REIT Due Diligence
When considering an investment in a real estate investment trust (REIT), investors should analyse the REIT under consideration in detail. REIT due diligence consists of evaluating the following characteristics of the REIT:
- The remaining lease terms
- Inflation protection
- In-place rents versus market rents
- Cost to re-lease space
- Tenant concentration in the portfolio
- Tenants financial health
- New competition
- Balance sheet analysis
- Quality of the management
On this page, we discuss all these due diligence considerations for REITs in more detail.
Due diligence considerations
A REIT investor should analyse the following aspects closely:
- Remaining lease terms: An analyst should evaluate the length of remaining lease terms in conjunction with the overall state of the economy. Short remaining lease terms provide an opportunity to raise rents in an expansionary economy, while long remaining lease terms are advantageous in a declining economy or softening rental market. Initial lease terms vary with the type of property. Industrial and office buildings and shopping centres generally have long lease terms, while hotels and multi-family residential real estate have short lease terms.
- Inflation protection: The level of contractual hedging against rising general price levels should be evaluated. Some amount of inflation protection will be enjoyed if leases have rent increases scheduled throughout the term of the lease or if rents are indexed to the rate of inflation.
- In-place rents versus market rents: an analyst should compare rents that a REIT’s tenants are currently paying (in-place rents) with current rents in the market. If in-place rents are high, the potential exists for cash flows to fall going forward.
- Costs to re-lease space: When a lease expires, expenses typically incurred include lost rent, any new lease incentives offered, the cost of tenant-demanded improvements and broker commissions.
- Tenant concentration in the portfolio: Risk increases with tenant concentration: a REIT analyst should pay special attention to any tenants that make up a high percentage of space rented or rent paid.
- Tenants’ financial health: Since the possibility of a major tenant’s business failing poses a significant risk to a REIT, it is important to evaluate the financial position of the REIT’s largest renters
- New competition: An analyst should evaluate the amount of new space that is planned or under construction. New competition could impact the profitability of existing REIT properties.
- Balance sheet analysis: Due diligence should include an in-depth analysis of the REIT’s balance sheet, with special focus on the amount of leverage, the cost of debt, and the debt’s maturity.
- Quality of management: Senior management’s performance record, qualifications, and tenure with the REIT should be considered
We discussed some of the most important aspects that an analyst should consider when performing a REIT due diligence.