset.

The advantage of commercial REITs is that they let you invest in commercial properties – and invest in real estate – without needing to buy and run the property yourself.

The types of business properties that fall under the category of a commercial real estate REIT include:

• Parking lots
• Office buildings
• Restaurants
• Hotels
• Industrial buildings
• Retail stores

As an investor, you can purchase shares of these entities, which are traded on the public exchange market much in the same way as you would buy shares of stock.

How do commercial real estate REITs work?

A REIT may own one or many commercial properties. The REIT manages those buildings and collects rent from tenants, distributing profits to the shareholders.

REITs let you invest in real estate portfolios – and investing in one is more common than you might think. Nearly 170 million Americans, or about 50% of American households, own REITs, according to a 2024 study by Nareit^®, the National Association of Real Estate Investment Trusts.

Commercial REITs are different from residential REITs, which are REITs that own and manage properties for people to live in – think condos, vacation homes, and apartment buildings.

Pros of investing in commercial REITs

Knowing the potential advantages to investing in commercial REITs can help you decide if it fits your short- or long-term financial goals. Advantages of commercial REITs include:

• High return on investment. Since REITs are legally bound to distribute 90% of profits to shareholders, it's possible to see a higher return on investment.
• Easy to invest. Commercial REITs are purchased the same way as stocks and bonds, allowing you to invest easily without spending a lot of capital.
• No mortgage required. If you buy a property, you may need a mortgage or up-front funding. Commercial REITs let investors spread the money, and risk, across all shareholders of the trust.
• No management responsibilities. Direct real estate investing – think house flipping or buying a rental property – may require you to manage the property. Commercial REIT investors benefit from not having to manage an investment property.
• High performance. Historically, REITs have performed well. That's because commercial properties have long-term appreciation.

Cons of investing in commercial REITs

Like most investments, there are some potential risks that come with investing in REITs. Unlike a bond, commercial REITs aren't a guaranteed, fixed-income investment.

Let's look at some potential downsides and risks:

• Sensitivity to interest rate fluctuations. Often, the value of a REIT is directly linked to interest rates. When rates are up, REITs are up. But in a low-rate environment, the slowdown can affect a REIT's overall performance.
• Yields change with the economy. Because real estate trends are affected by economic changes at the global and local levels, REITs are susceptible to yield changes. For example, COVID-19 drastically affected the commercial real estate market because so many people worked from home.
• Dividend taxation. For the investor, REIT dividends often are taxed the same as long-term capital gains, which is a much higher rate than other investment vehicles.

How do I assess the value of a commercial REIT?

It's generally a good idea to check return-on-investment metrics before investing in any asset, including REITs. Essentially, ROI metrics figure out the profitability of an investment. This can be achieved by comparing the investment's net profit against the total cost of the investment.

Let's look at a few of the most common metrics used to figure out how a commercial REIT is doing:

Funds from operation (FFO)

This is the REIT's cash flow. To calculate net FFO, you'll need to tack on losses or noncash expenses, such as depreciation, amortization, and any losses on the sale of assets, to the net income.

An FFO is often expressed on a per-share basis. This is like an earnings-per-share metric for a stock.

Here's an example:

A commercial REIT has an annual net profit of $200,000, depreciation of $50,000, gains of $50,000, and interest income of $5,000. Here’s how to find this example’s FFO:

• Add the net profit and depreciation, $200,000 + $50,000 = $250,000
• Subtract gains and interest income, $250,000 - $50,000 - $5,000
• FFO = $195,000

Adjusted funds from operation (AFFO)

Adjusted funds from operations measures a REIT’s financial performance.

Stacked against the FFO, it adjusts the FFO to factor in additional variables, such as maintenance costs. Think of it as like the adjusted gross income amount you calculate on your income tax return. You deduct specific expenses from your gross income on your personal tax returns.

With an AFFO, a REIT may need to account for major deductions that come with maintaining the property to reveal the true value per share.

Using the example above, a commercial REIT has an FFO of $195,000, with $50,000 in rent increases over the year, $100,000 in maintenance, and $30,000 in capital expenditures.

Here’s how to find the AFFO:

• Add rent increases to the FFO, $195,000 + $50,000 = $245,000
• Subtract maintenance and capital expenditures, $245,000 - $100,000 - $30,000
• AFFO = $115,000

Debt-to-EBITDA ratio

EBITDA is a common investment term that means earnings before interest, taxes, depreciation, and amortization. A REIT's debt-to-EBITDA ratio compares a company's liabilities in the form of net debt against its cash flow. That way, it can help gauge whether a company is over-leveraged.

Think of a REIT's debt-to-EBITDA ratio as like your debt-to-income ratio, which lenders use to compare your debt obligations with your income.

For example, a REIT might have a good FFO figure. However, if someone takes out large amounts of financing to get new properties, this squashes the profitability.

Credit rating

Like individuals, companies have a credit rating. Like a personal credit score, a corporate credit rating is used to gauge how likely a company is to repay its debts. A major difference is that most corporate credit ratings are publicly disclosed.  

The services that rate corporate credit scores are:

• S&P Global
• Moody’s
• Fitch Ratings

While the rating scales can vary, the ratings scale for Fitch and S&P Global range from AAA to D, with AAA being the highest rating, and D being the lowest. Moody's ratings scale is from AAA to C.

What makes up a good credit rating? Typically, a rating from AAA to BBB- can be considered a good rating.

FAQ

Here are answers to common questions about investing in commercial REITs.

What’s the difference between commercial and mortgage REITs?

Commercial REITs primarily make money through rental income and long-term equity growth in commercial properties. A mortgage REIT makes money through investing in mortgage origination and mortgage-backed securities.

What is a commercial REIT ETF?

ETF stands for exchange-traded fund. A commercial REIT ETF is a fund that will mirror the performance of a standard REIT index. With an REIT ETF, an investor gets all the returns from REITs without directly investing in the real estate investment trust.

Are commercial REITs a good investment?

Over the long term, REITs can generate solid returns. Commercial REITs can be a useful tool for diversifying your real estate portfolio, especially if you prefer not to manage an investment property directly. REITs are best used as a long-term investment option.

The bottom line: REITs can be an entry-level real estate investment

Commercial REITs can be a great way to make money in real estate. You won't have to stomach the upfront costs of purchasing a piece of property and they're relatively easy to invest in. However, before forging forward, you'll want to weigh the pros against the cons. That way, you can rest assured it's the right investment move for you.

If you’re more interested in investing in a home, get in touch with a Home Loan Expert at Rocket Mortgage^® to help determine the best mortgage option for you.