Complete Guide To Investment Companies, Funds And REITs

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Real Estate Investment Trusts (REITs) - Analyzing REITs And REIT Performance

There are a few things to keep in mind when assessing any REIT. They include the following:

  1. REITs are true total-return investments. They provide high dividend yields along with moderate long-term capital appreciation. Look for companies that have done a good job historically at providing both.
  2. Unlike traditional real estate, many REITs are traded on stock exchanges. You get the diversification real estate provides, without being locked in long term. Liquidity matters.
  3. Depreciation tends to overstate an investment's decline in property value. Thus, instead of using the payout ratio (what dividend investors use) to assess a REIT, look at its funds from operations (FFO) instead. This is defined as net income less the sale of any property in a given year and depreciation. Simply take the dividend per share and divide by the FFO per share. The higher the yield the better.
  4. Strong management makes a difference. Look for companies that have been around for a while or at least possess a management team with loads of experience.
  5. Quality counts. Only invest in REITs with great properties and tenants.
  6. Consider buying a mutual fund or ETF that invests in REITs and leave the research and buying to the pros.

Let's illustrate with a simplified example. Suppose that a REIT buys a building for $1 million. Accounting requires that our REIT charge depreciation against the asset. Let's assume that we spread the depreciation over 20 years in a straight line. Each year we will deduct $50,000 in depreciation expense ($50,000 per year x 20 years = $1 million).

Let's look at the simplified balance sheet and income statement above. In year 10, our balance sheet carries the value of the building at $500,000 (a.k.a., the book value) - the original historical cost of $1 million minus $500,000 accumulated depreciation (10 years x $50,000 per year). Our income statement deducts $190,000 of expenses from $200,000 in revenues, but $50,000 of the expense is a depreciation charge.

However, our REIT doesn't actually spend this money in year 10; depreciation is a non-cash charge. Therefore, we add back the depreciation charge to net income in order to produce funds from operations (FFO). The idea is that depreciation unfairly reduces our net income because our building probably didn't lose half its value over the last 10 years. FFO fixes this presumed distortion by excluding the depreciation charge. (FFO includes a few other adjustments, too.)

We should note that FFO gets closer to cash flow than net income, but it does not capture cash flow. Mainly, notice in the example above that we never counted the $1 million spent to acquire the building (the capital expenditure). A more accurate analysis would incorporate capital expenditures. Counting capital expenditures gives a figure known as adjusted FFO, but there is no universal consensus regarding its calculation.

Our hypothetical balance sheet can help us understand the other common REIT metric, net asset value (NAV). In year 10, the book value of our building was only $500,000 because half of the original cost was depreciated. So, book value and related ratios like price-to-book - often dubious in regard to general equities analysis - are pretty much useless for REITs. NAV attempts to replace book value of property with a better estimate of market value.

Calculating NAV requires a somewhat subjective appraisal of the REIT's holdings. In the above example, we see the building generates $100,000 in operating income ($200,000 in revenues minus $100,000 in operating expenses). One method would be to capitalize the operating income based on a market rate. If we think the market's present cap rate for this type of building is 8%, then our estimate of the building's value becomes $1.25 million ($100,000 in operating income / 8% cap rate = $1,250,000). This market value estimate replaces the book value of the building. We then would deduct the mortgage debt (not shown) to get net asset value. Assets minus debt equals equity, where the "net" in NAV means net of debt. The final step is to divide NAV into common shares to get NAV per share, which is an estimate of intrinsic value. In theory, the quoted share price should not stray too far from the NAV per share.

Taxes


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RELATED TERMS
  1. Funds From Operations - FFO

    A figure used by real estate investment trusts (REITs) to define ...
  2. Real Estate Investment Trust - ...

    A REIT is a type of security that invests in real estate through ...
  3. REIT ETF

    Exchange-traded funds that invest the majority of assets in equity ...
  4. Funds From Operations Per Share ...

    A metric for the performance of a real estate investment trust ...
  5. Adjusted Funds From Operations ...

    A financial performance measure primarily used in the analysis ...
  6. Cash Available For Distribution ...

    A real estate investment trust's (REIT's) cash on hand that is ...
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    Find out what sorts of securities are evaluated using funds from operations. Learn how FFO is calculated and why it is relevant ... Read Answer >>
  3. What is the difference between funds from operations per share and earnings per share?

    Find out how funds from operations (FFO) differs from net income. Learn how FFO is calculated and why REITs are evaluated ... Read Answer >>
  4. What are the pros and cons of owning an equity REIT versus a mortgage REIT? (AEC, ...

    Learn about investing in equity, mortgage and hybrid REITs. Explore the different strategies REITs employ to generate income ... Read Answer >>
  5. What is the difference between a REIT and a real estate fund?

    A real estate fund invests in securities offered by public real estate properties directly or indirectly through Real Estate ... Read Answer >>
  6. What are the potential pitfalls of owning REITs?

    Learn about pitfalls to investing in REITs, such as investors having to pay income tax, the REIT having to pay property tax ... Read Answer >>

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