How To Evaluate REITs Performance?

Traditional measurements such as earnings-per-share (EPS) and price-to-earnings (P/E) are ineffective when estimating the value of a real estate investment trust (REIT). A figure termed funds from operations is a more dependable method (FFO). Here’s all you should know about REIT FFO (or FFO REIT).

How do you evaluate REIT performance?

How do you judge a REIT?

This is how REIT investors compare the value of various businesses. The price-to-earnings, or P/E, ratio is used with stocks. The price-to-FFO ratio is a more accurate technique to determine if a REIT is pricey or inexpensive in comparison to its peers.

Before calculating the ratio, make sure you’re looking at FFO on a per-share and annualized basis. Equity Residential, for example, recorded $3.14 per share in FFO in 2018, which is a solid amount to utilize when determining its P/FFO ratio.

How do you know 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.

What is a good p FFO for a REIT?

The best tool for analyzing REITs is probably the price-to-funds-from-operations (P/FFO) ratio. P/FFOs have been in the high teens, with some going into the 20s, in the present interest rate environment. P/FFOs have been consistently low for various REITs, with some falling below 10.

What is a good PE ratio for a REIT?

The median P/E for all REITs is 19.73. Retail, residential, office, industrial, hotels, health care, and diversified are all subsets of the REITs category. Within the REIT area, industry-specific median P/E ratios range from -53.22 to 41.99.

Why REITs are bad investments?

Real estate investment trusts (REITs) are not for everyone. This is the section for you if you’re wondering why REITs are a bad investment for you.

The major disadvantage of REITs is that they don’t provide much in the way of capital appreciation. This is because REITs must return 90 percent of their taxable income to investors, limiting their capacity to reinvest in properties to increase their value or acquire new holdings.

Another disadvantage is that REITs have very expensive management and transaction costs due to their structure.

REITs have also become increasingly connected with the larger stock market over time. As a result, one of the previous advantages has faded in value as your portfolio becomes more vulnerable to market fluctuations.

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).

What is the maximum loss when investing in REITs?

A Real Estate Investment Trust (REIT) is a firm that produces and owns real estate to generate income. Some REITs are traded on the exchange, while others are not. Investors that invest in REITs are indirectly investing in the company’s real estate. Investing in REITs typically grants the investor voting rights, similar to ordinary shares of a firm.

REITs, unlike other real estate firms, do not construct real estate with the intention of reselling it. REITs hold or lease real estate and, as a result, distribute rental income to investors. Dividend-based income is what it’s termed. Office buildings, hotels, shopping centers, and houses, as well as data centers and cell towers, are examples of these properties. In typical market conditions, the income stream from a REIT investment can also be regarded somewhat stable because rents are usually stable.

Requirements for REITs

A corporation must meet specific criteria in order to be classified as a REIT. These requirements specify, for example, how a REIT should be run, what percentage of its assets should be real estate, and how much of its taxable revenue should be given to investors in the form of dividends. These percentages vary according on the REIT’s country of origin.

Typical examples of some of these provisions are:

The majority of REITs’ taxable income must be distributed to shareholders. Typically, roughly 90% of the total must be distributed.
Real estate must account for at least a specified percentage of the assets. This is usually around 75% of the time.
Rent or sale of real estate, as well as interest on mortgages, must account for at least a portion of its gross income. This is usually around 75% of the time.
A minimal number of people must own the beneficial ownership. A REIT may be required to have at least 100 shareholders if this is the case. This must be the case for at least 335 days in a taxable year, for example.

Different types of REITs

REITs come in a variety of shapes and sizes. These distinctions can be found in the manner in which investors can invest in them or in the type of product that a REIT specializes in.

A REIT does not have to be publicly traded, as previously stated. There are three different types of classifications:

REITs that are publicly traded can be bought and sold on major stock markets such as the New York Stock Exchange and the London Stock Exchange. Because many REITs are traded on traditional stock markets, they have a higher level of liquidity than investing directly in real estate. This means that investors will be able to acquire and sell REIT shares more readily on the exchange.
Non-exchange traded REITs are available to investors but do not trade on major exchanges.
Private REITs: These REITs are not traded on a stock exchange and are not open to all investors. These private REITs can only be invested in by specified people who are usually nominated by the REIT’s Board of Directors.

REITs can hold a variety of assets, including real estate, mortgages, and other financial instruments. The following are some instances of specialized REITs:

Mortgage REITs

Mortgage REITs, as you might expect, invest in mortgages. mREITs are another name for them. They may employ mortgages or loans directly or indirectly through mortgage-backed securities (MBSs).

Residential REITs

Residential REITs are typically focused on residential real estate. Apartment complexes or single-family rental properties are examples of this. This can be narrowed even further; for example, some REITs specialize primarily in student housing or specific neighborhoods.

Diversified REITs

REITs can be diversified, unlike the very particular REITs discussed in the previous types. A REIT must own a mix of two or more types of properties to fall into this category. This could be a mix of shopping centers and office buildings, for example.

Distribution

REIT dividends are subject to a different withholding tax than ordinary share distributions, and are frequently taxed more harshly. Before investing in a REIT, you should review the REIT’s investor relations page or speak with a local tax professional. The applicable tax will be determined by the type of distribution and the investor’s tax residency.

What are the risks and rewards of investing in REITs?

Investing in real estate investment trusts (REITs) can be profitable, but it is not without risk. DEGIRO is up forward and honest about the dangers that come with investing. The investor relations website of a REIT normally contains information on the REIT’s investment portfolio. Before investing in a REIT, it is a good idea to read the investor relations page. The maximum loss when investing in a REIT is equal to the total amount invested.

Regular income distributions and a potential price increase are two ways an investor might profit from a REIT investment. Dividends, rather than price appreciation, account for the majority of REIT returns. Capital appreciation is generally low because most income is transferred to shareholders. This, however, is not assured.

This material is not intended to be used as investment advice, and it does not make any recommendations. Investing entails taking risks. Your deposit may be lost (in whole or in part). We recommend that you only invest in financial products that are appropriate for your level of knowledge and experience.

How do you find the intrinsic value of a REIT?

Estimating a REIT’s NAV requires numerous computations, but the basic premise is straightforward: assess the current market value of the REIT’s portfolio, then add any other intangible assets, deduct all mortgage-related liabilities, and divide the NAV by the number of shares outstanding.

There are four primary phases to calculating a REIT’s NAV; we’ll go through each one below, along with where we can get each data piece.

The first stage in computing a REIT’s NAV is to determine the REIT’s NOI, or net operating income. In this phase, we’ll calculate the NOI by looking at the income statement for the following items:

Do REITs trade above book value?

REITs must distribute at least 90% of their profits to shareholders in the form of dividends.
For REITs, book value ratios are meaningless; instead, measurements like net asset value are more useful.
REITs should do top-down and bottom-up studies, using top-down elements such as population and job growth, and bottom-up factors such as rental income and funds from operations.

Do all REITs pay dividends?

A REIT is a security that invests directly in real estate and/or mortgages, comparable to a mutual fund. Mortgage REITs engage in portfolios of mortgages or mortgage-backed securities, whereas equity REITs invest mostly in commercial assets such as shopping malls, hotel hotels, and office buildings (MBSs). A hybrid REIT is a fund that invests in both. REIT shares are easy to buy and sell because they are traded on the open market.

All REITs have one thing in common: they pay dividends made up of rental income and capital gains. REITs must pay out at least 90% of their net earnings as dividends to shareholders in order to qualify as securities. REITs are given special tax treatment as a result of this; unlike a traditional business, they do not pay corporate taxes on the earnings they distribute. Regardless of whether the share price rises or falls, REITs must maintain a 90 percent payment.