Real Estate Investment Trusts are an easy way to add real estate to your portfolio. You can trade them just like any other stocks, and profit not only from appreciation potential but also high dividends.
However, don’t let the similarities fool you. Analyze REITs using the same traditional metrics from stocks and the numbers will trick you.
Standard benchmark metrics like Price to Earnings (P/E) and Book Value, don’t quite apply for REITs in the same way.
We already covered why invest in REITs, and here are 5 tips to help you analyze REITs. We’ll go through the subtle differences and also alternatives to better help you assess these investments.
1. Watch out for depreciation
Real Estate Depreciation is one of the great reasons this asset class is so tax-efficient. To better explain this, let’s go through a simple example.
From the U.S. Internal Revenue Service’s perspective, a property depreciates over time. So in a $1m residential building, we might end up taking $50k in depreciation each year (not actual numbers, just an example).
In other words, REITs can claim $50k each year as a business expense due to depreciation! They use it to offset income, rollover to the next tax year, etc.
Now, we all know that Real Estate tends to appreciate with time! So this difference between depreciating and appreciating asset creates an interesting scenario in earnings analysis.
Investors must be aware of this fact. Don’t take earnings and all its derivatives metrics too seriously for performance benchmarking.
2. Earnings are calculated differently
Look at the following example balance sheet. Note how depreciation is counted as expenses and affects the final net income or earnings.
An uninformed investor might start questioning this REIT. How can the company stock keep appreciating and distributing dividends, when its net income is so low?
Because earnings are so affected by the depreciation expense item, it doesn’t reflect the actual scenario of the company.
That’s also the reason why EPS and P/E can’t be used to compare REITs accurately.
The reality is, many REIT companies operate with little or even negative earnings per share, yet still, pay dividends and have rising stock prices.
3. Use Funds From Operating, not Earnings Per Share
FFO is a metric that corrects earnings. It adds depreciation and some other Real Estate specific expenses back, giving a more accurate earnings metric.
One important metric that derivates from Earnings is the Price to Earnings. Investors use the P/E Ratio to determine how much they are willing to pay for a stock relative to its earnings.
Because depreciation inflates REIT’s expenses, it brings net income down and thus negatively impacts price to ratio. There are not enough gains to justify the stock price.
Instead of dividing Share Price by EPS to get the P/E ratio, you should use Share Price by FFO to get a more accurate ratio for REITs.
4. Use Net Asset Value, not Booking Value
Another metric that corrects the depreciation factor explained above is Net Asset Value.
Going back to our example of a $1m building that depreciates $50k a year. At year 10 the building is worth $500k ($1m – 10 * 50k).
The value that accountants will enter on the company’s balance sheet at year 10 for this asset will be $500k. That’s the book value.
In reality, this building might be worth $1.2m at year 10. Net Asset Value corrects this difference.
Net Asset Value is calculated based on the actual value of a REIT assets.
It’s not easy to be calculated and not broadly available, but it should be pretty close to the market cap.
For example, a company with market cap of $10 billion should have approximately the same amount of real estate holdings minus liabilities.
This explains while a company with $5b in book value might have a $10b market cap.
5. Debt to Equity and Debt Coverage
This metric is readily available and works the same for REITs and other stock companies, but it’s particularly important in the real estate space.
REIT companies distribute almost all of its net profit as dividend. In the absence of earnings, they fuel their growth primarily via debt.
The debt to equity shows how much leverage a company is using.
If a company is bringing $100,000 in income and has $20,000 in debt, it’s debt to equity is 0.2, or 20%, a safe ratio.
On the other hand, a different company bringing the same $100,000 but with $200,00 in debt obligations, it is considered is highly leveraged (2 debt-to-ratio or 200%) and risky. It raises a red flag, and it’s worth further analysis before deciding to invest in it.
The industry average is at around 1.3 or 130% (2016), demonstrating that REIT companies do indeed rely on debt more than others.
Hopefully, you’re now equipped with enough to be able to compare REITs and make informed investment decisions.
I’d love to hear your perspective in analyzing these companies. Drop me a comment and maybe share some tips and tricks of your own!