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By Matt Frankel, Motley Fool Financials

7 Key Metrics For Evaluating Equity REITs

7 Key Metrics to Evaluate Equity REITs

Photo: wikipedia user Shaheen1234

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• REITs are a unique type of company, and are required to pay out 90% of their income as dividends

• Traditional accounting methods do not accurately reflect income from and the value of real estate

• So, traditional metrics of valuation such as P/E ratios and book value don’t tell the whole story

Why do we need special metrics?

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• FFO is a more accurate measurement of an equity REIT’s income than its earnings per share (EPS)

• Property depreciation is deducted from EPS on the income statement, but it isn’t an actual expense

• So, FFO adds depreciation back in and makes other adjustments in order to accurately show a REIT’s income

• Therefore, dividing the share price by the FFO is a more effective valuation multiple than P/E

1. Funds From Operations (FFO)

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Sample FFO calculation

Item Amount (Q1 2015)

Net Income $60.5 million

Depreciation $98 million

Depreciation (furniture, fixtures, and equipment)

($185,000)

Provisions for impairment

$2.1 million

Gain on sale of properties

($7.2 million)

Other FFO adjustments

($315,000)

Funds from operations (FFO)

$152.9 million

This is a sample FFO calculation from the Q1 2015 balance sheet of Realty Income Corp.

As you can see, net income (earnings) and FFO can be rather different

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• AFFO is used to compensate for certain capital expenditures

• This is considered to be an even more precise measurement of a REIT’s cash flow and ability to pay its dividends than FFO

• However, the methods used to calculate AFFO can vary between REITs, so it’s not an ideal way to compare one REIT to another

2. Adjusted Funds From Operations (AFFO)

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Examples of AFFO items include

• Certain amortization expenses

• Losses on investments such as interest rate swaps

• Capitalized leasing costs and commissions

• Capitalized building improvements

• Straight-line rent• Amortization of

above- and below-market leases

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• Because of the way depreciation works, a REIT’s book value suggests that a property’s value declines over time– For example, if a certain property was purchased for $1 million, and a

REIT depreciates $400,000 on its income statement over the next 10 years, the “book value” of that property falls to $600,000

• As we know, real estate values tend to increase over time

• NAV is an expression of the actual market value of a REIT’s properties, minus its debt

3. Net Asset Value (NAV)

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• Be aware that NAV is a subjective metric, as it is based on an assessment of properties’ market value

• Theoretically, a REIT’s NAV should equal (or be close to) its market capitalization

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• A REIT’s NAV divided by the number of outstanding shares tells you its intrinsic value per share

• Theoretically, intrinsic value and share price should be the same

• By comparing a REIT’s intrinsic value to its share price, you can determine whether its shares trade at a discount or a premium

4. Intrinsic Value

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Sample intrinsic value calculation

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• This is a metric used to express the profitability of properties

• For example, you might hear that a certain REIT “acquired $500 million worth of properties with an average cap rate of 7%”

• Cap rate is calculated by taking the properties’ annual operating income and dividing by the acquisition cost

5. Capitalization Rate (or “Cap Rate”)

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Example cap rate calculation

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• Debt-to-equity shows how much leverage a REIT is using

• Too much debt (leverage) can make a REIT vulnerable to market swings

• For example, if 80% of a REIT’s portfolio is financed with debt, a 20% drop in real estate values could wipe out shareholders’ equity

• On the other hand, a low debt-to-equity ratio (say 30%) insulates the REIT from market value fluctuations

6. Debt-to-equity

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• This metric tells us how much money a REIT takes in, relative to its debt payments

• For example, a debt coverage ratio of 4:1 means that for every $1 in debt payments, the REIT brings in $4

• A high debt coverage ratio indicates that the REIT will be able to pay its debt and still remain profitable during bad economic conditions

• Generally, I look for debt coverage of 4x or more

7. Debt coverage

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