Investors seeking to estimate the value of a real estate investment trust (REIT) will find that traditional metrics such as earnings-per-share (EPS) and price-to-earnings (P/E) do not apply. In this article, we'll discuss a more reliable method to estimate a REIT's value.
Examining Funds From Operations (FFO)
Let's start by looking at a summary income statement from XYZ Residential (XYZ), a fictional residential REIT.
From 2017 to 2018, XYZ Residential's net income, or "bottom line," grew by almost 30% (+$122,534 to $543,847). However, these net income numbers include depreciation expenses, which are significant line items. For most businesses, depreciation is an acceptable non-cash charge that allocates the cost of an investment made in a prior period. But real estate is different from most fixed-plant or equipment investments because property loses value infrequently and often appreciates. Net income, a measure reduced by depreciation, is, therefore, an inferior gauge of performance. As a result, it makes sense to judge REITs by funds from operations (FFO), which excludes depreciation. (For background reading on REIT investing, see The REIT Way.)
Companies are required to reconcile FFO, which is reported in the footnotes, along with net income. The general calculation involves adding depreciation back to net income and subtracting the gains on the sales of depreciable property. We subtract these gains, assuming they are not recurring and therefore do not contribute to the REIT's sustainable dividend-paying capacity. The reconciliation of net income to FFO (with minor items removed for the sake of clarity) in 2017 and 2018 is laid out as follows:
It's clear that, after depreciation is added back and property gains are subtracted, funds from operations (FFO) equals about $838,390 in 2017 and almost $758,000 in 2018.
FFO must be reported but it contains a weakness: It does not deduct for capital expenditures required to maintain the existing portfolio of properties. Shareholders' real estate holdings must be maintained, painting apartments for example, so FFO is not quite the true residual cash flow remaining after all expenses and expenditures.
Professional analysts, therefore, use a measure called "adjusted funds from operations" (AFFO) to estimate the REIT's value. Although FFO is commonly used, professionals tend to focus on AFFO for two reasons. First, it is a more precise measure of residual cash flow available to shareholders and therefore a better "base number" for estimating value. Second, it is true residual cash flow and a better predictor of the REIT's future capacity to pay dividends.
AFFO does not have a uniform definition but most calculations subtract capital expenditures, as mentioned above. In the case of XYZ Residential, almost $182,000 is subtracted from FFO to get AFFO for the year 2018. This number can typically be found on the REIT's cash flow statement. It's used as an estimate of the cash required to maintain existing properties, although a close look at specific properties could generate more accurate information.
Examining Growth in FFO and/or AFFO
We can estimate the REIT's value with greater accuracy when we have the FFO and AFFO in hand, looking for expected growth in one or both metrics. This requires a careful look at the underlying prospects of the REIT and its sector. The specifics of evaluating an REIT's growth prospects are beyond the scope of this article but here are a few sources to consider:
- the prospect of rent increases
- the prospect of improving/maintaining occupancy rates
- plans to upgrade/upscale properties (a popular and successful tactic is to acquire low-end properties and upgrade them to attract higher quality tenants; better tenants lead to higher occupancy rates (fewer evictions) and higher rents)
- external growth prospects (many REITs foster FFO growth through acquisition but it's easier said than done because a REIT must distribute most of its profits and typically doesn't hold a big cash hoard; however, many REITs successfully prune their portfolios, selling underperforming properties to finance the acquisition of undervalued properties)
Applying a Multiple to FFO/AFFO
The REIT's total return comes from two sources: dividends paid and price appreciation. Expected price appreciation can be broken into two further components: growth in FFO/AFFO and expansion in the price-to-FFO or price-to-AFFO multiple
Let's look at multiples for XYZ. Note we are showing price divided by FFO, which in reality is market capitalization divided by FFO. XYZ's market capitalization (number of shares multiplied by price per share) in this example is about $8 billion.
How do we interpret these multiples, aside from making a direct comparison to industry peers? Similar to P/E multiples, interpreting price-to-FFO or price-to-AFFO multiples is not an exact science and multiples will vary with market conditions and specific REIT sub-sectors). And, as with other equity categories, we want to avoid buying into a multiple that is too high.
Aside from dividends paid, price appreciation breaks down into two sources: growth in FFO/AFFO and/or expansion in the valuation multiple (price-to-FFO or price-to-AFFO ratio). We should consider both sources together when looking at a REIT with favorable FFO growth prospects, For example, if FFO grows at 10% and the multiple of 10.55x is maintained, the price will grow 10%. However, if the multiple expands about 5% to 11x, price appreciation will be approximately 15% (10% FFO growth + 5% multiple expansion).
A useful exercise takes the reciprocal of the price-to-AFFO multiple, i.e. 1 ÷ [Price/AFFO] = AFFO/Price. This equals about 7.2% ($575.7 ÷ 8,000) with XYZ Residential and iis called the "AFFO yield." To evaluate the REIT's price, we can then compare the AFFO yield to:
1. the market's going capitalization rate, or "cap rate,"
2. our estimate for the REIT's growth in FFO/AFFO.
The cap rate is a general number that tells investors how much the market is currently paying for real estate. For example, 8% implies that investors are generally paying about 12.5 times (1 ÷ 8%) the net operating income (NOI) of each real estate property.
Let's assume that the market's cap rate is about 7% and our growth expectation for XYZ's FFO/AFFO is a heady 5%. Given a calculated AFFO yield of 7.2%, we are probably looking at a good investment because our price is reasonable when compared to the market's cap rate (it's even a little higher, which is better). In addition, the growth we are expecting should eventually translate into both higher dividends and price. In fact, if all other investors agreed with our evaluation, XYZ's price would be much higher because it would need a higher multiple to incorporate these growth expectations.
The Bottom Line
REIT evaluation produces greater clarity when looking at funds from operations (FFO) rather than net income. Prospective investors should also calculate adjusted funds from operations (AFFO), which deducts the likely expenditures necessary to maintain the real estate portfolio. AFFO provides an excellent tool to measure the REIT's dividend-paying capacity and growth prospects.