Types of Publicly Traded Real Estate Securities

The primary type of REITs, the equity REITs, are keenly managed enterprises that seek to maximize returns from their property portfolios by applying management skills in operations and finance.

Retail or Shopping Center REITs

This class comprises shopping malls of several sizes and, at times, individual buildings in prominent shopping neighborhoods.

Tenants in regional shopping malls tend to have long-term fixed-rate leases. In contrast, tenants in smaller units tend to pay a “percentage lease” consisting of a fixed rental price referred to as the “minimum lease” plus a sales ratio over a certain threshold.

Community shopping centers, e.g., stores linked by open-air walkways or parking lots commonly referred to as “power centers” or “big-box centers,” mostly pay predetermined rents that increase on a schedule.

Investors need to consider lease and sales rates per square foot as fundamental factors when inspecting a shopping center REIT.

Office REITs

Refer to office properties that typically rent space to multiple business tenants whose leases run for 5-25 years with rental increments over time. Tenants also pay a portion of property taxes, operating expenses, and other shared standard costs in proportion to their office space size (i.e., they operate net leases).

Office REITs typically experience a supply-demand disparity attributed to the length of time taken to construct these properties. This, in turn, results in differences in tenancy rates and rents over the economic life.

Investors need to consider factors such as the property’s location, new space under construction, utilitarian, architectural appeal, convenience, ease of access, quality of space, and building condition.

Residential or Multi-family REITs

These refer to investments in rental apartments for lease to individual tenants, mainly on a year’s lease. Multi-family REITs have a relatively stable demand. However, rental income tends to fluctuate over time with every new property construction.

Rental income is affected by various variables such as economic strength and any move-in inducement offers.

Investors willing to invest in a residential REIT need to consider local demographic trends, availability of alternatives, rent controls imposed by local authorities, age of the property, and architectural designs. Additionally, since rents are based on the gross lease, the effect of rising costs must be considered.

Healthcare REITs

These refer to investments in nursing facilities (nursing homes), assisted living, independent residential facilities for retirees, hospitals, rehab centers, etc.

Many countries have barred REITs from operating in this kind of business by themselves. However, to participate in this property sector, REITs lease properties to health care service providers while maintaining their tax-free status through net leases.

Inasmuch as healthcare REITs are relatively unaffected by the overall state of the economy, other important factors, e.g., government funding of healthcare, demographic shifts, demand versus new construction, increase in the cost of insurance, and the potential of lawsuits by residents, are all factors to be considered by investors.

Industrial REITs

These refer to properties owned and used in activities such as manufacturing, warehousing, and distribution. These properties are less cyclical. Besides, they are not subject to rapid changes in rental income over time due to the long-term nature of their net leases of between 5-25 years, the short time required to construct them, and the tendency to build and pre-lease them.

In analyzing industrial REITs, an investor needs to look at the local market for industrial properties, new properties under construction, and how the demand for space by tenants will affect the value of existing properties, shifts in the national and local composition of industrial bases, location, and ease of access through transportation links.

Hotel REITs

Hotels typically lease properties to management companies. Therefore, the REIT receives only passive rental income. Hotel revenues are subject to fluctuations determined by business and leisure travel changes, and a lack of long-term leases intensifies the sector’s cyclical nature.

Experts compare numerous data against market averages (operating profit margins, occupancy rates, and average room rates) in analyzing hotel REITs. One essential measurement closely monitored is RevPAR (the revenue per available room), which is derived as:

$$\text{RevPAR} = \frac{\text{Average Daily Room Rate}}{\text{Occupancy Rate}}$$

Other closely watched variables are the level of margins, forward bookings, and food and beverage sales, and expenses related to sustaining the properties.

Since the time lag associated with bringing new hotel properties online (up to three years), demand’s cyclical nature should be considered.

Storage REITs

Storage REITs are also referred to as mini-warehouse facilities. They own and operate self-storage facilities where space is rented under a monthly gross lease, i.e., no additional payments for operating costs or property taxes.

In their analysis of storage REITs, investors pay attention to the rate of construction of new competitive facilities, trends in housing sales that can impact demand for storage, local demographic trends, new business start-ups, and seasonal trends in demand for storage facilities.

Diversified REITs

They own more than one REIT category, and some investors prefer the reduced risk and broader opportunities from diversification.

Since diversified REITs hold a range of property types, investors need to assess management’s background in the kinds of real estate investments they are interested in when analyzing this REIT class.

Question

Maryanne Wong, an investment manager, is looking to add REITs to her portfolio. She is aware that some REITs have greater cash flow volatility than others, and she would like to choose the REIT with the least volatility. Which type of REITs should Wong most likely select?

1. Hotel REITs.
2. Shopping center REITs.
3. Industrial REITs.

Solution

The correct answer is B.

Shopping center REITs have the lowest cash flow volatility since most lease contracts with tenants are long-term-fixed contracts ensuring a steady inflow of rental income.

A is incorrect. Hotel REITs have the highest cash flow volatility because hotel revenues are subject to fluctuations determined by business and leisure travel changes. A lack of long-term leases intensifies the sector’s cyclical nature.

C is incorrect. While Industrial REITs have a higher cash flow volatility than that of hotel REITs, they are not as steady as those Shopping center REITs.

Reading 37: Investments in Real Estate Through Publicly Traded Securities

LOS 37 (a) Discuss types of publicly traded real estate securities.