A Short History of REIT Valuation
The story of REITs begins in the United States with the enactment of Public Law 86-779,
signed by President Dwight D. Eisenhower in 1960. The legislation’s champion in Congress
was Representative Howard W. “Judge” Smith of Virginia, and it was designed to provide all
investors with access to the income-producing real estate market. This led to the creation of the
first REIT, American Realty Trust, in 1961 by Thomas J. Broyhill.
In these early years, the valuation of REITs was not standardized and often relied on
conventional stock market metrics like Earnings Per Share (EPS) and Price-to-Earnings (P/E)
ratios. However, these metrics proved to be poor indicators of a REIT’s performance due to the
significant impact of depreciation, a non-cash expense that artificially lowered a REIT’s net
income while its underlying real estate assets were often appreciating in value. This led to the
rise of Net Asset Value.
The use of Net Asset Value (NAV) as a key valuation metric did not become widespread until
the 1980s, gaining significant traction and analytical rigor with the founding of influential
research firms in the middle of that decade. The adoption of NAV marked a critical evolution in
REIT analysis, moving away from traditional stock metrics to a method that better reflects the
intrinsic value of their underlying real estate assets.
A pivotal moment in this transition was the establishment of Green Street Advisors in 1985 by
Mike Kirby and Jon Fosheim. Based in Newport Beach, California, Green Street
championed a research-intensive methodology centered on calculating the NAV of REITs. They
meticulously estimated the private market value of a REIT’s real estate portfolio, providing a
more tangible and defensible measure of its worth than accounting book value. This approach
gained credibility and influence throughout the late 1980s and early 1990s.
By the time the National Association of Real Estate Investment Trusts (Nareit) formally
introduced Funds From Operations (FFO) in 1991 as a supplementary measure of operating
performance, NAV was already becoming an established and essential tool in the analyst’s
toolkit.
Investing in Real Estate Investment Trusts (REITs) is like navigating a labyrinth of possibilities in the real estate world, offering a promising avenue for investors to earn consistent income and capital appreciation. However, when it comes to evaluating REIT stocks, the traditional Price to Earnings (P/E) ratio may not always be the best tool.
Choosing the right method of REIT valuation is essential to ensure that you are making informed investment decisions for your investment. In this blog, we’ll explore some of the most popular methods of REIT share price evaluation and discuss their pros and cons.
In this blog post, we’ll delve into the fascinating realm of REITs and explore why the P/E ratio often falls short in assessing their true value. We’ll also provide you with practical tips and alternative methods for evaluating REIT stocks, ensuring you can make well-informed investment decisions.
The Unique World of REITs
Real Estate Investment Trusts, or REITs, are a unique asset class in the investment landscape. They offer individuals the opportunity to invest in income-generating real estate properties without directly owning, managing, or financing these assets. REITs can own a wide variety of real estate, from office buildings and shopping centres to apartment complexes and healthcare facilities. This diversity makes them an attractive investment option for many investors.
But here’s the twist: REITs are required by law to distribute at least 90% of their taxable income to shareholders in the form of dividends. This makes them a favourite among income-seeking investors. Moreover, REITs often provide a layer of diversification, as the value of the real estate assets within the trust can span multiple sectors and geographic locations.
The Trouble with P/E Ratio when it Comes to REIT Valuation
How to value a REIT? Now, you might wonder, why can’t we simply use the Price to Earnings (P/E) ratio to value REIT stocks as we do with other companies? The answer lies in the unique characteristics of REITs themselves.
P/E ratio is a metric that divides a company’s stock price by its earnings per share (EPS). It gives you a glimpse into how much you’re paying for each dollar of earnings generated by the company. However, REITs operate differently from traditional corporations. They are legally obligated to distribute the majority of their income as dividends, which makes their earnings more like “pass-through” income.
REITs often leverage significant debt to finance their real estate holdings, and as a result, their earnings can be artificially low or negative due to depreciation and interest expenses. While these factors don’t necessarily reflect the health of the REIT, they can skew the P/E ratio and mislead investors.
Investing in physical real estate involves a specific expense known as depreciation, which can significantly distort P/E ratio calculations. Real Estate Investment Trusts (REITs) have the privilege of gradually reducing the value of their real estate assets over time through depreciation. Each year, a specific portion of the value of real estate assets can be reduced. If you were to explore the company’s income statement, this depreciation would look like a business expense on paper. However, in reality it’s not costing the REIT anything.
Practical Tips for Evaluating REITs
So, how should investors go about evaluating REIT stocks? Let’s dive into some practical tips and alternative methods. Normally, you would go for a top-down approach whereby you look at the wider market impact first. For example, you’re interested in healthcare REITs – how is the industry doing in general? Then we can zoom in on specific businesses operating in this sector.
Just like you would do with evaluating normal stocks comparing P/E ratios of several similar companies to find the undervalued ones, similarly with REITs you’d use the below methods to establish a benchmark.
1. NAV or Net Asset Value Method
This is my favourite method as it’s simple and relatively accurate. However, if you want to do a proper job of REIT valuation, you want to use at least a couple of different methods and then assess the compound results.
The Net Asset Value (NAV) method is one of the most commonly used methods of evaluating REIT shares. NAV is the value of all the assets owned by a REIT, minus its liabilities. The NAV method calculates the value of the shares of a REIT by dividing the NAV by the total number of outstanding shares.
One of the advantages of using the NAV method is that it provides a more accurate picture of the underlying value of the REIT’s assets. However, a limitation of this method is that it does not take into account any future income potential or growth prospects of the REIT.
The simple NAVPS formula goes like this:
NAV per Share = (Total Asset Value - Total Liabilities) / Shares Outstanding
Then what you do is take the resulting number and compare it with the REIT share price. NAVPS shows the actual value per share of a trust. If share price is lower than NAVPS, we say that the shares are traded at a discount, or essentially the trust is undervalued. If share price is higher than NAVPS, it means the REIT is overvalued but using this method you will soon find that the majority of REITs are overvalued, so you may ask how is this favourite method of yours any good?
Important thing to note is that when operating with NAVPS to evaluate REITs and other trusts, just like operating with P/E (price to earnings) when it comes to valuing normal stocks, the effort is more valid when you work by comparing stocks.
Essentially, the way of thinking here is – let me pick 20 to 50 stocks that have common traits. For example, “50 large cap REITs” or “Top 20 healthcare REITs” or “Midcap semiconductor shares” etc etc and analyse their NAVPS (or P/E) in comparison. Then, out of your initial 50 seed list, you pick a handful stocks that are undervalued. Otherwise, if you just perform NAVPS calculation for one or two REIT stocks, this tells you absolutely nothing.
REIT Valuation Model in Excel or Google Sheets
To make your life considerably easier, I’ve prepared a downloadable spreadsheet detailing NAVPS calculation for the Top 50 REITs by market cap. You’ll be able to see the formulas and it will give you an idea of the comparison methodology. Considering most REITs are likely to be overpriced, this method would suggest we pick the stocks that are overpriced by the lowest margin, and we would expect that the stock gradually catches up with its more expensive neighbours thus giving us better growth.
You need to be registered and logged in to see the spreadsheet. There is a free option, so go on and get on board. Once you’ve logged in, come back to this page and you will see a hidden content section below explaining how to access the REIT valuation model in Excel/Google Sheets.
2. How to Value a REIT by Funds from Operations (FFO)
One of the key metrics for evaluating REITs is Funds from Operations (FFO). FFO is a measure designed specifically for the real estate industry and aims to provide a clearer picture of the REIT’s operating performance. It begins with net income, adds back depreciation and amortization, and subtracts gains on sales of property. FFO is a more accurate reflection of the REIT’s ability to generate cash flow from its real estate assets.
FFO considers the REIT’s net income, adds depreciation expense, adds amortization expense and then subtracts gains resulting from sale of real estate assets. Hence, FFO is a measurement of the amount of money a company is generating via its business activity.
To assess a REIT using FFO, you can calculate the Price to FFO ratio. A lower Price to FFO ratio suggests that the REIT may be undervalued compared to its cash flow, making it potentially attractive for investors.
3. AFFO or Adjusted Funds from Operations Method
A spin-off from the previous method is the Adjusted Funds from Operations (AFFO) method which is another popular method of evaluating REIT shares. It is calculated by taking the FFO (Funds from Operations) and subtracting a reserve for capital expenditures. This method provides a more accurate picture of the REIT’s cash flows, as it takes into account the REIT’s capital expenditures.
This evaluation method gives you a competitive edge as not many real estate investors are as savvy as to trawl though companies’ balance sheets looking for the “capital expenditures” position.
One of the advantages of using the AFFO method is that it is a more reliable indicator of the REIT’s performance than the NAV method. However, a limitation of this method is that it relies heavily on management estimates for capital expenditures, so there may be some variability in the calculation. Another downside is that you can only apply this to a limited shortlist of REITs… if you were to do AFFO on all 400 of them, you’d probably overheat your brain.
4. Dividend Yield
Since guaranteed income-seeking investors often flock to REITs, dividend yield is a critical factor. This metric calculates the annual dividends paid by the REIT as a percentage of its current stock price. A higher dividend yield indicates a higher income potential for investors.
The dividend yield method is a simple yet effective way of evaluating REIT shares. It is calculated as the annual dividend payout divided by the current share price. The dividend yield method provides an indication of the return generated by the REIT’s dividends.
One of the advantages of using the dividend yield method is that it provides a clear picture of the expected return on investment through dividends. However, a limitation of this method is that it does not provide any insight into the REIT’s future growth prospects or underlying asset value.
So don’t just jump at the highest dividend yield REIT valuation method without considering other factors. A very high yield could be a sign of distress or unsustainability. Always evaluate the REIT’s dividend history and sustainability before making a decision. Also consider this – if you invest in a REIT that pays 8% dividend but the stock plummets by 10% over the course of a year, you’re effectively out of pocket.
5. How to Value a REIT by Occupancy Rates
The health of a real estate investment is closely tied to the occupancy rates of its properties. It’s crucial to investigate the REIT’s occupancy rates in various properties and sectors it invests in. High occupancy rates typically indicate strong demand for the properties, potentially leading to stable rental income. In contrast, low occupancy rates may suggest a decline in property demand or management issues.
Although this method of REIT valuation is no good on its own, it is really important to have a fundamental understanding of the sector you’re investing in.
6. Debt Metrics
Given the leverage that many REITs employ, it’s vital to examine their debt metrics. Look at metrics like the Debt to Equity ratio, Interest Coverage ratio, and Debt Maturity Schedule. These metrics will give you an insight into the REIT’s ability to manage its debt and avoid financial distress.
7. Geographic and Sector Diversification
Diversification within a REIT’s portfolio can mitigate risk. A well-diversified REIT is less vulnerable to localized economic downturns or sector-specific challenges. Therefore, assess the geographic and sector diversification within the REIT’s portfolio to understand its risk profile. On the other hand, if you go for REITs that represent narrow niche in terms of their assets or in terms of their geographic speciality, you may strike gold if you do you research. For example, if you have an insider knowledge of self-storage sector in Chicago and you know there is a growing demand then investing in a Chicago storage REIT sounds like a great idea.
8. Management Quality
The experience and expertise of a REIT’s management team play a significant role in its success. Investigate the track record of the management team, their investment strategies, and how they’ve navigated previous challenges as part of your REIT valuation effort.
REIT Valuation Methods
Overall, REIT valuation methods can provide valuable insight into the underlying value and potential of a REIT. It is essential to use multiple methods and carefully consider various factors before making an investment decision. Remember that a combination of these methods can help you get to grips with the REIT market,
Real Estate Investment Trusts offer an intriguing investment opportunity for those looking to diversify their portfolio, earn consistent income, and potentially benefit from real estate appreciation. However, evaluating REIT stocks requires a different approach than traditional corporations. The Price to Earnings (P/E) ratio often falls short because of the unique characteristics of REITs, including their legal requirement to distribute most of their income.
Instead, investors should focus on metrics like NAV or Funds from Operations (FFO), dividend yield, occupancy rates, debt metrics, diversification, and the quality of the management team. By keeping these practical tips in mind, you can make well-informed investment decisions and unearth the hidden gems within the world of Real Estate Investment Trusts.
Key Statistics About REIT Valuation
Recent market data reveals a dynamic landscape for Real Estate Investment Trusts (REITs),
with valuations influenced by a confluence of economic factors. Analysis of key metrics,
particularly the critical Net Asset Value (NAV), provides investors with a clearer picture of the
sector’s health and potential.
As of the latest available data, the U.S. REIT market continues to be a significant component of
the broader economy. According to the National Association of Real Estate Investment Trusts
(Nareit), the equity market capitalization of all U.S. REITs stands at approximately $1.431
trillion. This robust market size underscores the importance of understanding the valuation
metrics that drive investor decisions.
One of the most widely used metrics in REIT valuation is the Net Asset Value (NAV), which
provides an estimate of a REIT’s intrinsic value by assessing the market value of its underlying
real estate assets. Recent reports from S&P Global Market Intelligence indicate that as of April
2025, the U.S. equity REIT sector traded at a median discount of 19.1% to its consensus NAV
per share. This represents a notable widening from the 15% discount observed at the end of
March 2025, suggesting a potential buying opportunity for value-oriented investors.
Different property sectors within the REIT universe exhibit varying valuation characteristics. For
instance, the S&P Global report highlighted that the regional mall sector experienced a
significant valuation decline, moving from a slight median discount of 0.3% to a more substantial
14.8% discount to NAV in April 2025. Conversely, other sectors may trade at premiums to their
NAV, reflecting stronger investor sentiment and growth prospects.
Beyond NAV, other key statistics offer insights into REIT valuation:
● Dividend Yields: A hallmark of REITs is their mandate to distribute at least 90% of their
taxable income to shareholders in the form of dividends. According to Nareit, as of May
2025, the dividend yield for the FTSE Nareit All Equity REITs Index was a key indicator
for income-focused investors.
● Price-to-Funds From Operations (P/FFO): Funds From Operations (FFO) is a widely
used metric to assess a REIT’s operating performance. The P/FFO multiple provides a
valuation measure analogous to the price-to-earnings (P/E) ratio for traditional stocks.
Fluctuations in this multiple can signal shifts in investor sentiment and growth
expectations.
● Leverage Ratios: Nareit’s data as of the first quarter of 2025 shows a debt-to-asset ratio
of 32.5% for all equity REITs. This metric is crucial for assessing a REIT’s financial risk
and its capacity for future growth.
For international context, data on Japanese REITs (J-REITs) from sources like the Sumitomo
Mitsui Trust Research Institute also provide valuable insights. Their reports track the historical
fluctuation of the premium or discount of J-REIT unit prices to their NAV, offering a comparative
perspective on market sentiment.
A comprehensive understanding of REIT valuation requires a multifaceted
approach that goes beyond simple price-to-earnings metrics. By analyzing a range of data
points, with a particular emphasis on NAV, investors can gain a more nuanced view of the
opportunities and risks within this important asset class. The current discount to NAV in the U.S.
REIT market, as highlighted by recent data, presents a compelling area for further investigation
for those seeking to capitalize on potential market inefficiencies.
