If you have been reading about real estate investment trusts and can’t wait to invest in REIT funds, you should first make sure you know all the basic REIT terms. That’s because if you have ever learned a foreign language, like French or Spanish, you know that it’s very important to learn the vocabulary first. Learning basic words for introduction, the weather, hobbies, and food is probably one of the first things you will do. Such an emphasis is placed on vocabulary because if you don’t know what words mean, you cannot progress in your language learning journey. Progressing in your investment journey is no different. To make informed investment decisions, it’s crucial to understand common terms related to an investment product. So, if you have been curious about real estate investment trusts, here’s a handy list of the basic REIT terms you should know.

1. Mortgage-backed securities

REITs typically earn income through rent. However, they can also earn income through interest when they invest in Mortgage-Backed Securities (MBS). An MBS is a type of asset that pools mortgages together. So, when an REIT fund invests in MBS, it is indirectly giving out a loan to home buyers. The bank is the intermediary here that handles the loans and then it bundles them together and sells it to investors such as REIT funds. As per the guidelines by the Securities and Exchange Board of India (SEBI) real estate investment trusts in India cannot invest more than 20% in assets such as MBS, money market instruments, etc.

2. Funds from operations

While REIT units trade like shares in the stock market, you can’t look at the general metrics such as net income and Earnings Per Share (EPS) ratio because the underlying asset here is real estate and the way the income is accounted for is different. Instead, you need to look at Funds from Operations (FFO). FFO is an accurate measure of the income or cash flow of an REIT fund because it adds depreciation, amortisation, and losses on the sale of assets to the net income and subtracts the gain on the sale of assets. By dividing FFO with the number of outstanding shares, you get the FFO-per-share which should be looked at instead of the EPS ratio for REIT funds evaluation.

3. Capitalisation rate

In REIT terminology ‘capitalisation rate’ or the ‘cap rate’ is another important valuation metric you should know about. The cap rate is what indicates the rate of return that a real estate property is likely to generate based on its current market value. It can be used as a quick metric to compare different REIT funds and properties because it shows you, the investor, what kind of returns you can expect from this investment. The cap rate is calculated by dividing the net operating income by the current market value of the property and is expressed as a percentage. If the income remains the same and the market value goes up, then the cap rate comes down. But if the market value goes down while the income remains the same, the cap rate goes up.

4. Distribution per unit

One of the most important REIT terms for you as a potential investor in REIT funds is Distribution Per Unit (DPU). It’s similar to dividend per share for stocks where the DPU tells you how much dividend you will receive for every unit of an REIT fund that you own. The important thing to note about REIT funds is that they are required by law to distribute 90% of their income as dividends to investors every year. So, if you are looking to invest in an asset that has the potential of offering attractive and regular returns, REIT funds may be a good option to consider. Make sure to look at the FFO, cap rate, and DPU, of the REIT fund, among other metrics, before you make your investment decision.

5. Tenant concentration risk

If you come across this REIT terminology listed as a potential risk for a specific REIT fund, then that means that a large proportion of the rental income in the portfolio is dependent on one or a small number of tenants. While REIT funds with a greater tenant concentration have better operational efficiency and profitability, it is also a risk. That is because if the tenant, say a major company, that is renting the office premise, were to exit, it would severely impact the rental income, and hence the overall financial performance, of the REIT fund until a replacement is found.

6. Total return

One of the REIT benefits is that they are total return investments. This means that they aim to provide both capital appreciation and high dividend yields to the investors. In REIT terminology, ‘total returns’ means a combination of these two types of returns from the investment and is expressed in annualised terms. For instance, if an REIT stock were to pay a 7% dividend and there was a rise in its price by 5% in the same year, then the total returns of that REIT fund for the year would be 12%.

Key takeaways

Now that you know these essential REIT terms, you may also have a better idea of what to look for in a REIT fund and how to relatively evaluate REIT funds. Since real estate investment trusts in India are a recent concept, you may want to learn more about how this investment should be approached. You can consult a financial expert to guide you on the REIT funds you should invest in and what exposure of real estate you should add to your current investment portfolio.

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