REIT Valuation

There are a number of ways to measure increases in a REIT’s value, but evaluating streams of income and cash flows are perhaps the most commonly used metrics. Investors in common stock generally use net income as a key measure of profitability, but the typical way of doing things in REIT-dom is to use funds from operations, or FFO.

The SEC requires that all publicly-traded companies file audited financial statements. This includes their recorded “net income,” a term that is clearly defined under generally accepted accounting principles (GAAP).  

Since REITs are publicly traded companies, net income and net income per share can always be found on a REIT’s annual audited financial statements, with unaudited net income in particular being reported quarterly as well.  

Keep in mind that REITs consider reported earnings per share to be of little value to investors, since real estate company earnings are generally weighed down by depreciation costs that are non-cash in nature and also not reflective of asset value changes.

For a REIT, net income is simply less meaningful as a measure of profitability since, in accounting, real estate depreciation is always treated as an expense. Yet, in the real world, real estate appreciates in value as long as it’s in a good location and well-managed. Here’s why…

Depreciation and GAAP Net Income 

Generally, land prices grow due to inflation and increasing construction costs, rising rents and operating income, property upgrades and, of course, the fact that there’s a finite amount of land to begin with. That’s why, when a REIT’s net income under GAAP reflects a large depreciation expense, it’s meaningless as a measure of cash flow and it’s necessary to add back real estate depreciation to net income. 

There are other adjustments that should be made too, such as subtracting from GAAP net income any capital gain income recorded from the sale of properties.

Also, GAAP net income is normally determined after “straight-lining” contractual rental income over the term of the lease. However, since rents normally increase, adjustments should be made when examining FFO to reflect the actual contractual rental revenue received during the reporting period.

To address this shortcoming, a new term “Funds from Operations” was adopted by the National Association of Real Estate Investment Trusts (NAREIT) in 1991 and then formally accepted as a reportable financial term by the Securities and Exchange Commission in 2003.

What Is FFO?

FFO = Net Income + Depreciation + Amortization – Gains on Sales of Property.

Computing FFO is simple:

FFO = Net Income + Depreciation + Amortization – Gains on Sales of Property.

Upon its adoption, FFO multiples (rather than earnings multiples) quickly became the yardstick for comparative REIT valuations. As previously described, this makes sense. However, it still has definite shortcomings, since some non-cash and seldom-occurring items have to be removed from the earnings equation in order to arrive at the equation.

In that regard, FFO is rather like a proxy for recurring cash flow that can be used to support dividend payments. 

What Is AFFO?

Recognizing this, many analysts and some companies began to report “adjusted funds from operations” (AFFO). The biggest change by far that this makes to FFO is to subtract recurring capital expenditures, also known as CapEx. 

Basically, this is an acknowledgement that not all depreciation is non-cash. If you’re a landlord, you can generally expect to be called upon to make improvements to your real estate each time you sign up a new tenant. Those tenant improvements will generally suffice for the duration of the lease term, but signing up a tenant for a lease renewal will likely also require an added tenant improvements allowance.

So the question is this: How much do real estate companies have to shell out every year to retain their portfolio quality and tenant occupancy levels? AFFO tries to factor that in. 

With that said, there is more to AFFO than just recurring CapEx. For instance, straight-lined rents are a beauty. 

AFFO: Real Estate’s Real Value

In one of the more poorly conceived parts of GAAP, rental income is often required to be straight-lined over the term of a lease. 

Say you have annual rent increases of 2% a year for a contracted five-year rental period. By the fifth year, rents will be about 8.25% more than they were in the first; so, under GAAP, you even the rents out. This means that you show rents of just over 4% more than you actually collected in the first year.   

The offsetting entry to this phantom income is an accrued rent receivable that will grow over the first half of the lease and then start to decline in the second half. Many companies book the receivable without any allowance for doubtful accounts. And, of course, there is no discounting rent to reflect the fact that a dollar in the fifth year will be worth less than a dollar in the first. 

One obvious result from straight-lined rents is that FFO-per-share growth will be lower than actual cash flows would suggest. The omission of not deducting this clear non-cash inflation of revenue may have been because straight-line rent GAAP adoption occurred after NAREIT’s 1991 adoption of FFO.

AFFO = FFO – Straight-Lined Rents – Recurring Capital Expenditure (CapEx) + Equity-Based Compensation + Lease Intangibles + Deferred Financing Cost

Since AFFO is designed to be a closer proxy for actual normalized cash flows per share, a common calculation of AFFO might appear as follows:

AFFO = FFO – Straight-Lined Rents – Recurring Capital Expenditure (CapEx) + Equity-Based Compensation + Lease Intangibles + Deferred Financing Cost 

That second-to-last term, “lease intangibles,” started to appear around 2004 and is supposed to reflect the cost to procure tenants for a building. Prior to that, those considerations were simply chalked up to part of the valuation process. So adding this non-cash number into AFFO  generally makes sense because such costs are never reflected in any MAI appraisal. 

Deferred financing costs are also non-cash factors just as long as any fees associated with bank or bond financing are paid up front and then subject to a non-cash expense later. But, really, this is all about timing; and there is a clear cash component that is recurring here as bonds and bank notes mature and are replaced. 

Equity-based compensation is also non-cash, but the dividends allocated to that newly issued equity are not. In addition to the adjustments to FFO in the AFFO formula above, some companies may periodically include other items if they believe it will help shareholders arrive at a normalized number more reflective of corporate recurring cash flows. 

With all of that said, you need to know that AFFO is not sanctioned by the SEC and isn’t always consistently reported. Plus, not all analysts view it the same and some make their own adjustments to it. That said, AFFO disclosure by companies is very helpful to determine their high-level estimate of normalized cash flows per share. 

So, Which Should You Use to Analyze a REIT? FFO or AFFO?  

Hands down, the nod goes to AFFO. 

Straight-lined rents can be material, which will inflate their FFO. On the other hand, they tend to have modest, if any, recurring CapEx requirements, which is a big deal. 

This is because of the lack of comparative transparency that many analyst reports resort to when dealing with FFO comparisons. For my money though, comparisons like this will tend to make the net lease space relatively cheaper to others that lack AFFO disclosure. 

What About FAD? 

In Ralph Block’s book, Investing in REITs, he writes:

Some REITs and investors who use funds (or cash) available for distribution (FAD or CAD) often distinguish it from AFFO” to account for “non-recurring capital expenditures.  

Unlike AFFO, which deducts the amortization of real estate-related capital expenditures from FFO, FAD or CAD is often derived by deducting nonrecurring (as well as normal and recurring) capital expenditures. And some REITs (or investors) who calculate FAD or CAD may also deduct repayments of principal on mortgage loans.  

Unfortunately, as Block adds, “There is no widely accepted standard for making these adjustments when calculating CAD or FAD.”

What About NAV? 

Many institutional investors and analysts refer to net asset value (or NAV) as a measure of valuing REITs. While we consider this approach important at iREIT, it’s not our primary method for determining value because it is more of a liquidation approach. Most dividend investors prefer analyzing cash flows as a measure of value instead. 

However, NAV is relevant and the methodology is simple: The investor or analyst determines a capitalization rate, or cap rate, for each group of properties and applies it to a 12-month forward-looking estimate of net operating income (NOI).  

This adds an estimated value of land, developments in process, equity in consolidated joint ventures, and an approximate value of fee income streams, non-rental revenue businesses, and other investments into the financial picture. Then, debt and other obligations are subtracted, and adjustments are made for government-subsidized financing. Finally, the dollar amount of outstanding preferred stock is deducted. 

The per-share NAV takes into account “in the money” options, operating partnership units, and convertible securities.

NAV = (Assets – Liabilities – Preferreds) / Number of shares outstanding  

NAV = (Assets – Liabilities – Preferreds) / Number of shares outstanding  

Keep in mind that this approach is subjective. The investor or analyst can assign any cap rate to the NOI; and since REITs are rarely liquidated, investors should always be reluctant to pay more than 100% of NAV unless there are strong catalysts for value creation (i.e., low cost of capital, robust FFO, and dividend growth forecasted).  

Green Street Advisors, an independent REIT research firm, has a well-deserved reputation in the use of NAV and is a leading advocate of this valuation metric. For more information about them, click here