A Complete Guide To Commercial REITs
Lauren Bowling8-minute read
February 28, 2023
Owning real estate – it’s the backbone of the “American Dream,” right? But outside of owning a primary residence, getting involved in real estate investing takes a lot of spare time, money and effort. Fortunately, there are avenues for those who want to make money in real estate without the heavy lifting: Commercial REITs. It’s important to note that Rocket Mortgage® does not offer commercial financing.
There are many different types of real estate investments trusts (REITs):
This article focuses on commercial REITs.
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, office buildings and more. Investors can purchase shares of these entities, which are traded on the public exchange market much in the same as big-name companies like Amazon, Apple and more.
You can buy “shares” in an REIT in the exact same way as you would buy shares of a company using any brokerage account.
What Qualifies As An REIT?
It’s the Internal Revenue Service (IRS) that defines how REITs are formed. So, before you grab your siblings and friends together to form a REIT, there are actually quite a few restrictions from the IRS on how REITs are formed and what they can and can’t do.
The reason REITs are tricky to form is because the IRS gives special tax treatment to REITs; an entity that qualifies as an REIT is allowed to deduct all dividends from corporate taxable income. Pretty sweet, right?
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:
- 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.
How Do Commercial Real Estate REITs Work?
From an income perspective, a commercial REIT makes money for shareholders in much the same way as a mutual fund. For example, as an investor, if you buy shares in a mutual fund, you’re buying into a fund managed by a professional money manager, and these individuals invest the money of the fund on behalf of investors like you. They’ll invest in a variety of vehicles in hopes of earning money for their investors. In return, they take a share of the profits, but essentially when you make money, they make money.
A commercial REIT works in the same way. An investor buys shares of the trust, and then the trust takes that money and invests it into commercial real estate. The trust may buy a commercial building (or several), and then they’ll manage those buildings and collect rent from tenants, distributing any profits (left over after expenses) to the shareholders.
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The Pros And Cons Of Investing In Commercial REITs
While everyone’s investment strategy varies, there are a few things to consider when evaluating if commercial REITs are right for you.
The Pros Of Commercial REITs
- Higher Return On Investment: Since REITs are legally bound to distribute 90% of profits to shareholders, it’s easy 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 and without spending a lot of capital.
- Invest Without Taking On A New Mortgage: When directly investing in a real estate property, there is 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 owning 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 Commercial REITs
- Sensitive To Interest Rate Fluctuations: Often, the value of a REIT is directly tied to interest rates. So, when rates are up, REITs are up. In a low-rate environment (such as the one we’re having now), 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 and 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 as everyone went home to work rather than to the office. This was unavoidable, but just one example of how quickly REIT returns can change based on the state of the economy.
- Dividend Taxation: Remember when we mentioned REITs get special tax treatment by the IRS? The entity gets special treatment, but not the investor. At the individual level, 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 assess REITs. Utilizing these metrics can help potential investors determine the risk involved, plus estimate the market value of the REIT’s assets.
Evaluating a REIT is a little bit different than analyzing a traditional fund metric like earnings-per-share (EPS) and price-to-earnings ratio (P/E), so it’s important to pay attention to the information below to see if the REIT you’re evaluating is actually a good buy.
Funds From Operation (FFO)
This is the number REITs use to measure the cash flow from the trust’s investments. Often Funds from Operation (or FFO) is the metric REITs use to determine overall operating performance.
To get to the FFO figure, the trust would take its overall profit, but then add in depreciation, amortization and losses, while subtracting out any gains and interest income.
- For 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.
- Add depreciation ($50,000) = $250,000.
- Subtract Gains and interest income = -$55,000
- FFO = $195,000.
To keep it simple, many REITs quote this number on a per share basis, which means for novice investors, evaluating a REIT by the FFO-per-share could be used as a great replacement for the typical earnings-per-share metric.
Adjusted Funds From Operation (AFFO)
AFFO takes the Funds from Operation 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.
- First, we’ll add the rent increases to the final FFO number.
- Then subtract out maintenance and capital expenditures (CapEx).
- $195,000 + $50,000 = $245,000 - $100,000 - $30,000 = AFFO of $115,000.
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 applying for a mortgage, Banks look at debt-to-EBITDA ratio when evaluating whether or not to loan money to big entities. With a REIT, the debt-to-EBITDA is expressed as a multiple of its pre-tax income, so 3:1, 5:1, 6:1, etc.
You want to look for a REIT with a healthy debt-to-EBITDA (D/E) ratio, but this is up to your risk appetite. Investopedia reports the average D/E ratio for a REIT is 3.5:1. Don’t get scared, remember: All REITs need debt to grow the portfolio, but too much debt equals more risk.
If a REIT has a high credit rating, this means it’s both reputable and can borrow money for cheap. Looking at the credit rating of each REIT is a quick tool to evaluate which REITs are worth your time and money before doing a deep due-diligence dive into each one.
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.)
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FAQ: Commercial REIT
Commercial Vs. Mortgage REITs: What’s The Difference?
You may sometimes hear commercial REITs referred to as “equity REITs.” This means they primarily make money through rental income and long-term equity growth in the property. This term is often used when comparing a commercial REIT to a “mortgage REIT,” because they each make money differently.
A mortgage REIT makes its 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, which means a Commercial REIT ETF is a fund you can invest in that will mirror the performance of a standard REIT index. With a REIT ETF, an investor gets all the returns from REITs without directly investing in the real estate investment trust. These funds are different from investing directly into a stock of a company (like Gamestop, for instance) or even into a REIT directly.
Rather, think of an ETF as a basket full of REIT investments; you buy shares of the basket and get paid out based on the performance as a whole, not by individual items in the basket. ETFs are passively managed investments meant to earn returns even despite sector turmoil and volatility.
Are Commercial REITs A Good Investment?
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. Over a long-term time horizon, REITs can be great investments: recent research shows REITs outperformed the stock market over the last 30 years, with returns teetering between 10-12%.
REITs are best used as a long-term investment option, as there are other short-term investments that would likely provide better returns without the risk. As with any investment, potential investors should consider their individual budget and risk potential before buying.
The Bottom Line
Mutual funds are incredibly popular because they offer a diverse portfolio and provide average investors with opportunities to make money in real estate. 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 out the risk across all shareholders of the trust.
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