One common metric used to measure a stock's financial performance is EPS, or earnings per share. This metric divides a company's net income by the number of outstanding shares. Basically, it lets investors know the value of each share. Investors can determine the company's growth rate by looking at EPS over time.
Can we use EPS to measure the financial performance of REITs? You could, but it is not the best metric for REITs. Instead, FFO (funds from operations) should be used because of the unique structure of REITs.
What Is a REIT?
A REIT (real estate investment trust) is a company that owns, operates, or finances income-generating real estate. REITs can be private or public. Public REITs trade like stocks on public stock exchanges.
REITs are required to pay out 90% of their taxable income. This has the potential to create very competitive yields for REIT investors. Payouts are usually monthly or quarterly.
REIT Performance as Measured by FFO
FFO means funds from operation. It is to REITS what EPS is to stocks.
FFO is a measure of the cash generated by the REIT. That may sound like cash flow, but it is different. FFO and cash flow are related but not the same. Cash flow is a measure of cash going into and out of a business. FFO is a measure of the cash generated by the REIT but factors in depreciation, providing a more accurate picture of the REIT's cash flow.
FFO was developed by NAREIT (National Association of Real Estate Investment Trusts). Most REITs adhere to NAREIT’s definition of FFO.
The formula for FFO is:
FFO = net income + [depreciation (non cash add back) + amortization]
+ [(sales loses) - (sales gains)] - (interest income)
Where capital gains from property sales = (sales loses) - (sales gains)
In GAAP accounting, equipment can be depreciated. However, unlike real estate, equipment doesn’t appreciate. This is why REITs use FFO as a financial metric. FFO adds back depreciation. REITs have large depreciation expenses, which can greatly decrease their net income.
FFO isn’t the last stop in measuring REIT performance. Investors often build on FFO to derive another metric called AFFO.
AFFO stands for adjusted funds from operations. It is also called cash available for distribution. AFFO is similar to cash flow but is specific to REITs. There is no standard formula for AFFO. However, it can be better to use AFFO than FFO for measuring a REIT’s financial performance.
The formula for AFFO is:
AFFO = FFO + rent increases - capital expenditures - routine maintenance amounts
As you can see, FFO must be calculated before AFFO can be used. Some consider AFFO a better measure of residual cash flow since it deducts CaPex (capital expenditures). CaPex is required for the upkeep of REIT properties.
FFO and AFFO are non-GAAP formulas.
EPS Vs. FFO
As hinted at above, FFO and EPS are not the same. EPS captures net income from operations. FFO is levered and captures the impact of taxes and preferred dividends. FFO also does not measure cash flow.
EPS is a ratio of net income to the number of outstanding shares. Net income takes out all costs. Because of these costs, there is generally an impact on cash flow. The largest REIT expenses are depreciation and amortization, which do not impact cash flow.
REITs are sensitive to depreciation expenses since most of their assets are depreciable. Such expenses don't impact the cash that a REIT makes.
Some investors take the price of a REIT and divide it by FFO. This metric provides a percentage that can be used for the annual growth of a REIT. Similar to how EPS can be used to gauge a stock's growth.
Why can't REITs just use GAAP metrics (i.e., EPS) like most companies? Due to GAAP, depreciation and amortization are deducted from net income. But this can lower earnings per share artificially in the case of a REIT. REITs appreciate over time while depreciation and amortization decrease earnings. This creates a very low EPS as property appreciation is not truly captured (due to depreciation and amortization).
Valuing REITs is different from valuing stocks. If one used traditional stock valuation methods on REITs, they would get an inaccurate picture. It's best to use FFO and even AFFO as metrics when valuing the financial performance of REITs.
