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Real estate investment trusts (REITs) can be excellent long-term investments with great returns. If you’re looking through dozens of REITs and wondering which one to put your money into, you’ll know that information can be challenging to sift through.
Understanding how to value a REIT can make all the difference in your long-term earnings. These five metrics are essential for REIT valuation.
Understanding a REIT Income Statement
An income statement is one of several types of financial statements. Companies operating in the United States are legally required to submit an income statement to the U.S. Securities and Exchange Commission (SEC).
Understanding how to read an income statement can give insights into a company’s revenue, expenses, losses and gains. Each of these metrics is further subcategorized to provide extra information.
While private companies are not required to publish income statements publicly, public companies must publish quarterly income statements for everyone to view.
Below is a public income statement for Sunrise Senior Living Real Estate Investment Trust for 2005 and 2006.
Sunrise Senior Living Real Estate Investment Trust Consolidated Balance Sheets As at December 31, 2006 and 2005 (In thousands of Canadian dollars)
|Real estate investments:
|Income properties (note 4)
|Intangible assets (note 5)
|Properties under development (notes 3 and 6)
|Mezzanine loans receivable (note 7)
|Other assets (note 8)
|Deferred financing costs, net
|Receivables from related party (note 18)
|Cash and cash equivalents
|Liabilities and Unitholders’ Equity
|Debt (note 9)
|Convertible debentures (note 10)
|Accounts payable and accrued liabilities
|Due to related party (note 18)
|Income taxes payable (note 13)
|Non-controlling interest (note 11)
|Unitholders’ equity (note 12)
|Total liabilities and unitholders’ equity
Some terms may be unfamiliar to you as you look through this income statement. Here are the general terms that might help you better understand this statement:
Assets: The asset value represents everything the company owns. Total assets include buildings, personnel, intellectual property and everything else the company owns that has value.
In the case of a REIT, the vast majority of assets are commercial real estate assets.
Liabilities: Every company has liabilities. The key figure to look for within the liability category is debt. The debt-to-income ratio is an essential factor to consider when evaluating REITs.
Equity: Equity represents the amount of value that investors in the company hold. Liabilities plus equity will always equal a company’s total assets.
Operating Revenue: Operating revenue represents the total income that the company makes through its primary business model.
In the case of a REIT, this figure will represent the money earned through rent or other property income.
Operating Expenses: These figures represent a business’s expenses through regular operations. Operating expenses include rent in office buildings, wages, legal fees, etc.
Interest Expenses: Interest expenses represent the costs that a business incurs through paying off debts. In most cases, interest expenses are primarily mortgage payments.
5 REIT Valuation Metrics
These are the five most important metrics to consider when analyzing REITs.
Price-to-FFO is an essential measure in understanding a REIT’s value. This metric essentially represents earnings per share of stock. More specifically, it represents the share prices for the period in relation to the cash flow a company is receiving through regular operations.
In most cases, REIT companies will provide this information directly to potential investors on their website. If the company is publicly traded, this figure will appear in income statements as “operating revenue.”
A good price-to-FFO ratio for a particular company depends upon the company and the current economy. In general, you should look at the company you want to invest in as well as several competitors.
If the company you want to invest in has a significantly different price-to-FFO ratio than the others, you should be wary of investing.
Growth in FFO or AFFO
FFO and adjusted funds from operations (AFFO) can help predict a REIT’s future growth when you use them in combination with other data.
When considering whether the FFO or AFFO will continue to increase, consider the overall probability of increased rent in areas where the REIT owns properties, the potential of maintaining current tenants, future plans and external growth prospects.
EBITDA stands for “earnings before interest, taxes, and depreciation.” Understanding how much a company makes in earnings compared to how much it owes in debt is a good figure for judging a REIT’s leverage.
When considering this ratio, you should look at multiple similar REITs. They should have EBITDA-to-debt ratios that are relatively similar to each other.
If one REIT has a significantly different ratio, you should consider that a red flag.
A credit rating can give you a lot of insight into the value of a REIT. This rating will tell you how much faith creditors have in a REIT’s ability to repay loans and other debts.
Additionally, a high credit rating indicates that a REIT can borrow money at a lower interest rate, increasing profits faster. Business credit ratings are on a letter scale where AAA is the best and C or D is very poor.
Generally, you should look for REIT companies with credit ratings at or above an A or BBB rating. The three primary agencies that make business credit reports are Moody’s, Fitch Ratings and Standard & Poor’s.
You can search for a company on each agency’s website to see its credit score and what that score means.
The payout ratio measures how much a company pays its investors in dividends compared to its FFO. For most companies, a 30-50 percent dividend payout ratio is good, while more than 50 percent is too high. REITs, however, are different.
Because of how they operate, REITs tend to have higher payout ratios than companies in other industries. You should look for a payout level of about 70-80 percent.
Lower payout ratios indicate that a company is investing in long-term growth. While this may be good for long-term investors, you will also want to reap the benefits of your investment in the short term to create cash flow.
A payout ratio higher than 80 percent is likely unsustainable and means that a company is stagnating or struggling financially.
Finding REIT Financial Information
You can find most REIT information through the National Association of Real Estate Investment Trusts (NAREIT).
This platform contains most of the information about individual REITs that you will need to determine if a particular REIT is a good investment.
Additionally, many companies will publish this information on their websites, even if they are private companies without an obligation to do so.
Other Factors to Consider Before Investing
Understanding the economic value and potential growth of a REIT can help ensure that your investment is safe, but there are other factors to consider.
For example, these factors may play a part in a REIT’s success:
- Regional portfolio diversity
- Real estate type portfolio diversity (office properties, homes, retail, etc.)
- Corporate policies
- Past success in times of economic downturn
Finding and sorting through information for potential investments can be difficult and time-consuming, but putting in the effort may make all the difference when it comes time to cash out.
Due diligence is essential for all investments, and you should always check multiple sources for information before you invest.
REIT Valuation FAQ’s
These are questions frequently asked about valuing REITs.
What is the best way to evaluate a REIT?
The best way to evaluate a REIT is to look at debts, net income, portfolios, and dividends paid to investors.
Additionally, investors can look at capital expenditures, the estimated market value of a REIT’s portfolio and the potential future growth rates of regions the REIT is invested in.
How cyclical is a REIT?
The cyclicality of a REIT depends on the sector in which it primarily invests.
Retail space REITs are cyclical because they are highly economy dependent, but residential properties are much less cyclical because they tend to be used regardless of economic factors.
How do you value a private REIT?
Valuing a private REIT is more complex than valuing a public REIT because they are not required to publish information about their finances, but it is possible.
You can look at net asset value, equity versus net funds from operations, and cap rates (net operating income to property value ratio) to determine the value of a private REIT.
How do you calculate the intrinsic value of REITs?
You can calculate the intrinsic value of a REIT by estimating the current market of a REIT’s portfolio and assets, subtracting liabilities, and then dividing that number by the value of outstanding shares.