A Complete Guide To Commercial REITs

Outside of owning a primary residence, getting involved in real estate investing can take a lot of spare time, money and effort. Fortunately, there’s an avenue for those who want to invest in real estate without the heavy lifting: commercial REITs. It’s important to note that Rocket Mortgage® does not offer commercial financing.

Many types of real estate investments trusts (REITs) exist:

• Residential
• Mortgage
• Health care
• Commercial

A basic understanding of commercial REITs will give new investors a better idea of whether this asset class is the right fit for their portfolio and how to get started.

What Are Commercial REITs?

Commercial REITs (also known as “equities”) are real estate investment trusts that are specific to business properties, such as hotels, parking lots and office buildings. Investors 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 big-name companies.

What Qualifies As An REIT?

To qualify as an REIT, a company must be connected to a real estate investment and distribute at least 90% of its taxable income to shareholders annually. An REIT must also meet the following requirements:

• 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 an REIT
• Have no more than 50% of its shares held by five or fewer individuals

How Do Commercial Real Estate REITs Work?

With a commercial REIT, an investor buys shares of the trust, which is managed by a professional money manager. Then, this manager invests that money into commercial real estate. The trust may buy one or several commercial buildings. They'll manage those buildings and collect rent from tenants, distributing any profits (left over after expenses) to the shareholders.

The Pros Of Investing In Commercial Real Estate REITs

Below are some advantages of investing in commercial REITs.

• Potentially 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 investors to get “in on the action” easily without spending a lot of capital.
• Invest without taking on a new mortgage: When directly investing in a real estate property, there’s added risk because so much capital is needed to obtain funding (a mortgage or loan) for a piece of property. It’s an expensive endeavor, and commercial REITs allow investors to spread the money, and risk, across all shareholders of the trust.
• No management responsibilities: Direct real estate investing (like with house flipping or buying a rental property) can offer substantial returns, but it comes at a cost: the time, headaches and effort involved in property management and being a landlord. Commercial REIT investors benefit from not having to manage property, so all money they earn from trust profits is truly passive income.

The Cons Of Investing In Commercial Real Estate REITs

Investment strategies vary by individual, so carefully consider these drawbacks before investing in commercial REITs.

• Sensitive to interest rate fluctuations: Often, the value of an REIT is directly tied to interest rates. So, when rates are up, REITs are up. In a low-rate environment, the economic outlook may not be great, which can signal to the real estate market that now isn’t the best time to buy and sell. That slowdown can impact overall REIT performance.
• Yields change with the economy: Because real estate trends can fluctuate based on economic changes at the global and local level, REITs are especially susceptible to yield changes. For example, COVID-19 drastically impacted the commercial real estate market because so many people worked from home. That’s just one example of how quickly REIT returns can change based on the state of the economy.
• Dividend taxation: For the investor, REIT dividends are often 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?

REIT investors use several valuation metrics to determine an REIT’s risk and estimate the market value of the REIT’s assets.

Funds From Operation (FFO)

This is the number REITs use to measure the cash flow from the trust’s investments. Often, FFO is the metric REITs use to determine overall operating performance.

To get to the FFO figure, the trust would take the sum of its overall profit, depreciation, amortization and losses then subtract any gains and interest income.

For example, let’s say 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

To keep it simple, many REITs quote this number on a per-share basis. Evaluating an REIT by the FFO-per-share is a great replacement for the typical earnings-per-share metric.

Adjusted Funds From Operation (AFFO)

AFFO takes the FFO metric and then adjusts for capital expenditures, or large expenses needed to maintain the properties in the trust portfolio over time. The main purpose of this number is to provide investors with an idea of how profitable the REIT truly is. You could make $40,000 in a year, but if a big office complex needs a new roof, there goes all of your profit.

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

Most REITs use some type of leverage (debt) to acquire multiple commercial investment properties. This is why potential investors should also closely monitor an REITs debt-to-EBITDA ratio. EBITDA is an accounting term that stands for earnings before interest, taxes, depreciation and amortization (EBITDA).

Similar to how a bank will look at your personal debt-to-income ratio (DTI) when you apply for a mortgage, banks look at debt-to-EBITDA ratio when evaluating whether or not to loan money to big entities. With an REIT, the debt-to-EBITDA ratio is expressed as a multiple of its pre-tax income, so 3:1, 5:1, 6:1, etc.

Credit Rating

Looking at the credit rating of each REIT is a quick way to evaluate which REITs are worth your time and money before doing further research into each one. If an REIT has a high credit rating, this means it’s both reputable and can borrow money more cheaply.

When evaluating REITs, you want to look for a credit rating issued by one of the primary rating agencies: Standard and Poor’s, Moody’s and Fitch Rating Services. Anything from a AAA to a BBB- is considered a good credit rating for a commercial REIT (or any investment or fund manager for that matter).

Commercial REIT FAQs

For more information about commercial REITs, review these frequently asked questions.

What’s the difference between commercial and mortgage REITs?

Commercial REITs primarily make money through rental income and long-term equity growth in the property. Conversely, a mortgage REIT makes money through investing in mortgage origination and mortgage-backed securities rather than in rental income and property equity.

The main difference is that income through rental properties is more stable, but investing in mortgage REITs, which earn money through interest income and the stock market, often provides much higher dividend yields.

What is a commercial REIT ETF?

ETF stands for exchange traded fund, and 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 be great investments. Commercial REITs can be a useful tool for diversifying a real estate portfolio, especially if you’re interested in real estate or in benefiting from the profits real estate can provide without doing all of the heavy lifting of maintaining a property. REITs are best used as a long-term investment option, as there are other short-term investments that would likely provide better returns.

The Bottom Line

A commercial REIT is appealing because it’s a type of real estate investing that allows individuals to build a commercial real estate portfolio (by buying shares of the REIT) without having to buy or manage property.

There are many ways to make money in real estate, but when you factor in the cost of your time, REITs offer all the gains of investing in real estate but enable investors to do so passively while spreading the risk across all shareholders of the trust. If you’d rather buy an investment property yourself, start an application with Rocket Mortgage^® today.