Understanding and Evaluating REITs

Adam Johnson

Understanding and Evaluating REITs offers important information for how best to evaluate the performance of real estate investment trusts (REITs).

Potential REIT investors must be careful when doing research to ensure that they use the most accurate financial metrics. Missteps can be costly.

Understanding and Evaluating REITs: An Introduction

What is a REIT?

A REIT owns, operates or finances income-producing real estate. There are a wide range of property types that REITs invest in, including apartment buildings, warehouses, offices, retail centers, medical facilities, data centers, hotels, cell towers, timber and farmland.

Generally, REITs follow a straightforward business model: the company buys or develops properties and then leases them out to collect rent as its primary source of income. However, some REITs do not own property, choosing the alternative route of financing real estate transactions. The REITs generate income from the interest on the financing.

Investors can buy shares in a REIT company, the same way shares can be purchased in any other public company. Investors can buy REIT shares on major public stock exchanges such as the NYSE or NASDAQ.

There are more than 225 REITs in the United States that trade on major stock exchanges, as well as are registered with the Securities and Exchange Commission (SEC). These REITs, which are primarily traded on the NYSE, have a combined equity market capitalization of more than $1 trillion.

Understanding and Evaluating REITs: Top-Down vs. Bottom-Up Analysis

When picking stocks, investors sometimes hear of top-down vs. bottom-up analysis.

Top-down approach seeks to identify a broad picture of concerning sectors or industries that an investor might want to invest in. This approach focuses on macro economic factors such as taxation, gross domestic product (GDP), employment, interest rates, etc. Bottom-up focuses on specific characteristics and micro attributes of an individual stock. REIT stocks clearly require both top-down and bottom-up analysis.

From a top-down perspective, REITs can be affected by anything that impacts the supply of, and demand for, property. Population and job growth tend to be favorable for all REIT types.

However, Interest rates can have opposing impacts on REIT profitability. A rise in interest rates usually signifies an improving economy, which is good for REITs as people are spending and businesses are renting more space. Rising interest rates tend to be good for apartment REITs, where people prefer to remain renters rather than purchase new homes. On the other hand, REITs can often take advantage of lower interest rates by reducing their interest expenses and thereby increasing their profitability.

Understanding and Evaluating REITs: REIT vs Traditional Investing

REITs are a unique investment that is designed to offer distinct benefits to investors. REITS are great for decreasing volatility and increasing diversification within a portfolio, as well as producing income for investors.

Typically, potential investors use earnings per share (EPS) and net income when researching new investments. Traditional per-share measures of stocks, like EPS and price-to-earnings (P/E) ratio, are not often a reliable way to estimate the value of a REIT. Instead, REIT investors mainly use funds from operations (FFO) or adjusted funds from operations (AFFO), both of which make adjustments for depreciation and required dividend distributions.

Understanding and Evaluating REITs: Why EPS, P/E and Net Income are Less Reliable Investment Guides

Since REITs are regarded as high-yield investments that pay reliable dividends, it is important to look at the payout profile of a REIT before investing.

It may be the instinct of a potential investor to look at the earnings per share (EPS) of the stock to understand if the dividend is reliable. However, the traditional EPS ratio does not translate well to REITs. This is because of depreciation.

The issue is that depreciation is reflected in a REIT’s net income as an expense, even though it doesn’t cost any cash per se. REITs typically have large depreciation expenses that reduce their net income. Therefore, REIT’s net income and EPS don’t give an accurate picture of the company’s cash flows from operations.

Understanding and Evaluating REITs: Funds From Operations

Instead of EPS, it is important for investors to look at a REIT’s funds from operations (FFO). FFO is essentially operating cash flow generated by a REIT. Real estate companies use FFO as a benchmark of operating performance.

Funds from operations can be found by using the following formula:

FFO = Net Income + Amortization + Depreciation – Gains on Sales of Property

There are a few helpful ratios that include FFO, including price-to-FFO and FFO per share. Price-to-FFO is helpful when comparing the valuation of more than one REIT, as it can highlight if a REIT is cheap or expensive.

FFO per share is usually provided as a supplementary piece of data, along with the REIT’s EPS. Looking at EPS and FFO per share together helps paint a more complete and accurate picture for investors.

Understanding and Evaluating REITs: Adjusted Funds From Operations

Adjusted funds from operations (AFFO) is another important metric. AFFO is equivalent to free cash flow for a REIT. AFFO indicates how much cash the company is generating after running its operations and investing enough capital to preserve what it already owns. AFFO is even sometimes referred to as “funds available for distribution.” AFFO is an investor’s best indication of whether or not the dividend is reliable.

Understanding and Evaluating REITs: Net Asset Value (NAV)

The book value and related ratios like price-to-book are pretty much useless for REITs. The net asset value, or NAV, for a REIT calculates the fair market value of the company’s assets and subtracts liabilities.

The idea behind NAV is that the value of a REIT should be based on the current market value of its assets, so its shares on the stock market should be priced accordingly. This market value estimate replaces the book value of the building.

Understanding and Evaluating REITs: The Bottom Line

Investors who are considering buying shares in a REIT need to know the best way to evaluate a potential REIT investment. A combination of top-down and bottom-up analysis is the best way for an investor to make an informed investment decision. Although EPS, P/E and net income are common metrics used to evaluate many stock market investments, they are not the best way to research a REIT.

Funds from operations, adjusted funds from operations and net asset value offer by far the most accurate way to evaluate REIT cash flow performance. However, like any other investment metric, FFO is best used in conjunction with other measurements such as growth rates, dividend history and debt ratios. All together, these metrics create a well-rounded picture of a REIT’s valuation.

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