One way for investors to diversify their portfolio beyond stocks and bonds, and to obtain exposure to real estate is by investing in a real estate investment trust (REIT).
Of course, before making any investment, a rational investor will always consider the criteria and information available to determine whether the investment is worth their time and a fit for their risk tolerance.
Investing in a REIT can be quite different from investing in a stock or bonds. One thing to keep in mind is that REITs are corporations that are required by law to distribute 90% of taxable income to shareholders as dividends, whereas other investment vehicles may not necessarily be subject to this requirement. The distribution of income from other investment types may vary based on a number of factors, such as earnings and capital needs. Investing in a REIT is also different than buying traditional real estate investments, such as a home or multi-family property. Unlike individual ownership of real estate investments, which requires a significant upfront cash down payment typically beyond the reach of the average investor, investing in a REIT can provide diversification across a number of properties without potential hassles of directly managing real estate.
REITs can also deduct non-cash expenses, such as depreciation and amortization, which can have a significant impact on earnings. Consequently, common and standard stock analysis tools, like the Earnings Per Share (EPS) calculation, are not to be relied upon for valuation analysis and financial performance assessment. Instead, investors should look to two key metrics to provide insight into a REIT’s true operating performance: Funds from Operations (FFO) and Adjusted Funds from Operations (AFFO), each of which backs out certain non-cash expenses to help provide a clearer picture of a REIT’s cash flow and ability to pay distributions.
Understanding these two metrics can help you evaluate a REIT’s financial performance, as well as its ability to meet its dividend obligations, and growth potential of the dividend — all key factors in the ultimate success of a REIT investment. As mentioned previously, in order to qualify as a REIT, a company is required to distribute at least 90% of its taxable income. Taxable income is a calculation that is defined by IRS regulations, and is highly complex. As such, most companies tend to align the dividend payout with AFFO, which is a measure of a REIT’s true cash flow (see definition below). Typically, REITs look to distribute a percentage of AFFO, which at a minimum satisfies the taxable income requirement, but enables the company to retain cash flow to fund growth initiatives. Currently, the average dividend payout rate (annual dividend as a percentage of AFFO) is in the 75-80% range for public net-lease REITs.1 Keep in mind that the payment of dividends is never guaranteed.
Here’s what you should know about how to evaluate REIT performance.
First, here’s why earnings per share (EPS) doesn’t relate to REIT valuations
While Earnings per Share is one of the more commonly used metrics to determine the operating performance of a stock, it is a misleading metric in the context of a REIT valuation.
This is because the calculation of EPS includes a number of critical items that are incompatible with how real estate and, in particular, REITs, perform and should be valued. For example, when evaluating equities, the EPS calculation divides a stock’s net income (that is, revenues minus all expenses) by the number of total available shares.
Most traditional companies which evaluate their operating performance with EPS do not have extensive property holdings. But real estate, where factors such as depreciation and amortization, which are non-cash expenses, can significantly reduce a property’s net income, don’t typically reflect operating performance or value. Valuing a property based on revenues alone is misaligned with how REITs tend to establish a dividend because it doesn’t account for the operating expenses of the REIT, including property taxes, utilities, and interest payments on its debt, making this metric an unhelpful tool in trying to evaluate the financial performance of a REIT.
REITs are sensitive to depreciation expenses because their major assets are depreciable physical properties, though these expenses don’t impact the cash a REIT can generate from rental income. That’s where FFO comes in — it eliminates the impact of such non-cash expenses within its calculation.
FFO excludes depreciation and amortization
Funds from Operations, or FFO, remove the impact of non-cash costs of a real estate investment.
You can calculate FFO by starting with a REIT’s net income adding back any depreciation and amortization, and eliminating the impact of gains/losses on the sale of assets, since this tends to be non-recurring:
As an example, consider a REIT that had $1 million in net income for the year. During that period, the REIT sold one property for a gain of $100,000 and another for a loss of $20,000, a net gain of $80,000. For the year, the REIT reported $20,000 in depreciation and $15,000 in amortization.
$1 million + $20,000 + $15,000 - $80,000 = FFO of $955,000
AFFO provides an even clearer picture
While Adjusted Funds from Operations, or AFFO, is a widely used metric within the REIT sector, there is no standardized definition. According to Nareit, the leading industry association for REITs, AFFO is used to measure a real estate company’s recurring/normalized FFO after deducting capital improvement funding. Typically, AFFO is calculated by subtracting from FFO both 1) normalized recurring capital expenditures by the REIT necessary to maintain a REIT's properties and its revenue stream (e.g. leasing expenses and tenant improvement allowances) and 2) the adjustment for GAAP revenue adjustments which are generally not reflective of cash revenue (“straight-line rents”). AFFO then can provide additional insight into a REIT’s cash flows by taking into account capital expenditures and straight-line rent payments, the latter of which is a non-cash revenue item.
Here’s how to calculate AFFO based on Nareit’s definition:
Capital expenditures are reoccurring expenses that improve the property — like fresh paint or new carpets — as well as leasing related costs.
Straight-line rental calculation averages rental income over the life of the REIT. Commercial rents often increase over time and may include incentives like free or discounted months for tenants as incentives to attract tenants or extend leases. By looking at average straight-line rents, investors can filter out short-term fluctuations and understand the long-term income potential of an investment property. Note that in the early years of a lease, straight-line rents are deducted because the rental revenue recognized is greater than cash received, while in the later years of a lease straight-line rents are added back because rental revenue is less than cash received.
Using the same example as above, we know that net income plus depreciation plus amortization is $955,000. Now, let’s say our sponsor also spent $50,000 on reoccurring capital expenses and had $60,000 in straight-lined rent. In this case, AFFO for this REIT would be calculated as follows:
$955,000 - $50,000 - $60,000 = AFFO of $845,000
Here’s where it can get complicated. Because there is no standardized definition of AFFO, investors and analysts should understand how the measure is defined by each company. In the case of Modiv, there are many other adjustments taken into account for AFFO including deferred financing costs, stock compensation, amortization of lease intangibles, and gains/losses on interest rate swaps, among others. Details can be found in our quarterly filings, which can be found on the Securities and Exchange Commission’s website at www.sec.gov, which include a detailed description of the calculation of FFO and AFFO in Management’s Discussion and Analysis in our quarterly filings filed on Form 10-Q and our annual filings filed on Form 10-K.
How to use FFO and AFFO to determine performance
Once you know a REIT’s FFO or AFFO, you can perform an analysis to determine dividend potential and valuation comparisons to other REITs. As for dividends, you can compare the payment to FFO and AFFO to determine dividend coverage (i.e., the amount by which FFO or AFFO exceeds the dividend payment expressed as a percentage) and potential for dividend growth.
With regards to valuation, you can divide FFO and AFFO by shares outstanding, and then divide that by the stock price to determine a multiple of FFO or AFFO to stock price (e.g., the stock price is 10x of 2020 FFO). This multiple can be compared to other REITs to determine if the REIT is fairly or over/under valued.
AFFO can also provide information about likely dividend payments. As mentioned above, public net-lease REITs typically pay out an average of 75-80% of AFFO in dividends. So, taking our previous example, a REIT with an AFFO of $845,000 would be expected to pay out dividends between $633,750 and $676,000 (i.e., $845,000 multiplied by 75%-80%). By dividing this amount by the number of outstanding shares, investors can estimate the average potential dividend payments per share. You can then take this number to help determine if a particular REIT you are looking to invest in is paying out more or less than the average to evaluate if there is room for potential dividend growth or when comparing one potential REIT investment against other REITs.
In most cases, you would not need to calculate FFO on your own because public REITs are required to show their FFO calculations on their public financial statements. This figure is typically disclosed in a REIT’s income statement.
While commonly used for REITs, note that these metrics are not defined formally under GAAP or the International Financial Reporting Standards. As a result, investors should understand how the measure is defined by each REIT before using it to make an investment decision. Despite this lack of standardization, both FFO and AFFO are valuable tools for evaluating REITs.
For investors, using FFO and AFFO metrics provides you with better tools for evaluating real estate investment opportunities. As we’ve shown, these metrics can help you estimate how much income you may earn from your REIT investment, whether that dividend income is likely to rise or fall in the future, and how one REIT compares to another REIT. For REITs, AFFO is particularly useful in determining an appropriate dividend policy.
1) S&P Global Market Intelligence
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The views and opinions expressed in this commentary reflect Modiv Inc.’s (together with its affiliates, “Modiv”) beliefs and observations in commercial real estate as of the date of publication from sources believed by Modiv to be reliable and are subject to change. Modiv undertakes no responsibility to advise you of any changes in the views expressed herein. No representations are made as to the accuracy of such observations and assumptions and there can be no assurances that actual events will not differ materially from those assumed. The forward-looking statements in this paper are based on Modiv’s current expectations, estimates, forecasts and projections, and are not guarantees of future performance. Actual results may differ materially from those expressed in these forward-looking statements, and you should not place undue reliance on any such statements. These materials are provided for informational purposes only, and under no circumstances may any information contained herein be construed as investment advice or as an offer to sell or a solicitation of an offer to buy an interest in any Modiv program or offering. Alternative investments, such as investments in real estate, can be highly illiquid, are speculative, may not be suitable for all investors, and there is no guarantee that distributions will be paid.