There's no question that real estate is a great investment, but buying individual properties can be a lot to take on. Luckily, commercial real estate stocks provide an alternative way to invest in real estate. Picking the right commercial real estate stocks will allow you to reap the many benefits of real estate investing without the headache of managing the properties yourself.
What are commercial real estate stocks?
Commercial real estate stocks are typically a type of real estate investment trust (REIT). These types of real estate stocks own, manage, or finance various types of commercial real estate properties. REITs invest in properties that produce rental income or provide financing in order to profit from the net interest income. REITs are required to pay out at least 90% of their taxable net income to investors in the form of dividends. Many investors purchase commercial real estate stocks to earn passive income from these dividends.
Commercial REITs invest in one or more of these types of assets:
Other types of REITs also invest in assets such as residential properties and timberland.
What should you look for in commercial real estate stocks?
The commercial real estate stock that's right for you depends on your investment goals and your risk tolerance. Some REITs are more stable but have a lower dividend yield. Others have a much higher dividend but experience large price fluctuations. Finding a balance between risk and reward that fits your goals is key in choosing the best commercial real estate stocks to invest in. That's why it's important to do your research on each company you're considering for your own portfolio. Taking a deep dive into the following seven categories will provide a lot of insight about whether a particular commercial real estate stock is a good fit for you.
1. Investment strategy
You have to feel comfortable with the investment strategy of the commercial real estate company you're investing in. If you're concerned that a certain asset class is going to struggle, investing in that type of REIT may keep you up at night. If you're confident that senior housing is going to grow, look at a company that invests in that type of multifamily property.
Looking at how focused a commercial real estate company is with their types of investments is also wise. For example, a company focused on Class A multifamily properties in emerging markets is going to be able to navigate market changes better than a company that invests in any class of property in whichever area they find a deal.
What knowledge and experience do the officers and management of the REIT you're looking at have? If they came from another commercial real estate company, how did that company perform when they were there?
You'll also want to consider how diversified their leadership is. Having a well-rounded type of knowledge and experience across the leadership team is crucial. For instance, a new CFO without experience directly related to real estate finance could be nerve-racking for some shareholders.
Some investors may be more comfortable investing in a real estate company that has conservative management, while others may be excited to invest in an organization whose leaders have new, innovative ideas. Remember, when you're investing in a commercial real estate stock, you're putting your trust with the people running the company.
3. Historical performance
How a commercial real estate stock has performed in the past can be a good indicator as to how they will continue to perform. When evaluating the performance of a particular real estate stock, you'll want to look at its 52-week range as well as its performance over the past three, five, 10, and 15 years. Has the value of the company been trending up, down, or remained relatively level? To combat inflation, you want to invest in a realty trust that has steady growth.
Also, look at how it's been performing compared to the S&P 500. If the commercial real estate stock hasn't performed better, or as well, you'll want to consider whether it's the best way to invest your money.
4. Dividend yield
One of the most common reasons investors like commercial real estate stocks is the dividends. Typically, REITs have higher dividends than a lot of other types of stocks. Some even have as high as a 10% yield. If your interest in commercial real estate stocks is the dividend income, you'll want to compare the income from the particular property group you're looking at to other types of passive income investments.
5. Debt ratio
Another way to gauge the strength and stability of a commercial real estate stock is to look at its debt ratio. This metric shows how much debt the company has versus the total value of its assets. Companies with a high debt ratio, meaning they have a lot of debt for the amount of assets they have, are more vulnerable to a decrease in market values and rising interest rates. The reduced equity will hurt the value of the shares, while the higher interest rates will have a greater effect on the debt payments, which will reduce the overall cash flow.
On the other hand, it is healthy for a real estate investment company to have some debt. Debt is often needed to minimize risks in income fluctuations, and using debt to purchase more assets can increase the cash flow and value of the shares.
The formula to get the debt ratio is:
Total debt / total assets = debt ratio.
At the end of Q3 2019, the average debt ratio for equity REITs was 27.5%. Here's an example of how this would look:
Total debt: $27,500,000
Total assets: $100,000,000
$27,500,000 / $100,000,000 = 27.5%
Another way you may see this is 3.6:1, meaning there is 3.6 times more equity than debt.
There's not a magic number for an ideal debt ratio, but many investors view anything over 60% as being very risky.
6. Earnings per share and P/E ratio
Another common metric to look at is the company's earnings-per-share ratio (EPS) and its price-to-earnings ratio (P/E ratio). This can be another indication of the strength of a commercial real estate company.
The simple formula for EPS is:
After-tax profit / number of outstanding shares = earnings per share
Here's an example:
After-tax profit: $15,000,000
Number of shares: 5,000,000
$15,000,000 / 5,000,000 = $3 earnings per share.
From the earnings-per-share ratio, you can calculate the P/E ratio. This is the price per share compared to the earnings per share.
The formula for P/E ratio is:
Share price / EPS = P/E ratio
Here's an example:
$51 / $3 = 17
Again, there is no magic number with these ratios. These numbers will help you compare different commercial real estate stocks you are considering investing in. Overall, the lower the P/E ratio, the more earnings the company has compared to its share price.
You can learn more about EPS and P/E ratios in our article on Understanding EPS and P/E Ratios.
7. Funds from operations
The funds from operations, or FFO, provides a more accurate picture of the company's performance than the EPS ratio. The difference is that the P/E ratio is based on after-tax profit, while the FFO adds depreciation back into the equation.
Taking the $3 earnings per share from our previous example, let's say that once depreciation was added back to the after-tax profit of $15,000,000, the earnings were actually $30,000,000. That would mean the earnings per share is actually $6.
Since 51 / $6 = 8.5, that $6 EPS would change the P/E ratio from 17 to 9 (rounding 8.5 up to the next whole number).
You can get a better understanding of FFO by reading our more in-depth discussion on how FFO works.
The bottom line
Commercial real estate stocks can provide passive income through their higher dividends as well as contribute to the long-term growth of your portfolio. The commercial real estate stock that fits best in your portfolio will greatly depend on your risk tolerance and your overall investing goals. The above points to consider should help you decide which commercial real estate companies are best suited for you.