Analyzing REITs
REITs are dividend-paying stocks that focus on real estate. If you seek income, you will consider them along with high-yield bond funds and dividend paying stocks. As dividend-paying stocks, REITs are analyzed much like other stocks. But there are some significant differences due to the accounting treatment of property.
Let's illustrate with a simplified example. Suppose that a REIT buys a building for $1 million. Accounting requires that our REIT charge depreciation against the asset. Let's assume that we spread the depreciation over 20 years in a straight line. Each year we will deduct $50,000 in depreciation expense ($50,000 per year x 20 years = $1 million).
Let's look at the simplified balance sheet and income statement above. In year 10, our balance sheet carries the value of the building at $500,000 (a.k.a., the book value): the original historical cost of $1 million minus $500,000 accumulated depreciation (10 years x $50,000 per year). Our income statement deducts $190,000 of expenses from $200,000 in revenues, but $50,000 of the loss is a depreciation charge.
However, our REIT doesn't spend this money in year 10; depreciation is a non-cash charge. Therefore, we add back the depreciation charge to net income to produce funds from operations (FFO). The idea is that depreciation unfairly reduces our net income because our building probably didn't lose half its value over the last ten years. FFO fixes this presumed distortion by excluding the depreciation charge. (FFO includes a few other adjustments, too.)
We should note that FFO gets closer to cash flow than net income, but it does not capture cash flow. Mainly, notice in the example above that we never counted the $1 million spent to acquire the building (the capital expenditure). A more accurate analysis would incorporate capital expenditures. Counting capital expenditures give a figure known as adjusted FFO, but there is no universal consensus regarding its calculation.
Our hypothetical balance sheet can help us understand the other common REIT metric, net asset value (NAV). In year 10, the book value of our building was only $500,000 because half of the original cost depreciated. So, book value and related ratios like price-to-book - often dubious regarding general equities analysis - are pretty much useless for REITs. NAV attempts to replace book value of the property with a better estimate of market value.
Calculating NAV requires a somewhat subjective appraisal of the REIT's holdings. In the above example, we see the building generates $100,000 in operating income ($200,000 in revenues minus $100,000 in operating expenses). One method would be to capitalize the operating profit based on a market rate. If we think the market's present cap rate for this type of building is 8%, then our estimate of the building's value becomes $1.25 million ($100,000 in operating income / 8% cap rate = $1,250,000). This market value estimate replaces the book value of the building. We then would deduct the mortgage debt (not shown) to get net asset value. Assets minus debt equals equity, where the 'net' in NAV means net of debt. The final step is to divide NAV into common shares to get NAV per share, which is an estimate of intrinsic value. In theory, the quoted share price should not stray too far from the NAV per share.
