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.
Conclusion
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.
