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Real estate investment trust (REIT) valuation has been a complex subject for retail investors since it doesn’t follow the usual price/earnings multiple based valuation or the price to book/sales based valuation methods.
Real estate investment trusts are tax-advantaged companies that are (for the most part) exempt from corporate income tax. They are actively managed and own income-producing real estate, and they seek to profit by growing their cash flows. They often specialize in a particular type of property like shopping center REITs, healthcare REITs or industrial REITs, while still diversifying by geography or other factors.
The most popular REIT valuation method is P/FFO. P/FFO (or Current market Price/Funds From Operations) per share is very common amongst retail and institutional investors alike.
The formula to calculate Funds From Operations is as follows:
+ Depreciation and amortization
- Gain on sale of assets
*All figures are as of 12-31-2014
On 12/31/2014 LTC had a market price of $43.15. This brings us to its P/FFO per share of 16.92.
Real estate, by nature, has a property of appreciating in value rather than depreciating, which is the reason why we need to value it differently—since the EPS, which is used in the traditional price/earnings based stock valuation, accounts for the removal of depreciation. Gain on sale of real estate is subtracted because it isn’t income from continuing operations.
Similar to the PE analysis for any stock, this is P/FFO per share for a REIT, which is then applied in the same fashion you would use to value a stock: You compare it to its industry average and its most direct peers. Undervaluation or overvaluation would depend upon market conditions and future growth prospects for the industry and the company.
*P/FFO or P/AFFO are not easily available because they are non-U.S. GAAP measures and if the company hasn’t voluntarily calculated them for you, you would have to calculate it yourself. Hence the focus on calculation.
Valuing REITs takes into account a few more things that you might not consider for stocks.
REITs due to their structure have high payouts, and high dividend yields are very popular amongst income investors. A good deal of research is required before investing in REITs, as they don’t receive as much coverage as stocks making it hard to find key valuation metrics.