A. REITs are companies that own and manage properties, such as apartments, office buildings, hospitals, self-storage facilities, farmland, etc. they collect rents and pass as profits to investors.
REITs have generated very impressive returns, for example, Vanguard REIT Index fund (VGSIX), had cumulative total return of 188% between 2009 and 2015 (16% annualized return). But do REITs offer attractive valuation at this time? How to evaluate REITs?
REITs vs. Bonds
First, REITs are not bonds that have promised returns. REITs are stocks, if the managers or REITs overpay properties or fail to collect expected rents, REITs investors could suffer significant losses.
Yield Spread
An important metric an investor should check a REIT is its yield spread. A REIT's yield is the payout as a percentage of share price. Yield spread refers to the difference between the REIT's yield and 10-year Treasury notes. Historically, the average yield spread is about 1%. The higher the yield spread, the better.
Price to FFO Ratio
FFO stands for funds from operations, it's an important metric to evaluate REITs because REIT income statements are distorted by an often unrealistic depreciation charge and by property sales, both make evaluating how the company's properties perform difficult. FFO takes a company's reported profits and eliminates the depreciation and property sales to arrive at a standardized measure of cash flow that can be used to compare different REITs.
The historical Price-to-FFO ratio is around 16 and 17, if you are buying a REIT with higher Price-to-FFO ratio, you might be overpaying for the REIT.
The Bottom Line
REITs should be part of a investor's investment portfolio, but not too much. If the REITs you plan to invest have had a great run, it might be wise wait until valuations are not over stretched.