Investing in Real Estate Investment Trusts (REITs) offers a steady stream of income and a way to diversify your portfolio. REITs are popular among income-focused investors because they are required by law to distribute most of their income as dividends. But what exactly drives the yields (or returns) you can get from REITs? In this article, we’ll break down how yields are created through dividends and price changes, explain what affects these yields, and cover the key factors to consider when investing in REITs.

What Is a Yield?

A yield is the return you earn on an investment. When investing in Real Estate Investment Trusts (REITs), your returns come from two main sources: dividend payments and changes in the price of REIT shares. Here’s a breakdown of each:

• Dividend Yields: REITs are required by law to distribute at least 90% of their taxable income to shareholders in the form of dividends. This creates a steady income stream for investors, making REITs attractive to those seeking regular payouts. Dividends come from the rental income generated by the REIT’s properties, such as apartment complexes or office spaces, after expenses like maintenance, property taxes, and loan payments are covered. In REITs, the yield from dividends is relatviley stable, usually growing over time. If you don’t intend to sell the stock and what interests you is the ongoing cash flow you receive from your holding, dividend yield is the parameter to look for.
• Price Fluctuations: The value of REIT shares can rise or fall based on how the market views the REIT’s assets and management. If the REIT is managing its properties efficiently or if the real estate market is strong, the share price may increase, boosting your overall yield. However, if the market perceives risks or if the value of the properties drops, the share price can decline, impacting your returns. It’s important to note that as the company generates cash, it’s value grows over time as this cash accumulates in the company (besides the cash distributed as dividend). So, even if the value of the assets does not change, and the company doesn’t distribute all the cash flow it generates as a dividend, the valua and price should grow over time.

Cash Flow and Dividends

A major factor that drives REIT yields is how much cash flow the REIT generates to its shareholders, since it’s the most important factor that affects both the ability to distribute dividends and valuation. This cash flow is measured by Funds From Operations (FFO), which is a key metric for assessing the REIT’s operating performance. The more income the REIT brings in after covering expenses, the more cash it has to pay out in dividends. The main components of FFO include:

• Net Operating Income (NOI): This is the income the REIT generates from its properties after paying for property management, maintenance, and other operating costs.
• General and Administrative Expenses (G&A): These are the costs of running the REIT itself, such as paying staff and covering office expenses.
• Interest Payments: If the REIT has borrowed money to buy properties, it needs to pay interest on those loans. Higher interest rates mean higher payments and less cash available for dividends.
• Capital Expenditures: These are costs for improving or repairing the properties the REIT owns. While these expenses help maintain the property value, they can reduce the cash flow available for shareholders in the short term.

The dividend the REIT pays is a direct result of its FFO. The average dividend distribution rate of REITs typically ranges between 70% and 90% of their FFO. While REITs are required to distribute at least 90% of their taxable income, they usually pay out a percentage of their FFO, as some of that cash flow is retained for reinvestment or property maintenance. This range can vary by the type of REIT and its specific strategy, with some REITs focusing more on growth and others on maximizing immediate payouts. Of course, the cash retained in the company adds to the value of the company.

The REIT’s cash flow directly impacts both the dividends paid to shareholders and the valuation of the REIT itself. Consistent and increasing cash flow leads to higher dividends for investors and often results in a higher market valuation for the REIT. Conversely, if cash flow is declining, both dividends and the REIT’s share price are likely to suffer. 

Price Fluctuations and REIT Valuation

In the long term, capital market participants generally believe that a company’s market price fluctuates around its true value. This principle holds for REITs as well. Over time, a REIT’s share price is expected to align with the actual value of the properties it owns, adjusted for liabilities like debt, and to the cash flow it generates to its shareholders. Determining the value of the REIT is essential for investors, and there are two main valuation techniques used to assess a REIT’s worth: Discounted Cash Flow (DCF) and Net Asset Value (NAV).

Discounted Cash Flow (DCF) Analysis

The DCF method is a widely used technique to estimate the value of a REIT by projecting its future cash flows and discounting them to the present value. Since REITs generate consistent cash flow from rental income, this method helps investors determine the present value of that future income. Here’s how it works:

• First, analysts estimate the REIT’s future cash flows, which include rental income minus expenses like maintenance, taxes, and interest payments.
• These future cash flows are then discounted back to the present using a discount rate, which reflects the risk of the investment and the time value of money. For REITs, the discount rate typically includes a risk-free interest rate (such as government bond yields) plus a risk premium to account for uncertainties in the real estate market.
• The sum of these discounted cash flows gives an estimate of the REIT’s intrinsic value. Investors can compare this value to the current market price to assess whether the REIT is under- or overvalued.

The DCF method is particularly useful for REITs since the cashflow from properties is usually based on long term contracts and has a high visibility.

Net Asset Value (NAV) Calculation

Another common way to value a REIT is the Net Asset Value (NAV) approach, which focuses on the value of the REIT’s assets (the properties it owns) after subtracting any liabilities (such as debt). NAV provides a snapshot of the REIT’s balance sheet and gives insight into the value investors would theoretically receive if all assets were sold and debts were paid off.

To calculate NAV:

• First, the market value of the REIT’s properties is estimated. This is done by appraising the real estate assets using comparable property sales, income-generating potential, and other factors like location and condition.
• Next, any liabilities, like outstanding debts, are subtracted from the value of the properties. The result is the net value of the REIT’s assets.
• Finally, this NAV is divided by the number of outstanding shares to get a per-share NAV. Investors can compare this figure to the current market price to determine if the REIT is undervalued or overvalued.

NAV is particularly useful because real estate assets tend to have more reliable appraisals than assets in other sectors. Therefore, NAV can be a strong indicator of a REIT’s value.

Both DCF and NAV are essential tools for assessing a REIT’s valuation and can help investors determine whether a REIT’s market price aligns with its actual worth.

Another common method for assessing a REIT’s value is by using multiples, such as the FFO multiple. This method involves comparing the REIT’s market price to its Funds From Operations (FFO) on a per-share basis. The FFO multiple is similar to the price-to-earnings (P/E) ratio used for regular stocks and helps investors determine whether a REIT is fairly valued relative to its peers or historical averages. A high FFO multiple may indicate that a REIT is overvalued, while a lower multiple could suggest that it is undervalued compared to its cash-generating potential. This approach is particularly useful for quickly comparing REITs within the same sector.

Factors That Drive REIT Yields

Now that you know what yields are, let’s look at the factors that affect the yield from REITs. These factors are key to understanding how much you can expect to make from your investment.

1. Interest Rates

One of the biggest drivers of REIT yields is interest rates. Here’s why:

• Borrowing Costs: REITs often borrow money to buy properties. When interest rates are low, borrowing is cheaper, increasing the cash flow left to the shareholders. As borrowing costs increase, more of the cash flow generated by the properties goes to the debt owners, decreasing the cash flow to shareholders. If the property you own generates you 100$ annually but the debt payment increases from 40 $ to 60$, less cash is left to pay dividend.
• Discount Rates: Interest rates also affect how investors value future cash flows. When interest rates are low, future cash flows are more valuable today. But when interest rates rise, future cash flows become less valuable, lower the value of REIT shares. The same affect exists from an asset perspective- high discount rates lead to lower asset valuations. For example, if your property igenerates you 1004 annually, and the market discount rate for such properties if 6%, the property will be valued at 1,666$. But, if interest rates increase and the market will ask for a discount rate of 7%, the value will decrease to 1,428$.

2. Market Fundamentals

Market fundamentals refer to the supply and demand for real estate, which impact the value of the properties a REIT owns and the rent it can charge. For example:

• Supply and Demand: If demand for modern logistics spaces is high but supply is limited, rents will rise, boosting the income office REITs generate and, in turn, increasing dividends for shareholders and the asset value.
• Economic Growth: A strong economy means businesses are expanding, more people are buying homes, and consumers are visiting retail stores more frequently. This leads to higher property values and rental income for REITs.

During economic downturns, however, demand for real estate can fall, lowering property values and rental income. This reduces the cash flow available for dividends and the value of properties, and will cause the share price to drop.

3. Type of REIT and Risk

Different types of REITs invest in different kinds of properties, each with its own risks and opportunities. For example:

• Office REITs depend on how many businesses are renting office space. If more companies switch to remote work, office REITs may struggle with vacancies.
• Retail REITs are impacted by consumer spending and the rise of e-commerce. While malls have been affected by online shopping, some retail REITs focus on experiential retail or essential services to stay competitive.
• Residential REITs tend to be more stable because people always need a place to live, even during economic downturns. But, location is important, as demographic trends can affect the demand for properties.
• Industrial REITs, which own warehouses and distribution centers, have benefited from the growth of e-commerce, as demand for storage and logistics space has surged.

Riskier properties like offices and hotels tend to offer higher yields because investors expect a greater return to compensate for the risk. More stable properties like apartments typically offer lower yields because the risk is lower.

Conclusion: Key Takeaways for New Investors

Investing in REITs can provide steady income through dividends and potentially benefit from rising property values. Here are the key things to remember:

• Yields come from both the dividends REITs pay and changes in their share prices.
• Dividends are based on the cash flow REITs generate from their properties after covering expenses.
• The long-term market price of a REIT generally fluctuates around its true value, which can be assessed using valuation techniques like Discounted Cash Flow (DCF) and Net Asset Value (NAV).
• Interest Rates have a big impact on REIT yields—when rates go up, REIT yields tend to go down.
• Market Fundamentals like supply and demand for real estate affect how much rent REITs can charge and how much their properties are worth.
• Different REIT Types come with different risks—riskier properties offer higher potential yields but come with more volatility.

Disclaimer: The information provided in this post is for informational purposes only and reflects my personal opinions. It should not be considered as professional financial, legal, or investment advice. Please consult with a professional before making any investment decisions. I am not responsible for any actions taken based on this information. The full disclaimer can be found here.