Real Estate Investment Trust Metrics

Traditional metrics do not apply to the estimation of REIT performance.

In the last two years nearly $300 billion has been invested in commercial real estate, according to Real Capital Analytics, the US consulting company focused on the investment market for commercial real estate. Besides, Real Estate Investment Trusts (REITs) are clocking their competition. By the end of 2004, the average total return on S&P 500 stocks was just under 11% while the REIT stock index's total return was up over 31%.

There are several reasons why the real estate market is so attractive for the investors. First of all, the performance of real estate as an asset class is much higher compared to alternative investments such as stocks and bonds. Real estate market traditionally performs well and is highly predictable, and that appeals to investors who still remember the dotcom and tech bubble demise five years ago.

The specifics of evaluating the growth prospects of a Real Estate Investment Trust are the following: Prospects for rent increases; Prospects to improve and maintain occupancy rates; Development of a specific plan to upgrade and upscale properties (for instance, acquiring "low-end" properties and upgrading them to attract a higher quality tenant); External growth prospects (equity acquisitions, etc.).

Naturally, real estate is different than most fixed-plant or equipment investments. The main reason is that real estate property rarely loses value and often appreciates. While most investments are measured by Net income metric (a measure reduced by depreciation, an acceptable non-cash charge that allocates the cost of an investment made in a prior period), it is not suitable for real estate stock. REITs can instead be judged by Funds from Operations (FFO), which excludes depreciation.

The general FFO calculation involves adding depreciation back to net income and subtracting the gains on the sales of depreciable property, as these gains are not recurring and therefore do not contribute to the sustainable dividend-paying capacity of the REIT.

Although FFO is commonly used in estimating the value of a REIT, professional analysts use a more sophisticated metric called "Adjusted Funds from Operations" (AFFO). This metric is a more precise measure of residual cash flow available to shareholders. As AFFO estimates the true residual cash flow, it can be a better predictor of the REIT's future capacity to pay dividends. AFFO does not have a uniform definition. However, the most important adjustment made to calculate it is the subtraction of capital expenditures.

The total return on a REIT investment comes from two sources: the dividends paid and the price appreciation. To evaluate the price of the REIT, one can compare the AFFO yield to the market's going capitalization rate, or "Cap Rate". The Cap Rate is a general market-based number that tells the company how much the market is currently paying for real estate. For instance, 8% implies that investors are generally paying about 12.5 times (1 divided by 8%) the Net Operating Income (NOI) of each individual real estate property. Another factor of the REIT price evaluation is the current estimate of the REIT's growth in FFO/AFFO measurements.

In conclusion, Funds from Operations (FFO) metric provides a clearer picture of a Real Estate Investment Trust, than traditional Net Income measurement. Adjusted Funds from Operations (AFFO) metric is also a good measure of the REIT's dividend-paying capacity. Finally, the ratio price-to-AFFO and the AFFO yield (AFFO divided by price) can be used as tools for analyzing the REIT performance.

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