Before you start reading this section, you’ll have to forget almost everything you have learned about dividend stocks and how you analyse them. Unfortunately, since the tax structure of a REIT is different than a corporation, the analysis method must be different too. You can’t really look at the dividend payout ratio for example, as that will be huge. It’s normal as it is part of the REIT requirement to stay under this tax structure and to distribute at least 90% of its revenue…
And if you had a rental property on your own, you know that the difference on the profit you pay taxes on at the end of year is completely different to the free cash flow it had generated. As opposed to the REITs Guide Part I and Part II this section is a lot more technical, so grab an extra cup of coffee before reading further!
What sucks even more about analyzing REIT’s is that you will have to rely on data that is not provided in stock screeners, as it is not part of the GAAP (General Accepted Accounting Rules). Funny isn’t? If you own REITs shares already, you’ll know what I am talking about: the FFO (Funds from Operations) and AFFO (Adjusted Funds from Operations). So let’s start with this one:
FFO & AFFO Less Funny but more useful than LMFAO
The FFO & AFFO are probably the most useful tools to analyze a REIT. Since REITs main reason for existing is the distribution of its revenue, you must look at how healthy this distribution is, right? This is a similar thinking to dividend stock analysis, but with different data. But in the end, it’s all about cash flow.
The main problem when looking at a REIT financial statement is the inclusion of amortization in the calculation of its earning. The amortization concept is a GAAP that allows a company to reduce its income by applying a virtual loss in value to its equipment or buildings. Since REIT’s are in the business of owning and managing properties, they show an important amount in amortization that reduces their earnings on paper.
On top of that, in January 2011, the application of International Financial Reporting Standards (IFRS) modified the known definition of net income. In fact, IFRS requires REITs to consider their buildings as “investment properties” in their financial statements. Investment properties allow accountants to use the Fair Market Value model (FMV) in order to reflect the true value of the assets instead of a falsely depreciated asset according to amortization rules. This will help bring ratios closer to the business reality. However, there is already a measure existing that avoids any confusion among investors.
In reality, most properties will gain in value instead of losing value over time. Therefore, this GAAP is mixing your analysis. This is why we are using a different approach by looking at the FFO & AFFO. The AFFO will give you hints on the sustainability of future distributions. In other words, looking at the AFFO is like looking at the company’s real profit.
The difference in the FFO and AFFO is the consideration of the capital expenditure. The FFO will consider the company’s earnings and add the amortization to have a real look at the company’s income flow. It will withdraw the proceeds from property sales in order to show a net income flow. A new approach with the AFFO will go a little bit further by withdrawing capital expenditure to the ladder. This is to ensure the true net income flow from the REITs operations. Since each company will have to spend money in order to maintain and manage its property, it makes sense to include capital expenditures in your calculation. Therefore;
FFO = Earnings + Depreciation (Amortization) – Proceeds from Property Sales
&
AFFO = Earnings + Depreciation (Amortization) – Proceeds from Property Sales – Capital Expenditures
Before you let a big sigh out of your mouth I would ask you to hold your breath a few more seconds. I told you that the AFFO can’t be found with a free stock screener such as Google Finance or the TMX. However, REITs are giving the AFFO in their quarterly financial statements. Even though it’s not a GAAP and you would technically have to calculate it yourself, REITs management teams are well aware that you are looking for this info and therefore provide it to you on a quarterly basis. You can surely waste a few hours trying to calculate AFFO for each REIT yourself… or you can simply get the financial statement and read a few pages to find the information you are looking for ;-).
What do you do with them?
Both FFO and AFFO must be brought down on a per unit basis. You basically have to divide the number by the number of units and compare it to the distribution per unit. Then again, those numbers are provided in the company’s financial statement.
Here’s a quick example:
- Number of units: 100,000
- Distribution: $1.00 per units
- Earnings: $100,000
- Depreciation: $25,000
- Proceeds of sales & Capital expenditures: $20,000
AFFO would be:
$100,000 (earnings) + $35,000 (depreciation) – $20,000 (proceeds of sales & capital expenditures) = $105,000
AFFO per unit would be:
$1.15 ($105,000/100,000 units)
So if you would have looked at the payout ratio (distribution/earnings), you would have seen a 100% payout ratio. However, if you look at the percentage of distribution on the AFFO, you get an 87% ratio. The company could technically distribute up to $1.15 per units without being cash flow negative but would then show a 115% payout ratio.
The FFO and AFFO per unit should be lower than 100% in order to keep a healthy distribution over time. So the magic number will be high, but should be under 100%. That’s normal as REITs are required to distribute most of their income. One thing to consider is that if the REIT is distributing 100% of its cash flow, it leaves very little room for flexibility (unless the company accesses additional financing). However, it is also possible that the number exceeds the 100% mark. So is a 110% distribution rate dramatic? Not at all. Say what?
If the company distributes more than 100% of its AFFO, that means that it distributes more money than it receives. A negative cash flow position could eventually lead to a distribution cut or less attractive overall financial position. This is a similar rationale to the one that we apply on a dividend stocks with a payout ratio over 100%. However, there are 2 situations where a REIT can have a negative cash flow position and still be a good investment:
Consider the amount of units in DRIP. If you take the 2011 Q3 financial statement of RioCan (REI.UN), it shows a 104.5% distribution rate of AFFO. This technically means that the company is distributing more money than its cash flow. RioCan also shows 22.9% of its units to be part of the DRIP (Dividend Reinvestment Plan). Those investors don’t receive payouts, but more units on a monthly basis. When considering the distribution net of DRIP as a percentage of AFFO, the company shows a healthy 79.5%. REITs count a lot of investors participating in their DRIP which allows them more flexibility in regards to their liquidity.
Future income growth. If the company recently purchased an important complex, chances are that its distribution percentage will be higher than usual. You will then rely on the management’s ability to raise rents and improve profitability of the newer complex. If the future income should be higher due to better management on the recent acquisition, you can tolerate a higher distribution rate. As you can see, analyzing the payout ratio of a REIT incurs a lot more gray areas than dividend stocks!
Loan to value ratio
I have already mentioned this several times so far; REITs are not like regular stocks. Another example is when you consider REITs financing structure. As opposed to many companies or individuals, REITs don’t get much benefit from completely paying their mortgages. Instead, they use the equity built in their existing property portfolio in order to extend their business and create value for their unit holders. Therefore, many REITs are overleveraged.
This strategy is great in a prosperous economy, but it is important to make sure that management teams don’t go overboard with leveraging. As I have mentioned before, the cost of financing has been rising for REITs since 2008. This means that overleveraged properties will have a hard timing refinancing their mortgage later on.
The use of the loan to value ratio (LTV) is a great tool to analyze the future ability to raise cheap debts for REIT. The LTV is easy to calculate from the financial statement, as you only need 2measures of data:
LVT = Mortgage Amount / FMV of properties
With the new International Reporting Standards in place, it has become easier to calculate the LVT. This ratio will tell you how much the company can seek through refinancing and will also tell you if they can raise debt at a lower rate than their competitors. For example, if Rio Can has an LTV under 50% and Calloway’s is at 70%, chances are that Rio Can will raise debt cheaper.
Net Asset Value (NAV) – Another Non GAAP Data
Investing in REIT’s differs a lot from investing in other varieties of stocks. The NAV (usually shown by units) can be translated to the equivalent of a Price to Book ratio. You can’t do the calculation by using the GAAP once again since the property value won’t reflect the FMV. Therefore, what you need to calculate the NAV is:
NAV = Total Property Fair Market Value – Liabilities
Once you divide the NAV by the number of units, you have the equivalent of price to book valuation. In order to get a real use of the NAV, you have to compare it among its industry. After calculating it for a few REITs, you will have a better understanding of if the market is overrating one company compared to another. A lower than industry NAV is considered to be either a risky play or a value play. The AFFO and LVT will tell you which one it is.
Considering the Financing Structure
After looking at the LVT to know if the REITs have leverage potential, another factor to consider is the overall debt structure. You need to look at the current mortgages expiring matched with leases expiring. A great combination would be leases expiring soon (as the company has the ability to increase rents) with long term locked-in mortgage since borrowing rates are still pretty affordable right now.
Another point to look at in the financing structure is the number of units issued on a yearly basis. Most REITs will issue a lot of new units due to their popular DRIP. As issuing more units to pay its shareholders is not a problem over a short-term period, an increasing number of units combined with a slow growth will be catastrophic for the shareholders. If the main source of financing is done through issuing new shares, you could go closer to a turn around and give that money back to existing shareholders. It doesn’t sound healthy, does it?
I know this part is a little technical, but if you have any questions, now is the time to comment!
