As a real estate investor, you likely determine your investment choices based on the potential returns or yield you may receive. When it comes to real estate investment trusts (REITs), investors receive returns or yields in the form of quarterly or annual dividends.
Understanding the REIT rate of return can help you more easily compare investments and make a better-informed choice. While you can do this with public REITs by dividing the regular payouts by the share price, fluctuating prices can make this difficult. Likewise, yield is not the only factor you should consider when evaluating REITs.
Read on or skip to a specific section:
- What Qualifies as a REIT?
- How to Analyze and Calculate REIT Rate of Return
- FAQs About REIT Calculations
- Contact 1031 Crowdfunding to Learn More About REIT Opportunities
What Qualifies as a REIT?
REITs are pass-through companies that allow real estate investors of various financial means to invest in income-producing real estate assets that would normally be beyond their financial reach as individuals. By having a REIT status, a company can avoid corporate income tax. Unlike a regular corporation that pays taxes on its entire profit, a REIT must distribute most or all of its profits to the investors, enabling them to skip the taxation.
In addition to distributing dividends, REITs must meet other criteria to benefit from this special tax treatment. For a company or entity to qualify as a REIT, it must meet the following requirements from the IRS:
- Must be an association, trust, or corporation
- Must not be a financial institution
- Must be taxable as a domestic corporation
- Must hold at least 100 shareholders who receive transferable shares by the second tax year
- Must be managed by at least one director or trustees
- Must pay dividends of at least 90% of taxable income
- Must derive at least 75% of gross income from the sale of real estate, interest from mortgages of real property, or rents from real property
- Must not have more than 50% of its shares held by five or fewer investors
You can invest in several different types of REITs. Here are the types of REITs you may come across during your investment research:
- Publicly traded REITs
- Private REITs
- Public Non-Listed REITs (PNLRs)
- Equity REITs
- Mortgage REITs
Each type carries its own benefit and risk potential, be sure to do your research before choosing such an investment.
How to Analyze and Calculate REIT Rate of Return
There is more than one way to find the average return on REITs to help you find an investment that suits your needs. The two following examples include simplified versions of these strategies, but they will account for rental income your property might produce and ongoing costs like property taxes. Let’s examine how to calculate the average rate of return on REITs.
1. Calculating Funds From Operations (FFO)
The basic formula for calculating FFO is:
- (Net Income + Depreciation + Property Sale Losses) – Property Sale Gains – Interest Income
Here’s a simplified example of what that might look like for your investment. Say a REIT purchases an office building for $2 million with depreciation spread over 15 years. Each year, we’ll deduct $100,000 in depreciation expenses. Total depreciation for the asset is calculated as follows:
- $100,000 per year x 15 years = $1.5 million
Now, let’s say we have $500,000 in revenue and $400,000 in expenses annually. This leaves us with $100,000 in net income. However, $100,000 of the expenses is depreciation. This is known as a non-cash charge because the REIT doesn’t actually spend the money calculated for depreciation. Therefore, we’ll add depreciation back into the net income.
Remember that FFO includes several other adjustments for property sales and interest income and fixes the distortion by excluding the property’s depreciation amount. This is because buildings do not always lose half their value within a decade.
So for this example, here’s how you would calculate FFO:
- ($100,000 + $100,000 + 0) – 0 – 0 = $200,000
2. Calculating Yield for Dividends
Another way to determine your ROI for REITs is to look at dividends. Here are three steps to calculating the yield of REIT dividends.
- Combine the total amount of dividends the REIT paid over one year. You can estimate annual dividends by multiplying quarterly distributions by 4 or monthly distributions by 12.
- Divide this number by the REITs current share price.
- Multiply this number by 100 to change it into a percentage.
Keep in mind that this is a very simplified formula. You’ll want to consider other factors when using this calculation, such as the fact that share prices and REIT dividend yields will fluctuate.
FAQs About REIT Calculations
Determining the rate of return for a REIT can certainly help you make an informed investment choice, but you’ll want to know a few other things before diving into a new investment. Here are some common questions you may have when calculating ROI for REITs:
1. What Is the 90% Dividend Rule for REITs?
As stated above, REITs must distribute at least 90% of their taxable earnings as dividends to shareholders yearly. To those who are unfamiliar with REITs, this may seem like a large sum. However, the payment an investor receives is determined by the payout ratio. For instance, suppose a REIT has a payout ratio of 25%. This means for every dollar of net earnings, shareholders will receive 25% of that dollar through dividends.
Once the dividends are paid, however, stock prices may fall by that amount if the REIT is public. As a result, consistent and relatively high dividends take a piece out of the market price as they are distributed.
2. Why Should You Include Funds From Operations (FFOs) When Analyzing REITs?
When trying to estimate the value of a REIT, traditional measures of stocks, such as price-to-earnings (P/E) ratio or earnings per share (EPS) are not always reliable. Alternatively, using the FFO method allows investors to adjust for the investment’s depreciation and the REIT’s required monthly or quarterly dividend distributions.
However, the tax efficiency of this method is the primary benefit of including FFO when analyzing REITs.
3. Why Are REITs Subject to Depreciation?
Real estate investments depreciate over time, which reduces taxable income in a given year. This is simply an accounting figure, as an older property may be purchased multiple times and receive a new depreciation schedule each time.
These are just a few explanations as to how to navigate REITs as an investor. Using a real estate investment platform can help you understand the ins and outs of REIT investing and what factors can influence your returns.
All investments come with potential benefits and risks. Calculating the ROI for a REIT can help you find an investment that meets your financial needs and goals. At 1031 Crowdfunding, we aim to help investors like you make better-informed decisions about their investments.
From REITs to DSTs to Qualified Opportunity Funds, our experienced team will support you along the way. Our extensive online marketplace of vetted real estate properties can give you an idea of the type of asset you’re looking for and what suits you best. Check out our REIT blog page for more information, or contact us today to learn more about potential investment options.
This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise.This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary. Securities offered through Capulent, LLC Member FINRA, SIPC.
