Let’s have a look at a simple example. Let’s say a REIT pays $1 million for a building. Our REIT is required by accounting regulations to incur depreciation against the asset. Assume that the depreciation is spread out over 20 years in a straight line. We deduct $50,000 in depreciation costs per year ($50,000 per year x 20 years = $1 million).
Take a look at the above-mentioned simplified balance sheet and income statement. Our balance sheet shows a value of $500,000 (i.e. the book value) for the building in year 10, which is the original cost of $1 million minus $500,000 accumulated depreciation (10 years x $50,000 per year). Our income statement subtracts $190,000 in expenses from $200,000 in sales, but $50,000 of that is a depreciation charge.
How do you analyze a REIT performance?
In order to fund and expand its activities, a REIT must take on debt. This is especially true because they must pay out at least 90% of their taxable profits as dividends, reducing the amount of capital available for acquisitions.
Debt, in addition to being a crucial instrument for growth, permits businesses to make a larger return than they would if they bought everything with cash. This is particularly true in real estate, where the cash-on-cash return on an investment is nearly always larger than the cap rate.
Too much debt, on the other hand, might be problematic for a REIT. The number of loan installments rises in tandem with the amount of debt owed. When a company’s debt payment is too expensive, it can be difficult to fund all of its expenses, pay dividends, or buy more real estate.
Debt to EBITDA Ratio
The debt to EBITDA ratio is one of the easiest and most effective measures to evaluate a REIT’s debt. Earnings before interest, taxes, depreciation, and amortization (EBITDA) is the acronym for earnings before interest, taxes, depreciation, and amortization.
This debt ratio is commonly calculated using the company’s net debt, which is total debt minus accessible cash. The EBITDA must also be annualized. The formula for calculating net debt to EBITDA is as follows:
A larger ratio indicates greater indebtedness and danger. Looking for a ratio between 4x and 6x is a reasonable rule of thumb.
A debt-to-equity ratio of more than 6x could suggest that the REIT has too much debt. A ratio of less than 4x could signal that the REIT is being too cautious with debt and spending more of its own money than necessary.
Debt Maturity Schedule
You should also look at the REIT’s debt maturity schedule in addition to the debt to EBITDA ratio. This will show how much debt will be due to mature each year over the next few years.
A well-staggered debt maturity schedule is desirable, since it ensures that the amount that must be paid off each year is stable. With a substantial amount of the overall debt due in the next few years, there’s a better probability the firm will issue new shares, diluting whatever stock you acquire, or they won’t be able to raise dividends. If the amount of debt owed is significant enough, dividends may be reduced.
When looking at Realty Income’s debt maturity calendar, you’ll notice that it’s reasonably well-spaced throughout the next five years, with pauses between major maturities.
Interest Rate
When examining a REIT’s debt profile, another factor to evaluate is the debt’s cost. For each form of loan, the company’s debt schedule will normally offer a weighted average interest rate.
When considering the risk based on the REIT’s debt to EBITDA ratio and loan maturity schedule, this factor comes into play. A substantial quantity of debt maturing in the coming year, for example, may be a good thing if the interest rate is higher than the REIT’s ability to refinance it.
You can also look at the interest coverage ratio of the company. The interest expenses of a REIT are calculated using this method and compared to its EBITDA. The formula is as follows:
The benchmark for many REIT investors and analysts is a 3x interest coverage ratio. The higher the ratio, the more capital available to meet interest expenses for the REIT. Anything less than 2.5x may suggest a significant level of danger.
What is a good FFO for a REIT?
For all dividend stocks, the payout ratio is an important indicator. There are, however, two REIT-specific things to be aware of.
To begin, make sure you’re calculating the payout ratio using FFO rather than net income or earnings per share. FFO is a more accurate indicator of a REIT’s profitability.
Second, whereas most investors seek payout ratios of 4050% for traditional dividend companies, REIT payout ratios are sometimes significantly higher. This is due to the fact that REITs must pay out the majority of their profits.
A REIT with an FFO payout ratio of 80%, for example, isn’t cause for concern. There’s no reason to fear a REIT’s payout is too high or unsustainable as long as the ratio stays below 100 percent.
Is FFO the same as CFO?
Funds from operations (FFO) is a term used in the assessment of real estate investment trusts that is comparable to cash flows from operations (CFO).
How do you calculate FFO for REITs?
The statistic used by real estate investment trusts (REITs) to define the cash flow from their operations is called funds from operations (FFO). FFO is a metric used by real estate firms to assess their performance.
FFO is determined by first adding depreciation, amortization, and losses on asset sales to earnings, then removing any asset sales gains and interest income. It’s sometimes expressed as a per-share price. When examining REITs and other comparable investment trusts, the FFO-per-share ratio should be utilized instead of earnings per share (EPS).
Is FFO the same as Noi?
While FFO is commonly employed for examining REITs, traditional property-level real estate profit measurements are also very relevant, such as:
Net operating income (NOI) – Unlike FFO, which is a levered measure of profit after taxes and overhead, NOI is a pure measure of profit at the property level.
Cap rates Cap rates are the most commonly used measure of value in real estate, both for REIT valuation and property-level research.
It’s the same as valuing “normal” corporations with EV/EBITDA multiples.
What is the difference between FFO and AFFO?
The real amount of cash flow generated from core business operations is known as funds from operations (FFO). When compared to FFO, AFFO is a better metric because it takes into account the real estate property’s long-term maintenance expenditures.
What is the difference between FFO and Ebitda?
FFO and EBITDA are similar in that they both compensate for depreciation and amortization and are used as a substitute for net income. The fundamental distinction between FFO and EBITDA is that FFO is used to calculate free cash flow from operations, whilst EBITDA is used to calculate profitability from operations.
How do you tell if a REIT is overvalued?
Due to the large number of REITs currently trading on public exchanges, investors can examine the industry and invest in only the best-of-the-best.
To do so, an investor must be familiar with REIT analysis. This isn’t as simple as it seems; REITs have certain unique accounting features that distinguish them from conventional equities when it comes to evaluating their investment potential (particularly with regards to valuation).
With that in mind, this post will go over how to value real estate investment trusts, with two step-by-step examples based on a genuine, publicly traded REIT.
What is a REIT?
Before going into how to examine a real estate investment trust, it’s important to know what these investment vehicles are.
A REIT is not a company whose sole purpose is to own real estate. While real estate corporations do exist (for example, the Howard Hughes Corporation (HHC)), they are not the same as real estate investment trusts.
The distinction is in the manner in which these legal entities are formed. REITs are not corporations, but trusts. As a result, they are taxed differently, making the REIT’s investors more tax efficient.
Real estate investment trusts pay no tax at the organizational level in exchange for completing specific standards that are required to continue doing business as a ‘REIT.’ One of the most significant requirements for maintaining REIT status is that it distributes 90% or more of its net income to its shareholders.
There are a number of key distinctions between ordinary stocks and REITs. REITs are structured like trusts. As a result, fractional ownership of REITs that trade on the stock exchange is referred to as ‘units’ rather than’stocks.’ As a result, “shareholders” are really “unit holders.”
Distributions, not dividends, are paid to unitholders. REIT distributions aren’t called dividends since they have a different tax treatment. There are three types of REIT distributions:
When it comes to taxation, the ‘ordinary income’ element of a REIT payout is the most straightforward. Ordinary income is taxed at your regular income tax rate, which can be as high as 37 percent.
A ‘deferred tax’ might be thought of as the’return of capital’ element of a REIT distribution. This is due to the fact that a return of capital lowers your cost base. This means that when you sell a REIT, you only pay tax on the’return of capital’ component of the payout.
The final component, capital gains, is exactly what it sounds like. Short-term capital gains are taxed at a lower rate than long-term capital gains.
By REIT, the percentage of distributions from these three sources varies. Ordinary income makes up the vast majority of the distribution. Around 70% of distributions will be ordinary income, 15% will be a return of capital, and 15% will be capital gains (although, again, this will vary depending on the REIT).
Because the majority of REIT payments are taxed as regular income, they are best suited for retirement funds.
Retirement accounts eliminate this disadvantage, making REITs extremely tax-efficient.
This isn’t to say that owning a REIT in a taxed account is a bad idea. Regardless of tax implications, a good investment is a good investment. However, if you have the option, REITs should be put into a retirement account.
So, how does a REIT’s tax status differ from that of other types of investment vehicles? To put it another way, how much does a REIT’s tax efficiency increase the after-tax income of its investors?
Consider a corporation that earns $10 before taxes and distributes 100% of its profits to investors. The chart below indicates how much of the $10 would go to investors if the company were organized as one of the three basic corporate entity types (corporations, real estate investment trusts, and master limited partnerships):
REITs are far more tax-efficient than corporations, owing to the fact that they avoid double-taxation by avoiding tax at the corporate level. REITs, on the other hand, aren’t as tax-efficient as Master Limited Partnerships.
REITs are more desirable than corporations because of their tax efficiency. The rest of this article will go through how to identify the most appealing REITs depending on their valuation.
Non-GAAP Financial Metrics and the Two REIT Valuation Strategies
The final section of this article explained what a REIT is and why investors like this investment vehicle because of its tax efficiency. This section will explain why traditional valuation criteria cannot be used to evaluate REITs, as well as alternative methods that investors might use to examine their pricing.
As a result, depreciation is a large expense on these investment vehicles’ income statements. Depreciation is a real cost, but it is not a cash cost.
Depreciation is significant since it accounts for the up-front capital expenditures required to develop value in a real asset over time; nevertheless, it should not be used for determining dividend safety or the likelihood of a REIT defaulting on its debt.
Depreciation might also change over time. More depreciation is recorded (on an absolute dollar basis) at the beginning of an asset’s useful life in a traditional straight-line depreciation plan. Because of the volatility of depreciation expense over time, valuing a REIT using net income (as the typical price-to-earnings ratio does) is not a viable technique.
So, how might a smart security analyst account for a REIT’s real economic earnings?
Traditional valuation systems have two primary possibilities. The first evaluates REIT valuation using economic earnings potential, whereas the second evaluates REIT valuation using income generation capability. Below, we’ll go over each one in depth.
Rather than utilizing the usual price-to-earnings ratio (P/E ratio), REIT analysts frequently employ a slightly different variation: the price-to-FFO ratio (or P/FFO ratio).
The ‘FFO’ in the price-to-FFO ratios stands for funds from operations, a non-GAAP financial statistic that strips out the REIT’s non-cash depreciation and amortization charges to reveal the REIT’s cash earnings.
The National Association of Real Estate Investment Trusts (NAREIT) has established a widely accepted definition for FFO, which is listed below:
“Net income before gains or losses from the sale or disposal of real estate, real estate-related impairment charges, real estate-related depreciation, amortization, and accretion, and preferred stock dividends, and including adjustments for I unconsolidated affiliates and (ii) noncontrolling interests.”
The price-to-FFO ratio is calculated in the same way that the price-to-earnings ratio is calculated. We divide REIT unit price by FFO-per-share rather than stock price by earnings-per-share. See the example in the following section for further information.
The other method for determining a REIT’s value does not employ a Non-GAAP financial indicator. Instead, the present dividend yield of a REIT is compared to its long-term average dividend yield in this second technique.
If a REIT’s dividend yield is higher than its long-term average, it is undervalued; on the other hand, if the trust’s dividend yield is lower than its long-term average, it is overpriced. See the second example later in this post for more information on this second valuation technique.
The next two sections will provide extensive examples of how to construct valuation metrics relating to these unique legal entities now that we have a high-level description of the two valuation approaches available to REIT investors.
Example #1: Realty Income P/FFO Valuation Analysis
This section will walk you through the process of calculating REIT valuation using the price-to-FFO ratio. To make the example as relevant as feasible, we’ll utilize a real-world publicly traded REIT for this example.
The security that will be used in this example is Realty Income (O). It is one of the largest and most well-known REITs among dividend growth investors, thanks in part to its monthly dividend payment schedule.
For investors who rely on their dividend income to cover their living expenditures, monthly dividends are preferable to quarterly payouts. Monthly dividends, on the other hand, are uncommon. As a result, we compiled a list of roughly 50 equities that pay monthly dividends. Our monthly dividend stock list can be found here.
When computing the P/FFO ratio, REIT investors must select whether to utilize forward (forecasted) funds from operations or historical (previous fiscal year’s) funds from operations, just as they do with equities.
Investors must locate the company’s press release announcing the publishing of this financial data in order to find the funds from operations recorded in the previous fiscal year.
Note: Adjusted FFO is better than’regular’ FFO since it excludes one-time accounting charges (typically from acquisitions, asset sales, or other non-recurring operations) that artificially inflate or deflate a company’s reported financial performance.
Realty Income is currently trading at $72 per share, reflecting a price-to-FFO ratio of 21.3 (using last year’s financial performance as the denominator).
Alternatively, an investor could look at a company’s most recent quarterly earnings press release for forward-looking expected adjusted funds from operations for the current year, which is usually (but not always; some companies do not provide guidance) included in the company’s most recent quarterly earnings press release.
Realty Income revised its full-year outlook in its most recent quarterly earnings report, now expecting adjusted FFO-per-share in the range of $3.53 to $3.59 in 2021. Based on 2021 projected performance, the midpoint of adjusted FFO guidance ($3.56 per share) implies a 2021 P/FFO ratio of 20.3, making Realty Income look cheaper.
So, after calculating the price-to-FFO ratio, how do investors assess whether Realty Income is a good investment today?
First, investors should compare the current P/FFO ratio of Realty Income to its long-term historical average. If the current P/FFO ratio is high, the trust is probably overvalued; on the other hand, if the current P/FFO ratio is low, the trust is a good buy.
Realty Income stock has traded for an average P/FFO ratio of 18.9 over the last ten years, indicating that shares are currently expensive.
The second comparison that investors should make is with the peers of Realty Income. This is critical: if Realty Income’s valuation is attractive in comparison to its long-term historical average, but the stock is still trading at a considerable premium to other, similar REITs, the stock is most likely not a good time to buy.
Finding an appropriate peer group is one of the most difficult aspects of a peer-to-peer value comparison.
Fortunately, big publicly traded firms are required by the Securities and Exchange Commission to self-identify a peer group in their annual proxy filing. This filing, which appears as a DEF 14A on the SEC’s EDGAR search database, includes a table that looks similar to the one below (which was submitted on April 3, 2017 by Realty Income):
In this proxy filing, every publicly traded company is required to disclose a similar peer group, which is extremely useful when an investor wishes to compare a firm’s valuation to that of its peers.
Example #2: Realty Income Dividend Yield Valuation Analysis
The third technique for establishing whether a REIT is trading at a favorable valuation, as previously said, is to look at its dividend yield. This section will walk you through the process of evaluating REIT valuations using this technique.
Realty Income provides a monthly dividend of $0.2355, which equates to $2.826 in annual dividend income per unit at the time of writing. The company’s current unit price of $72 represents a 3.9 percent dividend yield.
The current dividend yield of Realty Income is compared to its long-term average in the graph below.
The current dividend yield on Realty Income is 3.9 percent, with a 10-year average dividend yield of 4.5 percent. Realty Income’s lower-than-average dividend yield implies that the stock is now expensive.
Because the trust’s dividend yield is lower than its long-term average, it’s safe to assume that now isn’t the greatest time to add to or start a position in this REIT. Most REITs in its peer group have yields exceeding 4%, therefore a peer group analysis would likely produce a similar conclusion. The previous portion of this article contains instructions for determining an acceptable peer group for any public corporation.
For real estate investment trusts, the dividend yield valuation method may not be as reliable as a bottom-up study using funds from operations.
- It is more efficient. Most Internet stock screeners provide dividend yields, but some don’t have the capacity to filter for stocks selling at low multiples of funds from operations.
- It can be applied to a variety of asset classes. While FFO is only reported by REITs (and some MLPs), it is evident that any dividend-paying investment has a dividend yield. As a result, the dividend yield valuation strategy can be used to value REITs, MLPs, BDCs, and even companies (albeit the P/E ratio remains the best way for corporations).
Final Thoughts
There are unquestionably benefits to investing in real estate investment trusts.
These securities provide investors with the economic benefits of real estate ownership while simultaneously providing a completely passive investment opportunity. Furthermore, REITs are tax-advantaged and typically offer higher dividend yields than the S&P 500’s average dividend yield.
REITs, like businesses, have analytical peculiarities that make them more challenging to assess. This is especially true when it comes to determining their worth.
The following are two analytical methodologies that can be used to value REITs:
Each has its own set of advantages and should be part of any dividend growth investor’s toolset that includes real estate trusts.
Bonus: Watch the video below to hear our chat with Brad Thomas on The Sure Investing Podcast about sensible REIT investing.
How do you know if a company is a REIT?
- Rents from real estate, interest on mortgages financing real estate, or sales of real estate must account for at least 75% of gross income.
- Each year, pay at least 90% of its taxable profits to shareholders in the form of dividends.
How do REITs make money?
REITs, like any other business, require capital. An IPO (initial public offering) is how a publicly traded REIT (real estate investment trust) accomplishes this. This is similar to selling any other stock to the general public, who are investing in the company’s income-producing real estate. People who purchase initial public offerings (IPOs) are investing in real estate that is managed similarly to a stock portfolio. These outside cash sources allow the REIT to acquire, develop, and manage real estate in order to generate profits. REITs generate income, and shareholders must get 90 percent of that taxable income on a regular basis. REITs create money by renting, leasing, or selling the assets they purchase. The shareholders elect a board of directors, which is in charge of selecting investments and recruiting a team to oversee them on a daily basis.
FFO stands for funds from operations, which is how most REIT earnings are calculated. FFO is defined by the National Association of Real Estate Investment Trusts (NAREIT) as the net income from rent and/or sales of properties after deducting administrative and financing costs. The NAREIT’s net income computations follow GAAP (generally recognized accounting rules). The issue is that depreciation of assets is presumed to be a predictable given in GAAP calculations, which skews the true measure of a REIT’s revenue in a negative direction because real estate, which is what REITs deal in, retains or even improves in value over time. As a result, depreciation is not included in FFO’s net income.
What does Affo stand for?
Funds from Operations Adjusted (AFFO) This is a calculation used by analysts and investors to determine a real estate company’s recurring/normalized FFO after capital improvement funding has been deducted.
