how-to-assess-a-real-estate-investment-trust

How To Assess A Real Estate Investment Trust

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REITs or real estate investment trusts are not similar to traditional stocks when it comes to
valuation. They are evaluated differently.

how-to-assess-a-real-estate-investment-trust

Did you know that metrics like P/E ratio and EPS do not translate well to REITs?

With that in mind, let us know more about the several valuation metrics that are important in
comparing and assessing REITs.

Funds From Operations (FFO) To Assess A Real Estate Investment Trust

funds-from-operations-reits-investments

This valuation metric is the main way to know how much money a REIT makes. This is a
different way of calculating earnings per share or net income.

Traditional calculation methods do not give the correct figures. The main reason being
businesses are allowed to depreciate the asset valuation over time. This helps in tax
benefits.

Normally, depreciation of an asset such as machinery or other items does not make enough
distortions in the earnings of a business. However, in REITS investment, all assets are
depreciable.

This results in lowering REITs taxable income as depreciation leads to major tax deductions.
But there is also a problem – depreciation does not cost the REIT a penny. In reality, the
value of the real estate asset tends to go up over time, while depreciation means a loss of
value.

So, rather than using the “earning per share” or net income procedure for analyzing how
much money a REIT has earned over a given quarter, or a year, the Funds From Operations
(FFO) metric is used for calculation. The biggest difference here is the depreciation
‘expense’ is brought back into the calculation.

This is one of the most important assessments of a REIT performance and should be
considered before investing.

For a clear understanding of how FFO works, given below is the first quarter 2019 FFO
calculation of a leading REIT, Equity Residential (NYSE: EQR)

ITEM Amount
NET INCOME $109.26 Million
DEPRECIATION (NET)$203.05 Million
NET GAIN ON SALE OF REAL ASSET $000.02 Million
TOTAL FFO $310.76 Million
*Data source: Equity Residential. Number addition may vary because of rounding up.

The above table shows that Equity Residential actually made approximately three times
what the net income figure suggests. This is how FFO is different from net income.

Also Read

Price – To – FFO (P/FFO) Ratio

This valuation metric determines if a REIT is expensive in comparison to its peers. It helps to
determine the comparative valuation of different companies. The price-to-FFO ratio (P/FFO)
is a better way to assess if a REIT is cheap or expensive than the traditional method of P/E
ratio calculation.

Ensure that the calculation is based on FFO per share and annualized before computing the
ratio.

Adjusted FFO/ Normalized FFO/ Core FFO

Many REITs report different FFO metrics for calculation, such as adjusted FFO, normalized
FFO, and Core FFO. There is no standard method to calculate any of them.

These are generally company-specific calculation techniques and can use various
adjustments, like taking the one-time expense from the equation. They give you a true
picture of the money the company is making.

Given below is the calculation of Equity Residential’s first quarter normalized FFO.

ITEM Amount
FFO $310.76 Million
WRITE–OFF PURSUIT COSTS$001.45 Million
NON–OPERATING ASSET LOSSES $000.23 Million
OTHER MISCELLANEOUS ITEMS $001.58 Million
NORMALIZED FFO $314.01 Million
*Data source: Equity Residential. Number addition may vary because of rounding up.

The difference between standard FFO and company-specific FFO is not large. In the above
case, the normalized FFO was 1.3% greater than the standard FFO. It shows that these
calculation metrics give the exact picture of how a REIT is performing.

Payout Ratio To Assess A Real Estate Investment Trust

payout-ratio-reits-investments

The payout ratio is an important yardstick for dividend shares. In the case of REITs, there
are two additional points to remember.

First, remember to use the FFO metric for calculating the payout ratio and not earning per
share or net income. Second, in the case of dividend stocks, the payout ratio of 40% to 50%
is standard, but REIT payout ratios are much higher since REIT must payout 90% of their
income.

A REIT payout with 80% FFO should not sway you away from REIT investing. As long as
the ratio is consistently under 100%, the dividend payout is normal and sustainable.

The Final Word

It is always important to assess a combination of metrics rather than using a single metric for
evaluating a REIT.

Any one metric can be deceiving. Be sure to look at a combination of metrics before deciding
if a particular REIT is worth investing in

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