Valuing REITs

Why this matters

REITs introduced real estate investment trusts as a way to own property through the stock market. To qualify, a REIT must hold most of its assets in real estate, earn most of its income from it, and distribute at least 90% of its taxable income to shareholders each year.¹ Those rules shape how it has to be valued. A REIT that looked only at its net income would appear to pay out more than it earns, and one valued on a price-to-earnings ratio would look far more expensive than it is.

The problem with net income

Depreciation, Amortization, and Capital Spending explained that depreciation spreads the cost of an asset over its life, on the assumption that it wears out. A well-located building that's kept in good repair may be worth more in twenty years than it is today. Deducting depreciation on it each year makes the REIT's profit look smaller than the cash its properties produce.

The industry's answer is funds from operations, or FFO. Nareit, the industry association, defines it as net income under accounting rules, excluding depreciation and amortization related to real estate, gains and losses from selling certain real estate assets, and impairment write-downs of certain real estate assets.² Gains on sales come out because selling a building isn't a recurring source of income.

	Amount
Rental revenue	220
Property operating costs	(70)
Net operating income from the properties	150
Head office costs	(10)
Depreciation	(60)
Interest on $800 million of debt	(40)
Gain on selling a property	12
Net income	52
Add back: depreciation	60
Remove: gain on selling a property	(12)
Funds from operations	100
Less: recurring spending on the buildings and on leasing	(20)
Adjusted funds from operations	80

Company P has 50 million shares. Per share, it earned $1.04 of net income, $2.00 of FFO, and $1.60 of adjusted FFO. It pays a dividend of $1.40.

Measured against net income, the dividend looks unaffordable: $1.40 paid from $1.04 earned. Measured against FFO, it's 70%. The second view is closer to the truth, but FFO flatters in its own way, which is why there's a third line.

Adjusted FFO

Buildings may not wear out the way depreciation assumes, but they aren't free to keep. Roofs get replaced, lobbies get refurbished, and each new tenant costs money in fitting out the space and paying agents. Adjusted FFO, or AFFO, subtracts that recurring spending. It's the better guide to what a REIT can pay out year after year. Company P's dividend is 87.5% of its AFFO, which leaves little room.

Unlike FFO, adjusted FFO has no standard definition. Each REIT decides what to subtract. The SEC's staff accepts FFO as Nareit defines it, and says any adjusted version has to meet the general rules for non-GAAP measures.³ So read each company's definition, and compare the spending it subtracts with what it actually spends on its existing buildings in the cash flow statement.

The rest of this lesson is for members

Still to come in this lesson: Valuing on cash flow, Valuing on assets, Debt and interest rates, Growth needs outside money, the key takeaways, and 2 quiz questions with explanations.

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