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Welcome to Investing for Beginners podcast, I’m David Ahern, and Andrew Sather’s here tonight. We’re going to talk about REITs. We have episode 33 tonight, and we’re going to talk a little bit about REITs.

What we will learn today:

• What a REIT is
• How to value them, hint: the same way as any other stock
• How a REIT can help your portfolio
• REITs can give you exposure to the real estate asset class
• How to treat dividends in REITs from a tax perspective
• Whether or not they are a good investment for you.

We had a listener comment on our podcast earlier a couple of episodes ago, and we wanted to go ahead and answer his question and speaking of answering this question. Andrew has his comment up, and he wanted to go ahead and get us started.

Andrew: yeah so this is from Bart. He says this was a comment he left on the blog on one of the episodes.

He says “guys love the show. The quick question whether your thoughts on REITs, they seem to pay high dividends but is there a catch?”

So maybe we should start off and introduce what a is REIT. Its REIT stands for Real Estate Investment Trust; it is basically like it says in the title it’s a trust and it usually holds a portfolio of real estate different properties. And there are different categories that you can see when it comes to these.

Some of them will hold commercial real estate so think the malls and office buildings and the real estate that’s attached to those. Some of them do residential real estate, there are other types which I don’t know the nitty-gritty on all of them. But there are quite a few different industries around REITs. And so basically they hold these basket of real estate properties, and they hold them and their income-producing properties.

Then what the owners will do is they’ll reallocate those whatever income comes from the trust then gets distributed to shareholders.

So it works like a stock as in you can buy it in the stock market on an exchange. You can see that price go up or down you get paid a dividend based on what the earnings are, and so it has a lot of similarities to stocks, but it also has some technicalities which I think we can get into as.

Dave: well yeah they’re they’re interesting, they’re different beasts for sure. They’re you know the valuations of them are a little different than other regular stocks. Just because of the way that they’re set up.

And you’re right on the money about the different types of REITs and you know I’ve read different things about REITs in some information about them and you know I’ve seen different blogs and listen to podcast people talking about them. Preston and Stig, two of our favorites had a great interview; I guess another interview I’m sorry they had a question-and-answer session not too long ago that Andrew was telling me about before we went on air.

That they talked a little bit about REITs on there well, and they had some great comments on the REITs as well. And so there’s a lot of great information out there about REITs and you know the thing that I kind of like about the REITs is I remember when I was a young kid my dad told me once that land was one of the greatest investments you could ever have because it’s a tangible asset. And it’s something you can always own.

Being somebody that’s not coming from a lot of wealth you know having the wherewithal to buy large plots of land to just kind of sit on and try to recoup that money at some point in the future is not something that’s really kind of in my nature.

The whole buying the house thing and flipping thing that’s just not me but REITs gives you that. The cool thing about them is they can give you a kind of an entry level into having a bit of real estate in your portfolio.

So that could be another asset class that you could add to your to your diversification of your portfolio.

You know there is the REIT industry has grown by leaps and bounds, especially since the 2008-2009 market crash. They’ve grown in prominence, and the last few years there’s been an increase in investing in REITs simply for the fact that the yield on those REITs is so extremely high.

One of the things that I know about REITs is that they’re the way the government is set up. So their laws that are set up they have to contribute I believe it’s 90 percent of the income they make has to go back out into dividends to the shareholders. So if a company makes $100 they got to give 90 bucks of it back to the investors. That’s a pretty sweet deal on that end of it I know for sure, and I know there are some other aspects of it too, and I’m sure Andrew is probably going to chat about those next.

Andrew: yeah it is ninety percent as the laws are today 2017. So I mean if you think about that it has some obviously some positives and some negatives.

A positive being you as a shareholder getting that cash back to you. The negative being okay well because they’re not able to reinvest many of these earnings perhaps the growth the future growth of the business won’t be. I’m sorry of the trust won’t be as much as you would see in business.

For example, so like you said it’s a great exposure to the real estate. I know a lot of people just kind of there’s a big community when it comes to investing. In general where you kind of just has the two camps. Where you get people who look into mutual funds, index funds and the stock market and individual stocks.

And then you’ll get people who kind of gravitate towards real estate and so what’s nice about REITs is it gives you a nice hybrid of the two, and it gives you some of the benefits of real estate without a lot of the negatives.

And you know to have to buy a property into I have to upkeep it and you can do maintenance on it or go out and find tenants. I mean that’s that could be a full-time job just enough in of itself and it’s a complete contrast to buying stock in the stock market and not having to do any work with it whatsoever.

What we’ve seen and I’ve written about this in the past when it comes to REITs is like Dave said, it gives a nice exposure to real estate. And so with different asset types when you think of asset types think of stocks bonds real estate falls in their currency or gold those they tend to all move in the same way.

And the kind of group and the same at the same time so when you’ll see stocks going up that doesn’t necessarily mean real estate is going to go up as well. If you’re diversified in different asset classes now, you can have stocks crashed tomorrow but if you have good exposure in bonds or real estate and those haven’t followed along in crashing. Then you have a hedge, and you have a nice smoothing out of your real performance.

It can go vice-versa the other way around; there’s also the effect that when inflation goes up property values tend to go up as well. And so it’s a nice hedge against inflation in the same way the stock market is.

Because a lot of the property values follow that same relationship and it’s if you want to get into REITs again.

Shout-Out to Preston and Stig, Preston had a great discussion about how interest rates affect real estate values so you have to think the way that the general person might go about acquiring a property.

You have to go out and get a mortgage and so depending on what interest rates are at the time if interest rates are lower. It’s going to be easier to take a mortgage now. It’s going to be easier to come up with capital to buy properties. And so that’s going to push property values up, and the same goes in vice versa.

There can be strategic times to jump into REITs but what’s nice is we don’t have to just like just like we say with the stock market. We don’t have to have a crystal ball; we don’t have to get the timing right per se because the REITs have valuations and metrics exactly as a stock does.

The way that they report their financials and what the income is what the earnings are how much assets and liabilities they have. It’s all the same restrictions that the SEC holds for public corporations. They also do for these REITs, and so the beauty of it is we can use value investing techniques to find REITs that are undervalued and capitalize.

Get the exposure you know get that asset exposure, get locked into deals that again kind of like the businesses that we see out there today.

One that I like as an example is Simon, and I can’t remember what the backend of that is but when you look around at the malls. Right, and a lot of the mall property is out there owned by the Simon group, and so it’s a way to kind of get into that space. And a way to be a part of those profits that are coming in from these businesses that come in and rent the real estate out.

So again it’s a nice compromise, and if we can use the things that we use in this podcast to decide whether these are great investments, then it can have some great potential for your portfolio.

Dave: yeah I agree the thing that I do like about REITs is like you were saying it does give you exposure to the different ways that you can invest in real estate and the thing that I’ve noticed when I have looked into REITs.

I don’t have one in my portfolio at the time right now. It’s not because I think they’re a bad investment. It just hasn’t found one that kind of meets my standards of what I’m looking to invest in. But the thing that I have noticed when I’ve looked into them is if there’s a for lack of a better word if there’s an area of the of the economy that you’re looking at trying to take advantage of or try to get a foothold into.

Let’s say that you’re interested in something in the healthcare industry, so maybe the-the biochem or the pharmacy thing scare you off because they’re so volatile.

One thing you can’t look at is looking at a REIT that would own a lot of let’s say retirement properties. So places that people go when they can’t take care of themselves or they need extra help. You know there’s a million of those places out there, and there’s a lot of invest a lot of REITs that will hold just those kinds of properties in in their portfolio.

And so that would give you an opportunity to get into that space by just finding one company.

One of the things that are can be a downside to the REITs is. And Preston and Stig talked about this in their podcast as well as with the interest rates and I know Andrew just mentioned that as well.

You know as the interest rates continue to rise that can be an issue because you know one of the things about REITs, we were talking a moment about the 90 percent that they have the pay to shareholders, one of the things that can be scary about REITs is their debt to equity ratio is quite high.

Mostly it’s because they have that it’s a function of how they’re set up because they have to pay so much out to us the people that are investing in them. The only way that they can a large part of the way they raise capital to buy other properties is by borrowing money and so when the interest rate starts to go up. We all know that then that money becomes more profit or I’m sorry more expensive, and then that could cut into the profits. And it can make the REITs kind of tenuous thing.

I know that Preston is a very conservative guy and I’m right there with him and so with interest rates and the environment we’re in right now. There is the opportunity for them to continue to rise and that could be a scary thing about getting invested in REITs.

Frankly, this will be the test of the invest ability I guess if that’s a word. Of REITs, because they have come to fore as I mentioned earlier in this kind of very no interest rate era that were in. That started in 2008-2009 when the government started cutting interest rates to try to generate more activity in the economy.

And we’ve been at historic low-interest rates around the world, and with that being so low and with the possibility of interest rates rising again it’ll be interesting to see how REITs perform when that happens. Because it has not happened since REITs have come to the forefront of investments.

The real driver for a lot of people investing in these is the dividend that they receive from them and you know in some cases it could be eight, nine, ten, fifteen percent which is extremely high. But it’s very attractive, especially with the market being at its all-time highs.

People are looking for trying to find yield in any way fashion that they can. Those are the great things about REITs, and those are some of the scary things about REITs as well.

Andrew: yeah and I just love how it has that same compounding interest effect that I always love to have when it comes to dividend stocks.

I always talk about finding stocks that pay and income and reinvesting it. Accumulating more shares and having the compounding grown that way.

That’s exactly what REITs are doing when it comes to just the properties that hold themselves because these are income producing assets you know they’re not like you said earlier in the episode. They’re not buying and selling; they’re not flipping these properties for the most part.

The general theme seems to be buying properties letting their values appreciate while also collecting those rent checks. So I think that’s a cool feature.

Now I’m glad you brought up dividends because that brings me to the next technicality. An important distinction between the dividends you’ll receive from a stock and the dividends you’ll receive from a REIT. Is that when it comes to dividends, and we haven’t touched on this hardly at all in the podcast.

Because you know I talked about the Sather Research eletter, and how it’s a Roth IRA portfolio and a lot of us who are just starting now are putting money into our retirement accounts.

And so those are tax-advantaged when it comes to the law and well basically when it when you have dividends that you receive in a Roth because of the tax advantages you don’t have to pay taxes on those dividends.

But you know if you’re investing in like a regular brokerage account you do have to pay taxes on your dividends. So there are two options when it comes to that. Now I don’t want to bore you with like tax accounting stuff but their short-term capital gains long-term capital gains. Those are the two different taxes when you sell a stock when it comes to dividends.

There are ordinary dividends and qualified dividends, so the ordinary is just going to be you know that’s going to be a high tax. So if you’re in an ordinary dividend tax means that your taxes at your ordinary income tax rate. So if you’re you know making a hundred thousand and your tax rates 28 to 33percent something like that you’re paying that tax on your dividends, so that’s pretty hefty

Now if the dividends qualified the requirement to make a dividend qualified is that you have to own the dividend stock for sixty days. There’s a hundred again I’m sorry about the numbers, there’s 120 one day period you have to hold the stock for 60 days. The date starts sixty days before the ex-dividend date, and if you’ve held it within a 60 day period inside of that 120 window, then you’re fine.

And your dividends are qualified and so you instead of having to pay your income tax rate you just pay the long-term capital gains tax rate which I don’t know off the top of my head, but it’s somewhere in the ten to fifteen percent range. So you’re essentially you know potentially looking at a half or more of a discount. Getting taxed your dividend tax as a qualified instead of ordinary the problem with REITs is that you can’t get those dividends taxes qualified.

They’re all ordinary an ordinary dividend tax rate, so it is going to be heftier.

It’s another reason why in the original article I wrote back in 2013 about REITs is you probably want to buy REITs in a tax advantage account, so you don’t have to pay these additional taxes that we’re talking about.

And something to keep in mind but you know obviously my accountant likes to say this shout out to Eric from accountancy who’s like you know if you’re paying taxes that means it’s a good thing. It means you’re making money, so keep that all in mind but obviously the yield of a REIT is very attractive and the payout ratio obviously we said that by law they’re required to pay out ninety percent.

So keep in mind that that payout ratio is going to be at least 0.9 and so if it’s somewhere from 0.9 to a one which means it’s paying either ninety percent to all of its earnings out as a dividend. That’s going to be a lot more acceptable in these types of analysis then like a regular stock would be.

But you also want to apply the same logic, and you know a company that pays out more in dividends than it’s earning is not going to be sustainable. And that’s something that still holds true even though these rules are in place so some little technicalities some differences here on the different REITs and hopefully you know this brings to light some of the questions and the answers some of the things that Bart was worried about.

As far as personally buying REITs myself, I haven’t pulled the trigger as of yet. I haven’t seen any float through down to my screen, but I’m not necessarily adverse to them it’s just not been something where it’s been an opportunity that’s popped up for me yet. obviously you tend to see that higher dividends could be you could see it as a catch and it could catch you by surprise. T

o use a thing if you’re not being diligent with looking at the financials and seeing what does the balance sheet look like and how is the earnings looking over time because you want to see those earnings also growing.

Another thing with the REITs is you’re not going to see that consistent dividend growth like you might see a dividend forretress company where they’re compounding and growing their dividend annually every year because their earnings will likely fluctuate. And since they’re tied to that 90% payment structure those dividends will likely fluctuate a lot higher than normal. So keep those things in mind, Dave I thought it might be interesting to run a quick like finvis.com screen on some REITs and just see what we come up with today.

Okay so let’s just do like a quick kind of finish demonstration typing over the air and just see, I just want to prove that this is just like any other stock and that we can use the tools that we use to analyze stocks to analyze REITs and potentially find winners and losers.

So what’s cool about fin vis is categorizes a lot of these different types of companies through their specifications so remember before I talked about how there are lots of different kinds of REITs. So finvis.com talks about how there are healthcare facilities hotel-motel REITs I think those are cool. So actually no I did own a hotel REIT, and that one did fairly well for me I believe Industrial REIT, an office REIT, residential REIT.

We tell, and then there’s diversified so like if I just pick one right like diversified REIT and then I use the same stock screeners that I always do. So if we look at something like a p/e under 30, price to sales under 3, and a price-to-book under 3.

as of right now there are two companies over a billion in market cap that fit this restriction but like Dave said they tend to have higher debt to equities so this one here CXW looks interesting because you’re looking at 6% yield, the debt to equity according to find’ is a 0.97. Which I would calculate that number on your own, it’s not the same way that finviz calculates that equity is not the same way I do, I’m a little bit more conservative.

But you know all in all this CXW looks like it could render further research because it has a nice price to earnings, a nice price to book. A pretty decent balance sheet and a high dividend, so I would also kind of contrast that with like earnings growth and looking at like the long-term picture to see if it’s really good.

By looking at let’s say residential REITs, you get kind of the same thing. Two of them popped up that were a decent size but in these cases that equity is really high. So you have a deck we have 3.6 and 4.9, those are going to be the kind of like value trap, really volatile. The ones are the risks to lose a lot in share price because they have high debt levels and little ticks in the interest rate are going to set them off.

not to mention the risks of going completely insolvent from having too many liabilities on the balance sheet. And then I mean you can go through on finviz, kind of look at some of the other options but what’s interesting to me is as I kind of click through these industries there are some on there that have decent debt-to-equity numbers.

So there it’s not to say that you know all REITs are going to be riskier or all of them are going to be I don’t know like it’s not necessarily going to have any less share price appreciation potential or dividend potential just solely because it’s a REIT.

You have to dig into the numbers but understand that it’s just like any other stock and you can pull up a 10k and read through their financials, and you’ll see a balance sheet. You’ll see that they owned real estate, you’ll see those values fluctuate over time. Just as you would a company who has inventories and factories and those assets that are on their balance sheet that also fluctuate over time.

Hopefully that kind of help with people who maybe didn’t even understand that there is this opportunity where you can buy real estate with the click of your computer. Or people who knew about REITs and kind of were unclear or maybe uncertain about whether number one whether it should be something to pursue in number two how to go about that.

So I would say when you’re analyzing them other than the whole payout ratio thing don’t give them any other special exceptions to the world because you can get in trouble in the market if you start making the exceptions to the companies here and there. I think you should have a solid valuation model and be using that all the way across with all the opportunities you buy.

Dave: I agree, and I think you know he made some great points and I think it was interesting to look through the just the kind of the different opportunities that you could find out there. And I like what he said about not lumping everything into high-risk, high debt. You know thoughts because as we were uncovering, we found a couple of different opportunities there that had quite low debt-to-equity. Which would one be of normally would be very much a death knell for anything that I would be interested in investing.

So that was kind of interesting for me, and I think what Andrew is talking about with the valuations and everything like that. I agree a hundred percent with them it’s good to have a kind of a solid foundation of what you’re doing and then just making sure that you’re being consistent with what you’re doing.

Andrew: yeah I mentioned earlier how I did hold a REIT, so I was I did the whole ticker symbol a SHO which was Sunstone hotel investors. Man, you know I got good timing only, but obviously, I bought it at a low valuation I didn’t pull up exactly what my return was, but it was somewhere around like the 20% range, and I must have held, you know about a year or so nice definitely. Obviously, I had a good experience, and I guess highly recommend

Dave: that’s awesome well I think that’s going to wrap it up for us tonight I think the final thing that I’d like to say about our conversation tonight is you know there’s a lot of great opportunities out there, and there’s a lot of great companies you can invest in and depend on what your comfort level, with different risk.

Aspects of different companies and different stocks that you’re looking at buying, REITs could be something that could fit into your portfolio, and you know they could be a great way of adding some more yield to your returns for sure.

And if you have any more interest in learning more about them I will link to Andrews post as well as the interview that Person and Stig gave on their show. And additionally, there was an article that I read a few weeks ago from our friend Ben Reynolds at Suredividend.com where he talked about valuing REITs, and that was an interesting read as well. So there’s a lot of great resources out there to help you find the great opportunities in this asset class, and they can help you make a lot.

So that’s awesome so without any further ado I’m going to go ahead and say.

Andrew: Nope sorry I’m not, just okay I have to be technical because I know some people are like that it was a 27.2% game I sold it in June of this year so okay there you go proof. Is it alright you look at the archives of the eLetter if you want to see that for yourself.

All right well very well noted, alright yeah me too I feel better, I’ll be able to sleep tonight that’s awesome all right without any further ado I’m going to go ahead and sign us off you guys have a great week. Go up there that’s with the margin find some great intrinsic value; you guys have a great week.