Real Estate Investment Trusts have evolved into a sector of their own. Equity REITs have already been established as a distinct asset class in the Global Industry Classification Standard by S&P Dow Jones Indices and MSCI. REITs have their own terminology and valuation parameters, which are different from your everyday stock valuation.
Dividend.com presents “Must-Know Terms” that every investor should be familiar with regarding REITs in the "REIT Glossary” listed below.
Funds From Operations goes by the following formula:
+ Depreciation and amortization
- Gain on sale of assets
When FFO is divided by the number of shares outstanding, we get FFO/share. For a detailed example that uses live numbers, check out “Understanding REIT Valuation”, where we break down LTC Properties (LTC ) and analyze other key valuation techniques.
Commonly used in the real estate investment industry, the capitalization rate is often referred to as “cap rate”. It tells you the return a property is likely to generate based on its current market value.
Net Operating Income / Current market value of the property (not original purchase price).
Property A – NOI = $2,00,000 Income per year, $3 million (Current market value)
Property B – NOI = $3,00,000 income per year, $2 million (Current Market value)
Property A Cap Rate = 6.67% per year
Property B Cap Rate = 15% per year
If the market value goes up and the income stays the same then the cap rate comes down. If the market value goes down, but the income stays the same then the cap rate goes up.
Equity REITs are companies that acquire commercial properties—office buildings, shopping centers and apartment buildings—and lease the structure to tenants. A simple example would be if Company ABC buys a property and rents it out to a tenant and collects monthly rent. Depending on the type of property purchased and the tenant in those properties, the REIT is further sub-categorized into industrial, mortgage, retail, healthcare, self-storage, diversified, office, hotel and timber.
A mortgage REIT lends money to real estate buyers. Mortgage REITs would primarily generate income from the interest they earn on these mortgage loans.
An example would be if company DEF lends out money to Company ABC, which is an equity REIT (as mentioned above) that primarily invests in healthcare properties. ABC would be a healthcare REIT while DEF would be a mortgage REIT that lives off the interest that ABC pays them on the money they loaned them.
Find a complete list of mortgage REITs here.
A hybrid REIT is a combination of both Equity REITs and Mortgage REITs. It owns mortgages as well as properties that it rents out to tenants.
NAV is used in the NAVPS formula. This formula compares the amount the REIT’s assets exceed its liabilities using current market value rather than accounting book value.
Estimated cash NOI/cap rate = current market value of the property (not the purchase price)
*We only played with the formula that’s explained in the capitalization rate formulation above.
Current market value of property + Cash & Accounts Receivable – Debt = Net Asset Value
When NAV is divided by the number of shares outstanding, the result is NAVPS, which is the estimated price a REIT should trade at.
|Estimated cash NOI||100|
|Assumed cap rate||8%|
|Estimated value of operating real estate (market value)||1250|
|PLUS: Cash + accounts receivable||100|
|LESS: Debt & other liabilities||400|
|Net asset value||950|
NAVPS is a less commonly used approach than P/FFO for REIT valuation purposes.
Total Market Cap
Total market cap equals Equity market cap + Debt market cap. Total market cap is important for REITs because a large portion of their assets are financed by debt. That’s why the general saying goes that one should avoid REITs in a rising interest rate environment. Equity dilution is a very common occurrence with REITs that plan to expand through further equity issuances than they already have. Debt as a % of financing may be significant as compared to equity; hence, this measure is an important indicator to judge the overall market value of the company.
Occupancy rates are defined as the number of units that are rented out vs. the number of units that are available to rent out. If a REIT owns 1,000 properties and has tenants in 950 of them, then the occupancy rate is 95%.
Vacancy rates are the exact opposite of occupancy rates. It’s defined as the number of units that aren’t rented out vs. the number of units that are available to rent out. Vacancy rates are simply 1 – The Occupancy Rate. Referring to the above example, since 50 properties are not occupied by tenants the vacancy rate is 5%.
Triple Net Lease
A triple net lease is a lease where the tenant is responsible for paying the building’s property taxes, maintenance charges, tax and all other expenses associated with the property, including the property’s rent.
A triple net lease rent is usually lower than a normal lease agreement. Triple net lease is a benefit to the landlord as he is hedged from possible maintenance charge increases or tax related payment increases. But, it comes at the cost of a lower rent that the lessee pays, as mentioned above.
Price/FFO is the most commonly used valuation ratio used by retail investors. The ratio isn’t easily available on popular finance websites. The price information is easily available and FFO guidance for the year end can be found on the respective websites of each company under the investor section. Lower P/FFO ratios are always welcome. Higher P/FFO ratios are an indication of higher expected growth in earnings through planned future investments by the company.
Find a detailed analysis of P/FFO valuation here.
AFFO is an extension of the FFO formula:
FFO – Non-cash rent adjustments – Recurring maintenance-type CAPEX & leasing commissions
Non-cash rent is defined as rent that the landlord is supposed to receive but doesn’t receive due to various problems that a tenant might face. So, if a tenant is supposed to pay $5,000 in rent but instead pays only $4,950 for the month then $50 is defined as non-cash rent.
Maintenance CAPEX refers to general maintenance-related expenses that a company has to undergo for all the properties that it rents out.
AFFO (as you can see above) is a better economic indicator than FFO since it accounts for the rent that’s actually received and also subtracts the expenses that a company undergoes during its course of operations.
|Fund From Operations||$100m|
|Subtract: Non cash rents||$20m|
|Subtract: Recurring maintenance type CAPEX||$5m|
|P/AFFO per share (Sh pr = $200)||5.33|
5.33 should now be compared to sector multiples and competitor multiples just like you would for P/FFO.
An UPREIT is an umbrella partnership REIT structure, where the REIT is the general partner and holds a controlling interest in a partnership that owns the properties. They are the most common REIT structure in the US.
In a DOWNREIT the REIT has an ownership interest in more than one partnership and can own properties at the partnership level and the REIT level.
There is always a possibility of a conflict of interest. When there is an opportunity to sell properties or take on more debt, general partners may act in their own interest rather than acting on behalf of shareholders’ interests.
Tenant Concentration Risk
If a particular tenant provides a majority of the REITs’ revenue then that is referred to as concentration risk. The lesser % contribution to the topline per tenant, the lower the tenant concentration risk.
Geographic risk refers to the concentration of properties that a REIT might have in a particular area that might not be suitable to their line of business. If a REIT has a high concentration of properties in Houston and the Houston economy suffers due to low oil prices, then that’s a geographic risk for the REIT since a poor local economy implies higher vacancy rates.
Same Store Rent Increase
REITs grow their businesses by raising rents on the properties they already own, which is called same store rent increases. Other factors contributing to their topline are rent from development and redevelopment, rent from acquired properties and rent lost through disposition of assets.
Discounted Cash Flow Approach
The DCF approach is the same approach one would use for stock valuation. Future dividends are discounted back using a discount rate.
|Dividends per share||$5||$5.10||$5.20||$5.25|
One can take the CAGR of dividends observed previously and estimate the future dividends. In the above example, we have assumed a 2% growth rate.
PV2017 Dividend + PV2018 Dividend + PV2019 Dividend + PV2020 Dividend (Terminal value)
Assume the discount rate is 9%
PV of dividends in 2019 = $5.25/(0.09 – 0.02) = $75.06
$5/(1.09) + $5.10/(1.09)^2 + $5.20/(1.09)^3 + $75.06/(1.09)^3
Remaining Lease Terms
Short remaining lease terms provide an opportunity for the REIT to increase rents, which is favourable in an expansionary economy while long remaining lease terms provide safety to the trust in times when the economy is contracting.
A REIT can have long lease terms with clauses that provide for same store rent increases every year. If the rate increases are higher than the inflation rate then it should be viewed as positively.
Lease terms vary with the type of REIT that you are evaluating. Shopping centers generally have long lease terms, while hotels and apartment REITs have shorter lease terms.
Cost of Capital
The definition of a cost of capital to a REIT is to raise money through equity and debt to finance investments. Money raised through equity is called cost of equity while money raised through debt is called cost of debt. Equity holders are paid back a return through dividends, while debt holders receive an interest that is paid before computing net income. Every REIT aims for ‘positive spread investing’ where the returns they aim for—through the investments they make by raising money through equity and debt—be higher than the cost it takes to raise capital.