Following the previous article on an Introduction to Real Estate Investment Trusts (REIT), this article will be focusing on REITs key valuation metrics.
REITs are not equities and are therefore valued differently. For instance, assets generally depreciate over time whilst real estate does not. On the contrary, real estate is known to appreciate in value over time, which is incorporated through the metric Funds From Operations (FFO). Adjusted Funds From Operations (AFFO) is even more accurate metric as it also incorporates expenditure on real estate improvements as well as increases in rental value. The third main valuation metric is Net Asset Value (NAV) which estimates the market value of a REITs portfolio which can then be compared to its share price and evaluated whether it is trading at a discount or premium. Additional metrics include the debt to FFO ratio, price to FFO ratio and cost of capital, amongst others.
Funds From Operations (FFO) – FFO is used to define the cash flow operations of REITs. Investors often use FFO as an operating performance benchmark, with all components of FFO’s listed on the REITs income statement.
The formula for FFO is:
FFO = Net Income + (Depreciation & Amortisation) – Gains from Property Sales
The key element here is that depreciation and amortisation are added back into the net income. Accounting figures require companies to depreciate their assets, but real estate often rises in value, making FFO a useful valuation metric when valuing REITs. Another key element is that gains from property sales are subtracted as these are one-off occurrences and do not represent a meaningful figure within the net income. FFO is a similar metric to operating cash flow but FFOs puts a larger emphasis on the real estate aspects thus providing a more accurate picture.
Adjusted Funds From Operations (AFFO) – Whilst there are no general standards for calculating AFFO, it is often seen as the most accurate representation when valuing REITs. AFFOs deduct capital expenditures on maintenance and improvements and also incorporate additional income sources such as rental increases.
The formula for AFFO is:
AFFO = FFO + rent increase – capital expenditure – maintenance
By incorporating these elements, investors can better predict future dividend payments whilst providing a more accurate figure of a REITs present value (as it represents a more true residual cash flow). It must be stated that AFFO is not consistently reported by various firms as it is not an official requirement. This often leads to firms having different valuation approaches and quoting different figures.
Net Asset Value (NAV) – NAV estimates the market value of the property portfolio which is determined by using a yield (or cap rate known in the US) and the income generated by the portfolio's properties. The assets (or capital value) are calculated by dividing the rental income by the yield. This figure is then subtracted by all the liabilities the firm accounts for. The result ie. the NAV provides a book value to the REIT portfolio.
The formula for NAV is:
NAV = Total assets – total liabilities.
Based on the NAV and a REITs current share price, investors will analyse whether the company is trading at a premium or discount to its Net Asset Value. Determining a NAV is often seen as subjective as setting a yield to a property is determined by a formula with certain assumptions based on subjective views.
Further metrics helpful in determining REITs include (but are not limited to):
Debt / FFO ratio - determines how risky a REITs debt is.
Price / FFO Ratio - looks at whether a REIT is expensive relative to its peers, which can be used as a good comparison to the PE Ratio in stocks.
Cost of Capital – Considering REITs are often raising capital, the cost of capital plays a big part in determining its investment potential. The three sources of capital are; undistributed cash flow, equity, and debt. The cost of capital is the weighted average of all three sources.
The above article has covered some of the main valuation metrics used for REITs. These do not consist of the full list of formulas, whilst investors also need to consider looking at REITs future growth prospects and understanding the broader real estate market & economy. By analysing the above metrics investors will get a good indication of whether a REIT is on the right track and is not raising any red flags. To understand further theories/metrics of a company’s financial strength, the article on Measuring a Company's Financial Health is helpful.
The following article and the last of this series will focus on whether investing in real estate and more specifically REITs, serves as a diversification tool within a multi-asset portfolio.