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 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:
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 the 2% rule in real estate?
Purchasing a property and renting it out can help you pay off your mortgage while also potentially generating additional cash. Renting out your property can also provide you with passive income, allowing you to focus on other things while still earning money. Buying and renting properties is a simple method to begin investing in real estate. What do you need to know?
In real estate, the two percent rule relates to what percentage of the total cost of your residence you should ask for in rent. To put it another way, for a $300,000 property, you should be asking for at least $6,000 a month to make it worthwhile.
However, in metro real estate markets, the 2 percent guideline is frequently impossible to achieve. However, the average rental cost in a place like Philadelphia is $1,660, while the average home is $203,000. This can be a decent rule of thumb for determining what you would need to charge in order to be cash-flow positive relatively soon. In other words, charging $4,000 for an average home rental will be out of line with the local rental market.
Capital gains tax on real estate investment property will apply if you are not intending to live in your investment property (If you live there for at least 2 years, you can minimize – or even eliminate – your capital gains tax responsibility).
If you own property for less than a year, you’ll pay the same amount in taxes as if you were earning regular income. It’s considered a long-term capital gain if you’ve owned the property for at least a year. These profits are taxed at a reduced rate of 0%, 15%, or 20%, depending on your income and filing status.
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.
Why are REITs a bad investment?
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.
Can you lose money in a REIT?
- REITs (real estate investment trusts) are common financial entities that pay dividends to their shareholders.
- One disadvantage of non-traded REITs (those that aren’t traded on a stock exchange) is that investors may find it difficult to investigate them.
- Investors find it difficult to sell non-traded REITs because they have low liquidity.
- When interest rates rise, investment capital often flows into bonds, putting publically traded REITs at danger of losing value.
What is the average return on a REIT?
Real estate investment trust (REIT) returns The five-year return of U.S. REITs, as measured by the MSCI U.S. REIT Index, was 7.58 percent in May 2021, down from 15.76 percent in May 2020. 5 A return of 15.76 percent is much higher than the S&P 500 Index’s average return (roughly 10 percent ).
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 debt to equity ratio for a REIT?
Real estate investment is exposed to interest rate risk because it might carry a lot of debt. The D/E ratio for real estate companies, including REITs, is typically around 3.5:1.
What is a good FFO?
A real estate investment trust’s cash flow is measured by funds from operations (FFO) (REIT). The funds come from the company’s inventory sales as well as the services it provides to its consumers. REITs are required by GAAP to depreciate their investment properties over time using one of the conventional depreciation methods, which might cause the REIT’s underlying performance to be distorted. Depreciation is misleading in describing the value of a REIT because many investment properties improve in value over time. To resolve this issue, depreciation and amortization must be added back to net income.
The FFO to total debt ratio assesses a company’s capacity to repay its debt only through net operating income. The lower the company’s FFO to total debt ratio, the more leveraged it is. If the ratio is less than one, the corporation may need to sell some assets or take out more debts to stay afloat. The greater the FFO to total debt ratio, the better the company’s ability to pay its loans out of operational income and the lower its credit risk.
Because debt-financed assets typically have longer usable lives than yearly FFO, the FFO to total debt ratio is used to determine if a company’s annual FFO fully covers debt, i.e. a ratio of 1, rather than whether it has the ability to service debt within a reasonable timescale. A ratio of 0.4, for example, indicates the potential to pay off debt in 2.5 years. Companies may be able to repay debts using resources other than cash flow; they may take out a second loan, sell assets, issue new bonds, or issue new stock.
Standard & Poor’s deems a company with an FFO to total debt ratio of more than 0.6 to be low risk. A company with mild risk has an FFO to total debt ratio of 0.45 to 0.6; one with intermediate risk has a ratio of 0.3 to 0.45; one with considerable risk has a ratio of 0.20 to 0.30; one with aggressive risk has a ratio of 0.12 to 0.20; and one with high risk has a ratio of 0.12 to 0.20. These requirements, however, differ per industry. For example, to get a AAA credit rating, an industrial (manufacturing, service, or transportation) company could need an FFO to total debt ratio of 0.80.
