Understanding and Evaluating REITs
By: Olivia Faucher,
Understanding and Evaluating REITs: Funds From Operations offer 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
A REIT is a company that owns, operates, or finances real estate that produces income. 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 and farmland.
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.
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 and net income when researching new investments. However, REIT performance measurement is more complex, and it uses a more specific metric that is called Funds from Operations (FFO).
Understanding and Evaluating REITs: Why EPS 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 anything from a cash perspective. REITs typically have large depreciation “expenses” that reduce their net income. Therefore, REIT’s net income and earnings per share don’t give an accurate picture of the company’s cash flows from operations.
Since the primary business of a REIT is owning real estate, the REIT’s earnings are significantly different than their operating cash flows because of non-cash depreciation.
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 a measure of the cash generated by a REIT; it is essentially operating cash flow. 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 + Depreciation + Amortization – 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 earnings per share. Looking at EPS and FFO per share together help paint a more complete and accurate financial 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. How exactly is this calculated? 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: The Bottom Line
Investors who are considering buying shares in a REIT need to know the best way to evaluate a potential REIT investment. Although EPS 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 offer by far the most accurate way to evaluate REIT operating (or 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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Olivia Faucher is an editorial intern with Eagle Financial Publications.