Monday, April 18, 2016

REIT: How to Evaluate Them

REITs are typically seen as the dividend cash cows for a portfolio much in the same way the golden snitch is seen as a win for Harry Potter in a quidditch game. These massive dividend payers are a dime a dozen however and their metrics seem to be all over the place. Why, you might ask? This is because of a number of factors.

The most important factor is that an REIT (Real Estate Investment Trust) is a unique type of investment that is forced by law to pay out 90% of their income received as dividend payments to shareholders. This causes your typical method of evaluation to fail. This is because the P/E ratio and subsequently most other common ratios become affected by the fact that the net income is slashed due to those dividend payments. How then can we tell if the REIT in question is worth our investment?

The most common answer to this question is to look at the company's FFO (Funds From Operation). This can be easily found in one of the stock's filed 10-K reports. Simply open up the report in their filing documents (can be found on Yahoo, TDAmeritrade, etc) and hit ctrl+f on your keyboard. Type in the words 'Funds From Operation' or simply 'FFO'. The result should be somewhere down the long filing report and it should detail some numbers after it. The reason we look to this as our most important number is because typically, a company's EPS has property depreciation subtracted from their income statement. This however is not an expense. FFO in turn is more accurate because it adds depreciation back into the equation of evaluation. Next, divide the share price by FFO and you will be left with a multiple. That multiple is what you will use to compare REITs to see which is more profitable over time (this replaces EPS as an evaluation tool).

The next item to look at is the net asset value (NAV for short). Due to the fact that REITs can often have huge amounts of depreciation because of the nature of owning property, it's important to remember that this is also affected by raising prices in real estate. These raising prices can affect how much is actually depreciating and not being made up for in raising values of the property. Locate the NAV through the same method of finding FFO and divide the number by number of outstanding shares. This will allow you to see the intrinsic value of the REIT. Compare the resulting number with the price of the stock. If the stock is selling below the intrinsic value and it has a raising FFO that shows it is more and more profitable, you found a discount REIT that may be worth the investment.

Other terms that are useful:

Capitalization Rate: determined by dividing operating income by the cost of the building that was acquired through purchase.  This shows how profitable the piece of real estate that was purchased by the REIT actually is. Higher percentage is generally better.

Debt-to-Equity: this ratio can show you how much debt the REIT has in relation to how much it actually has. If the stock has a really high debt-to-equity ratio, you're not very protected if the market decides to take a tumble. Aim for as low a number you can in this category so you know you can more easily weather the market WHEN it decides to take a crash.

Debt Coverage: if you ever seen this being talked about on a review of an REIT, they're simply stating that a company would have 'x' amount of dollars to cover 'x' amount of debt if they had to simply be able to make payments on their debts.

With all of this being said, you should now have a pretty good idea of how to evaluate an REIT. If there are any further questions, please leave them in the comments below or email me and I'll get back to you as quickly as possible. Thank you so much for reading.

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