A Guide to Understanding REITS: Metrics for Analysis

GuruFocus.com

- By Stepan Lavrouk

In an earlier piece, we talked through the basics of what a real estate investment trust (REIT) is and why an investor might want to invest in one. Here we look at some of the metrics that analysts use when evaluating different REITs and how an investor can add these methods to their own investing toolkit.


Analyzing REITS

REITs are income instruments in much the same way that dividend stocks and bond funds are. But the specialized nature of these securities requires the use of specialized metrics that many investors have not come across before.

  • Funds from operations (FFO)



This is calculated by taking net income, adding back depreciation and amortization charges and subtracting gains from property sales. Why use this, rather than earnings? Accounting rules require companies to apply depreciation charges to assets on their balance sheets.

Usually, this is a fair representation of the fact that assets lose value over time; however, in the case of REITs, their main assets are the properties they own. Assuming it is properly maintained, real estate generally appreciates in value over time. This means that the standard convention for calculating earnings artificially depresses the true earnings of a REIT, as a REIT with more expensive properties will have higher depreciation charges. Using FFO allows one to account for this.

  • Adjusted funds from operations (AFFO)



AFFO is derived by subtracting maintenance expenditures from FFO. You will perhaps note that this makes the formula similar to that for free cash flow (operating cash flow minus growth and maintenance capex). However, unlike free cash flow, AFFO does not subtract growth capex, because REITs typically do not reinvest significant portions of their earnings back into growth. It should be noted that there is no universal definition of how to calculate AFFO, because what constitutes maintenance capex is variably defined by different REITs.

  • Net asset value (NAV)



NAV is typically used in place of book ratios like price-book. As noted above, accounting rules require REITs to levy depreciation charges against their real estate assets, making book ratios an unreliable source of information. Calculating NAV requires capitalizing the income of a REIT by estimating the rate that its assets are generating. If an asset earned $500,000 in net income, and we assume that the cap rate for this asset is 5%, then we have $500,000/5% = $10,000,000. Determining the correct rate is part art, part science, and is one of the trickier parts of investing in the real estate sector in general.

  • Dividend yield



A REIT's yield is a measure of the relationship between its price and the income that it pays out. A high yield relative to historical averages indicates that the REIT is currently undervalued, whereas a low yield indicates that it is overvalued. While past performance is no guarantee of future returns, this is a useful rule of thumb that you can use to quickly filter out investments that clearly do not present good value for money.

Summary

Due to the unique nature of this asset class, analysis of a REIT requires the use of a few unusual metrics. If you can understand the underlying logic of why these unconventional tools are being used, then you will be well on your way to becoming an expert in the field.

Disclosure: The author owns no stocks mentioned.

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This article first appeared on GuruFocus.