How to Evaluate REIT Performance: Key Metrics Explained

Why Traditional Metrics Do Not Work for REITs

Standard stock analysis metrics like earnings per share (EPS) and price-to-earnings (P/E) ratio do not work well for REITs because of depreciation accounting.

Under accounting rules, REITs must depreciate their real estate assets over time (typically 27.5 years for residential, 39 years for commercial). This depreciation is a non-cash expense that reduces reported earnings, but real estate typically appreciates rather than depreciates.

This means a REIT can report low or negative earnings while actually generating significant cash flow. A REIT with $2.00/share in earnings but $4.50/share in FFO is not unprofitable, it is highly profitable with large non-cash depreciation charges.

The REIT industry developed specialized metrics to address this distortion. Understanding these metrics is essential for accurate REIT analysis.

Funds From Operations (FFO)

FFO is the most widely used measure of REIT profitability. It adds depreciation and amortization back to net income and removes gains or losses from property sales.

FFO Formula: FFO = Net Income + Depreciation + Amortization - Gains on Property Sales.

Example:

• Net income: $50 million
• Depreciation: $30 million
• Gain on property sale: $5 million
• FFO: $50M + $30M - $5M = $75 million

If the REIT has 25 million shares outstanding, FFO per share is $3.00.

Price-to-FFO ratio: Similar to P/E ratio but more accurate for REITs.

• Share price: $45
• FFO per share: $3.00
• P/FFO: 15x

Compare P/FFO to sector averages and historical ranges. A REIT trading at 12x FFO when the sector average is 16x may be undervalued (or may have problems justifying the discount).

Limitations of FFO: FFO does not account for recurring capital expenditures needed to maintain properties (new roofs, HVAC replacements, etc.). This is why analysts also look at AFFO.

Adjusted Funds From Operations (AFFO)

AFFO refines FFO by subtracting recurring capital expenditures and adding back straight-line rent adjustments. It provides a more accurate measure of the cash available for dividends.

AFFO Formula: AFFO = FFO - Recurring CapEx - Straight-Line Rent Adjustments + Non-Cash Items.

Example:

• FFO: $75 million
• Recurring CapEx: $10 million
• Straight-line rent adjustment: $2 million
• AFFO: $75M - $10M - $2M = $63 million

AFFO per share: $63M / 25M shares = $2.52.

AFFO payout ratio: This is the gold standard for dividend sustainability analysis.

• Annual dividend per share: $2.20
• AFFO per share: $2.52
• Payout ratio: $2.20 / $2.52 = 87%

An 87% payout ratio is manageable but leaves limited room for dividend growth or unexpected expense increases. A payout ratio of 70-80% is healthier and suggests room for dividend increases.

Note that AFFO calculation can vary between companies since there is no strict standard (unlike FFO, which NAREIT defines). Always check how a specific REIT calculates its AFFO.

Net Asset Value (NAV) and Other Key Metrics

Net Asset Value (NAV): The estimated market value of a REIT's properties minus its debt and preferred stock obligations, divided by common shares outstanding. NAV represents what the REIT's portfolio would be worth if sold today.

• If NAV per share is $50 and the stock trades at $42, the REIT trades at a 16% discount to NAV, potentially a buying opportunity.
• If the stock trades at $58, it trades at a 16% premium, investors are willing to pay above asset value for the management team's ability to grow.

NAV is estimated by analysts (not reported by companies), so different analysts may have different NAV estimates for the same REIT.

Other important metrics:

Same-store NOI growth: Measures revenue growth from properties owned for at least one year. Positive same-store growth indicates organic improvement. 2-4% growth is typical for healthy REITs.

Occupancy rate: The percentage of available space that is leased. Most equity REITs target 93-97% occupancy. Below 90% warrants investigation.

Debt-to-equity ratio: Total debt divided by total equity. Lower is generally better. Most well-managed REITs maintain ratios between 0.5 and 1.0.

Interest coverage ratio: EBITDA divided by interest expense. Higher is better. A ratio above 3.0 indicates the REIT comfortably covers its debt obligations.

Weighted average lease term (WALT): The average remaining term of the REIT's leases, weighted by revenue. Longer WALT means more predictable future income.