Investing in real estate is one of the classic asset allocations investors have to choose, but not everyone has or wants to own physical real estate. So what is the option? How about real estate investment trusts, or REITs for short? REITs can offer fantastic returns for all investors with a higher dividend yield than most stocks offer.

For example, the S&P 500 now offers a roughly 2% dividend yield, where it is relatively simple to find a REIT that offers 5% or higher.

When constructing your portfolio, it is generally the best idea to own assets that are not closely correlated to avoid big hits to your portfolio when particular sectors suffer bigger impacts than other sectors.

REITs allow you the opportunity to participate in investing in real estate without many of the headaches that accompany that asset class, such as finding the property, approval for the loan, and finding renters, maintenance, and many more.

REITs are also in many different sectors that include healthcare, apartments, industrial, retail, malls, office properties, and storage centers.

The trick with REITs, like any new investment, is discovering the language of this asset class and figuring out how to value a REIT. Like the financial sector, there are some particulars that we need to discover, and once we understand the different metrics, it is much easier to invest in REITs.

In today’s post, we will learn:

• What is a REIT?
• Different Metrics to Use When Analyzing REITs
• How to Analyze a REIT
• Methods for Valuing a REIT

Ok, let’s dive in and learn more about REITs and how to value them.

What is a REIT?

According to NAREIT, which is the National Association of Real Estate Investment Trust, that governs REITs:

“Real estate investment trusts (REITs) are companies that own and most often actively manage income-producing commercial real estate. Some REITs make or invest in loans and other obligations that are secured by real estate collateral. The shares of most large REITs are publicly traded.”

In 1960, Congress passed legislation that allowed the creation of REITs to enable investors to benefit from investing in large-scale, commercial real estate.

Investing in commercial real estate through REITs offers many benefits to investors, such as superior dividend yields and long-term share appreciation like any other stock investment. Plus, they allow for additional asset allocation for the investor’s portfolio.

The current yields of REITs is not an accident, and in fact, it is by design as REITs must contribute at least 90% of its net income to dividends. The regulations that govern REITs require the distribution of dividends, which leads to the much higher dividend yields than others such as Apple or Microsoft.

One might think because of the high yields on the dividends, that there isn’t much chance for reinvestment for the company or little to no share appreciation. But, in fact, REITs have returned annual returns of 10.6% since 1994, whereas the index that tracks the returns of the market has seen returns of 10% over the same period.

One might think that REITs focus solely on ownership of the commercial real estate, but REITs have a different structure as they are trusts, not corporations.

The difference lies in the structure of the legal entities. Because REITs are trusts, not corporations, they are taxed differently in a way that is far more tax-efficient for REIT investors.

How does that work?

Well, in exchange for operating as a REIT, the company pays no tax at the organizational level, which allows them to distribute 90%+ of its net income as dividends.

As the structure of REITs is different, the returns the REITs generate must be treated differently on a tax basis. The returns fall into three different categories:

• Ordinary income
• Return of capital
• Capital gains

The ordinary income taxes is currently 39.6% and is the most straightforward for tax considerations.

Return on capital comes into play when you sell the REIT and could be thought of as a deferred tax; you don’t pay any taxes until you sell.

Finally, the taxes on capital gains are on either the short-term or long-term rates depending on when you sell the stock.

Because the majority of returns generated by REITs are dividends, the best tax vehicle for them is retirement accounts. Taxes on dividends are ordinary income, and that means that retirement accounts eliminate that negative and make REITs very tax-friendly.

Different Metrics to Use When Analyzing REITs

As I mentioned in the intro, using traditional methods to analyze REITs don’t stand up well. Therefore using metrics such as EPS, PE, is not useful.

Rather there are specific metrics that were established by NAREIT as a means of assessing the value of REITs. The metrics we are going to discuss are not GAAP related metrics, so you will not find them in the accounting rules, but the investing community generally accepts them.

The main reason for the adjustments made to accommodate REITs is depreciation. The allowance of depreciation of business assets over time is a valuable tax benefit. In most instances, the business’s depreciation of items such as machinery, property, computers, and other items isn’t enough to distort the earnings of the company.

However, all of the REIT assets are depreciable, as they own real estate properties.

The deduction of depreciation is a major tax deduction every year and helps reduce the REITs taxable income. But the issue is that depreciation doesn’t cost the REIT anything. When you think about it makes sense, because while most assets depreciate, real estate usually appreciates, and therein lies the problem.

The solution is instead of using metrics like earnings per share or net income to measure the performance of the REIT; we use a metric called Funds from Operations, or FFO. The biggest difference in the metric is we add back the depreciation expense.

Funds From Operations

FFO, or funds from operations, is the most important REIT specific metric to understand before investing in REITs. All the others relate to FFO and thus the focus on the metric.

Let’s look at a company to illustrate how the funds from operations work.

For our guinea pig, I would like to focus on Store Capital (STOR), a REIT that is currently in Warren Buffett’s portfolio.

Store Capital 10-k, page 52 concerning FFO and AFFO calculations

We can see from the chart above, Store Capital calculates the FFO for us, and if you compare those numbers to the income statement, you will see the same result. Because FFO is a non-GAAP number, it is not included in the income statement, but fortunately for us, every REIT I have studied includes this calculation for us.

As you can see, the FFO is vastly different from the net income; by looking at the FFO for Store Capital, we can see that the company made almost double the net income.

Also notice the bottom line item from the chart above, which includes the term Adjusted Funds from Operations, or AFFO. Think of AFFO like adjusted earnings, which many REITs include as a way to offset any one-time charges or amortization of expenses that are not associated with operations.

The AFFO is a means of coming to a true picture of how much money the company is making.

FFO per Share

Just like earnings per share, once we have calculated the FFO, we simply divide that number by the shares outstanding, we arrive at our FFO per share, which is a better choice to assess the value of a REIT.

Looking at Store Capital, we can see the FFO for the year 2019 is $441.16, and the current shares outstanding are 230.29. We divide:

FFO per share = $441.16 / 230.29
FFO per share = $1.92

P/FFO

Next up is the P/FFO, which is the substitute for the P/E ratio. We use this to compare it to its peers to determine the value on a relative basis.

The current price for Store Capital is $27.98, and the per-share we calculated above is $1.92.

P/FFO = $27.98 / $1.92
P/FFO = 14.57

Payout Ratio

As with any company that pays a dividend, we can easily assess the payout ratio of a REIT by dividing the dividends per share by the FFO by share, and voila, payout ratio. Store Capital currently pays a dividend of $1.40 a share.

Payout Ratio = $1.40 / $1.92
Payout Ratio = 0.74 or 74% payout from FFO.

Remember that REITs are required to payout at least 90% from earnings. If we look at it from a dividend per share versus earnings per share basis, we get a 121% payout ratio, which seems high, but is historically consistent with the amount that Store Capital has paid over the last five years.

The high ratio for a company like Store Capital would merit some investigation, but if it is the range of 80% to 90%, I wouldn’t be greatly concerned.

Debt-to-EBITDA

REITs carry a lot of debt, but too much debt is a concern for anyone investing in a REIT. One of the best ways to assess the debt level from an overview level is to use the debt-to-EBITDA.

The target to look for in relation to this metric is a debt-to-EBITDA of 6.1, anything above that is something to investigate.

Store Capital currently has a TTM EBITDA of $665.2, and the total debt is for the latest quarters balance sheet was $3,393, which consists of all long-term debt.

Therefore, the calculations are:

Debt-to-EBITDA = $3,393 / $665.2
Debt-to-EBITDA = 5.1

A great practice is to compare the debt level of the company you are analyzing to peers to get an idea of how your company is performing. Sometimes looking at numbers in a vacuum is misleading.

Interest Coverage

Interest coverage for a REIT is important to assess because, as a company that carries higher debt loads, we must assess how easily the company can pay its interest expenses on the current debt. The higher the interest expense, the more impact it has on the cash flow of the company.

On a quarterly basis, the interest coverage is:

Operating income 2020 Q2 = $77.689
Interest Expenses 2020 Q2 = -$41.946

Interest Coverage = (-1 * $77.689) / -$41.946
Interest Coverage = 1.85

Remember, the higher the number, the better because it indicates it is easily able to hand its debt load. The number is going to be industry-specific; for example, a tech company might have a much higher interest coverage ratio because they have higher margins and can finance operations via their free cash flow.

Credit Rating

The last measure of screening through REITs is looking at the credit rating of the company. Why do we do this, you ask?

The company’s ability to borrow money to purchase properties is central to the operations of a REIT, and the stronger the credit rating, the lower the interest rates the company is charged and thus lower costs overall.

To find the credit rating of Store Capital, I log into my Moody’s.com account, which is free by the way, and search for Store Capital.

As we can see from above, Store Capital currently has a credit rating of Baa2, which according to Moody’s chart, is high medium grade and has moderate credit risk.

Another great practice is to compare your company to its peers to see how your company stands.

Ok, now that we have an understanding of what a REIT is and how to assess the company, let’s next take a look at the methods to value these companies.

Methods for Valuing a REIT

There are three main types of intrinsic valuation methods available to use to utilize. They encompass models we use for other companies, such as a discounted cash flow and the dividend discount model.

The new addition is a method utilized in the REIT world, which is the Net Asset Value or NAV.

Net Asset Value (NAV)

To use NAV, we need to gather a few numbers.

• Net Operating Income or Gross Income
• Cap Rate
• Overall debt of the company
• Cash and cash equivalents
• Accounts Receivable
• Goodwill
• Other Assets
• Shares Outstanding
• Accounts Payable
• Other Liabilities

We can find the majority of this information on the balance sheet and income statements. For our calculations, I am going to stay with Store Capital, and we will access the 10-k to calculate the NAV for the company.

A note on the cap rate for Store Capital, the easiest way to determine the cap rate for any REIT is to look in the financial statements in SEC.gov and use the Ctrl-F function, which allows you to search the text for a specific set of words.

To find the cap rate, use the ctrl-F function and type in the phrase “capitalization rate,” and you will find links to that phrase where we find that Store Capital has a cap rate of 7.9% for 2019.

The rest of the info we will pull from the statements for Store Capital.

• NOI, Net Operating Income – $648.8
• Cap Rate – 7.9%
• Cash & Cash Equivalents – $669.2
• Accounts Receivable – $618.5
• Total Debt – $3,591
• Accounts Payable – $201.4
• Shares Outstanding – 230.3

The process now that we have out numbers is:

• Divide NOI by the Cap Rate
  • $648.8 / 7.9% = 8,212.65
• Next, we add the cash and accounts receivable
  • 8,212.65 + 669.2 + 618.5 = 9,500.36
• We next subtract the total debt and accounts payable from our number.
  • 9,500.36 – 3,591 – 210.4 = 5,698.96
• Lastly, we divide the above number by our shares outstanding to find the per-share value.
  • $5,698.96 / 230.3 = $24.75

That is the process for calculating the NAV of Store Capital; try it out on another REIT as homework.

The above is an overview of the NAV model; I will add a more in-depth post about this model very shortly.

Dividend Discount Model (DDM)

Because dividends are a mainstay of REITs, it makes sense to approach the valuation of a REIT using the dividend discount model. I will provide the inputs I am using to arrive at our valuation, but if you are unfamiliar with this model, please check out this link for more details on how to use a DDM.

• A Thorough Breakdown of the Dividend Discount Model

The following are the inputs I will use for the model:

• Beta – 1.1
• Risk-free Rate – 0.70
• Risk-premium – 5.79
• Dividend Payout Ratio – 74%
• Retention Ratio – 26%
• Current Annual Dividend – $1.40
• Return on Equity – 6.17%

After plugging in the numbers into the model, we arrive at a value of $26.03 per share.

Discounted Cash Flow (DCF)

As we turn to our last valuation model, we will follow the same route as the DDM; I will list out the assumptions I am using to input into the models for the discounted cash flow if you are unsure about this model or would like more info, please follow the link below:

• Explaining the DCF Valuation Model with a Simple Example

For our model today, instead of using earnings or free cash flow, we are going to use the FFO per share that we calculated at the beginning of the post.

FFO for REITs is a version of free cash flow for the sector, thus why it works well for the discounted cash flow model.

Here are the inputs for our model:

• Beta – 1.1
• Risk-free rate – 0.70
• Risk premium – 5.69
• FFO growth rate – 8%
• FFO per share – $1.90
• Terminal rate – 3%

After plugging in the inputs into the model, the value we come back with is $37.02.

To make this easier on you, I use the discounted cash flow model that is available on gurufocus.com, it is free and gets in the ballpark.

Now if we assess our company on the three models:

• NAV value – $24.75
• Dividend Discount Model – $26.03
• Discounted Cash Flow – $37.02

Now, we can compare our results to the current market price, which as of writing this article, is $27.91, as of September 11, 2020.

We can see we have a range of undervalued to overvalued, but that is the best way to look at the valuation of any company is to assess the company on a range of values.

Never settle for one value and base your investment thesis on that single value; it is best to run the company through several valuation methods to see if you are in the ballpark.

Final Thoughts

Investing in REITs is a great opportunity to take a bite out of a sector you may not have access to any other way. Of course, there are risks involved with any investment, and the primary risk you face in regards to REITs is the debt load.

As we discussed above, there are multiple metrics available to use to analyze any REIT, and the best part is they are similar to ones we use for other companies.

REITs, like banks, have a slightly different language they speak, and once you understand that language, the sector opens up to you for additional analysis and other investment opportunities.

And when valuing the REITs, other than the NAV model, the same rules apply for any other model you wish to use, as long as you understand that the earnings and free cash flow are not the same as, say, Walmart. Once you understand those differences, it is a simple matter of applying what you already know.

That is going to wrap up our discussion today.

As always, thank you for taking the time to read this post, and I hope you find something of value on your investing journey.

If I can be of any further assistance, please don’t hesitate to reach out.

Until next time, take care and be safe out there,

Dave