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REIT Analysis using Funds from Operations (FFO)

Real Estate Investment Trusts (REITs) are a popular way to get real estate exposure without directly owning the physical property.  But as they are equities, how do we go about analyzing if they are good value?

I’ve mentioned numerous times before that I’m cautious over buying income trusts as the bulk of them pay out more in distributions than their reported earnings.   Even though it seems impossible, they still continue to do so.  To me, a strong REIT has recession resistant tenants, low vacancy, a growth strategy,  and most importantly, a sustainable distribution.

In the case of REITs, they often pay out more in distributions than reported earnings mostly because of how earnings/net income is calculated.  Typically, net income (used for earnings) takes into account depreciation/amortization which can reduce net income significantly depending on the business.  In the case of a REIT, buildings are depreciated for accounting purposes, but it doesn’t necessarily mean that the building has decreased in value.  In reality, the building has most likely increased in value.  To account for this and perhaps better represent the cash flow of a REIT, most analysts use Funds from Operations (FFO) per share instead of Net Income/Earnings per share as a measuring stick for REITs.

How is FFO/AFFO Calculated

Funds from operations takes net income, adds back the amortization/depreciation, then subtracts proceeds from property sales.  For those of you who prefer formulas:

FFO = Net Income + Amortization (or depreciation) – Proceeds from Property Sales

AFFO stands for Adjusted Funds from Operation and accounts for the capital expenditures.  Some believe that if amortization expense is added back to the Net Income, then capital expenditures completed on the properties should be accounted for somehow.  The formula is:

AFFO = Net Income + Amortization (or depreciation) – Proceeds from Property Sales – Capital Expenditures

How to DIY

As a do-it-yourselfer, I went on a quest to figure out how to calculate FFO/AFFO on my own.  As I am familiar with reading balance sheets, it wasn’t overly complicated as most of the information can be plucked from company cash flow statements, then calculated manually.

However, for those who couldn’t be bothered with cash flow financial statements, most REITs report FFO/AFFO in their annual/quarterly reports.

If we take a look at a REIT like Calloways, for Q1 2010, we see that their earnings are around $7.4M with distributions of around $39.5M.  Sounds impossible right?  However, if you look at the FFO and AFFO numbers, you’ll see that their distribution is closer to 100% of their actual cash flow.

Final Thoughts

So instead of looking at simple earnings as the way to see if REIT distributions are sustainable, a better way is to take a look at the FFO/AFFO which may show you the real cash flow of the REIT.  Do you have any tips when analyzing REITs?

For more information, Thicken My Wallet also has a few articles on REITs and FFO calculations.







18 Comments, Comment or Ping

  1. 1. Gerry

    This answers why the fundamental information at TD says Calloway is paying out 5.3x earnings and yet the stock price continues to remain high. Thanks FT. I suppose this would be valid for other types of Income Trust as well, as long as they exist?

  2. 2. Rachelle

    Great article FT.

    REIT’s must pay out a certain percentage of their income as distributions to retain their REIT status. 90% I believe.

    Something to remember is that private owners do not always choose to claim depreciation on their buildings because even thought they can claim it when they sell they get to pay capital gains on the difference between the depreciated price and the market price of the building. It’s a pay now or pay later scenario.

    In any case this is a great informative article.

  3. 3. Andrew F

    This generally only applies to REITs, generally because they depreciate assets that don’t actually depreciate in value (generally). Business trust depreciation is often a more accurate picture of the change in values of the firm’s assets. Of course, it’s always a good idea to look at cash flow and EBITDA rather than just net income per share.

  4. 4. Chris

    It’s even worse than that Rachelle. If you choose to claim CCA on your buildings, when you sell them for higher than the UCC you get CCA recapture (100% taxable) up to the original purchase price and then capital gains (50% taxable) on gains above the purchase price. Although if you plan to own the rental property for a significant period of time then it is beneficial to claim CCA – if only to bring your rental net income down to zero. It’s important to note that you cannot use CCA to create a LOSS on a rental property, only to bring the income to zero.

    Great article FT! I’ve been meaning to research a good method for evaluating REITs. I currently work with the accounting policy group at a large income trust that’s converting to a corporation at the end of the year and we report EBITDA, distributable cash, and now free cash flow in our reports. When it comes to income trusts or any corporation that pays a high dividend, the best measure is always cash flow because that’s where the investors get their value from owning the stock. Accounting net income is full of expenses that aren’t immediately cashflow based (although, over the entire life of the company, net income will equal cash flow) such as depreciation and amortization, many types of interest expense, and restructuring expenses.

    One thing to note – when Canada transitions to International Financial Reporting Standards (IFRS) on January 1, 2011, REITs will begin classifying most of their buildings as “investment properties” for accounting purposes. One of the options for buildings classified as investment properties is the use of the fair value model which allows companies to show their properties at their current market value. Any gains or losses on value are reported in net income for the year. This is currently not permitted under Canadian GAAP. The other big change with the fair value model is that amortization/depreciation is NOT recorded. So you’ll have one non-cash expense (amortization) being replaced with a non-cash gain or loss (gain or loss on fair value). You’ll need to adjust the given formula accordingly.

    From what I’ve read, most REIT-like companies in countries where IFRS has been adopted have chosen the fair value model for their investment properties.

  5. Thanks for the kind feedback guys/gals!

    @ Gerry, Warren Buffet often uses a similar calculation when evaluating investments in general and calls it “owners earnings”. It’s basically extracted from the cash flow statements: Net Income + Amortization/Depreciation – Capital Costs. It shows the real cash the company generates.

  6. 6. Sean

    Good blog.

    I don’t like investing in REITs because I already own my home. That’s enough exposure to real estate I think. Yes, it pays income in the sense that I am not paying rent.

    Besides, the management costs of these REITs are not very transparent. By the way, what do you think of REIT ETFs?

  7. Thanks for the link. Just remember that FFO does not comfort to GAAP. With real estate financing tightening up (on the commercial side), I have been looking a lot into debt loads of REITs and when they mature.

  8. 8. Leo

    Hi folks,

    Could anyone tell me, for tax purposes, what rate are REIT payouts taxed at? I understand dividends are most tax friendly. How about REITs? (And I’m guessing CDN REITs)

    Thanks!

  9. 9. Andrew F

    REIT distributions are taxed as income, and are not eligible for the dividend tax credit. This is because REITs are eligible for preferred taxation when compared to corporations.

  10. @ Leo, Andrew, it really depends on the REIT. If the REIT distributes a portion return of capital, interest, capital gains, dividends, then each portion will be taxed accordingly. Best to check the REIT website, then go over the distribution/tax information.

  11. 11. James

    i come from an accounting/ corporate finance back group and have experience with balance sheets as well but, have not spend significant time with REIT’s i am going to do some research and see what i come up with

  12. 12. Rachelle

    I just read this interesting article about REITs in the Globe. Basically Fabrice is saying that if you buy a building with a 5% cap rate but pay 7% interest on it that’s a bad buy.

    https://secure.globeadvisor.com/servlet/ArticleNews/story/gam/20100617/VOX17ATL

    Math 101 is pretty unpopular. Real estate is a sure path to riches – popular.

  13. 13. Andrew F

    Rachelle, I take his point. But, he seems to be suggesting that cash flow from investing activities should not be large outflows. How else do you create a firm? As a firm grows, it spends considerable cash buying assets, which is a cash outflow for investing activity. The only way for this aggregate cash flow to come back to net zero without dissolving the firm would be for these assets to appreciate and then be sold. Another way to look at it: the cash from operations is the return on the cash spent on investing activities. He didn’t specify the duration of these cash flows, but if we assume it’s ~ 7 years, the cash flow yield has been at worst 4.5%. Likely the duration of that investing cash flow is less. If it was, say, 4.5 years, the cash flow yield has been 7.1%. Not at all terrible, since that does not include unrealized increases in asset valuation.

    Nonetheless, an interesting article. If the cap rate is far less than the yield on the REIT, they should be buying back units. Unfortunately, managers have an incentive to grow their firm (and hopefully their paycheque) rather than always make investment decisions that maximize shareholder return. The fear is that small players tend to get acquired and while that is often good for shareholders it’s bad for job security for the management.

  14. 14. Rachelle

    Andrew,

    That’s not my take on it. The only reason to buy an investment property is for it to create income for you. If you plug in the numbers on a 5 cap property after paying the mortgage there is almost no cash flow left.

    If you compare this to a retail setting it’s like buying an item for a dollar and selling it for 98 cents.

    When you’re buying income property especially one this size you can’t acquire it on this basis. Yes potentially it could appreciate due to better management but this is the mechanism that is supposed to add value and equity for your stakeholder not subsidize a bad acquisition.

    These REIT’s have been spoiled rotten with too much cheap money. Their house of cards is going to collapse one day.

    This is just my personal opinion of course.

  15. TMW,

    That’s a great article. It is important to understand what you are buying into with REITS, and as a result you cannot use traditional dividend payout ratios. You could check the trend of the FFO payout however in order to gauge the sustainability of the distribution.

  16. 16. Tim

    Understood FrugalTrader.

    An example of one such investment is a 9% return on a retirement center to be built, once it was 95% occupied.

    I would be very interested in a post talking about real estate companies such as League which seems to be a rather prominent and well-established Canadian company. Definitely order the blue book from them which is complementary.

    I’m the type that isn’t exactly satisfied with 2% return on RRSPs. I mean, the best thing about the RRSPs is that some of the money you’re using really isn’t yours anyway (Since it’s the governments), so you want to make sure you get as much of a return as possible on it.

    Thanks!

  17. 17. Best Internet Savings Accounts

    Good Information on REIT, but tell me how can I access REIT? Depreciation is a large part of expenses, but in case of real estate it may not apply.
    ——————–
    Susan

  18. 18. daniele

    Is it possible that capital expenditures are higher than FFO?

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