Lesson 3 of 7
Reading a REIT
A REIT is read on funds from operations, not net income, because straight-line depreciation says a building loses value every year regardless of rent.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A REIT must distribute at least 90 percent of its taxable income to keep its tax status, so a high payout is a floor set by tax law, not only a management choice.
- Funds from operations adds real-estate depreciation back to net income, because GAAP depreciation assumes a building loses value on a schedule, while real-estate values have historically risen and fallen with the market.
- A REIT's payout is compared with FFO, not with net income, or a well-run REIT looks unable to afford its own dividend.
A REIT is read on funds from operations rather than net income, because net income is charged for depreciation on buildings that, unlike a machine, do not wear out on a schedule. What matters next to that figure is how much of it goes out as a dividend, and how the property is financed.
From net income to funds from operations
- Net income$100
- Real estate depreciation+$80
- Gains on property sold−$20
- Funds from operations= $160
Why net income understates it
GAAP requires depreciating a building over its useful life the same way a factory machine is depreciated, on the assumption that both lose value every year. A well-located, well-maintained property often does not: it can be worth more after ten years than when it was bought, even as the accounts have charged a decade of depreciation against it. That depreciation is real for tax purposes and it is a real non-cash charge, but taking it as a proxy for how the property's value is actually changing is the mistake a REIT's own reporting exists to correct.
Funds from operations
Example$100 + $80 − $20 = $160
Nareit's 2018 restatement of its FFO white paper standardises the adjustment: start from net income under GAAP, add back depreciation and amortisation on real estate and impairments of depreciable real estate, and remove gains (or add back losses) on the sale of property, because a sale is a one-time event rather than the recurring operating result FFO is meant to measure. Many REITs also publish an adjusted FFO that goes further, subtracting the recurring capital spending needed to keep the properties leasable, which is the closer analogue to free cash flow.
The payout rule, not a policy
Internal Revenue Code sections 856 through 857 require a REIT to distribute at least 90 percent of its taxable income to shareholders each year in order to avoid paying corporate tax on it. That is why REITs run high payout ratios as a matter of tax law, not generosity, and why a REIT retaining most of its earnings the way an industrial company might is not choosing to: it would lose its REIT status.
Property against debt
A REIT's other question is what its real estate is worth against what it owes on it. Debt is compared with an estimate of what the properties are worth, not with book value at cost less depreciation. US REITs do not report that value, so analysts estimate it by dividing net operating income by a market capitalisation rate. A REIT financing income-producing property with a long-dated, fixed-rate mortgage is in a different position from one funding the same portfolio with short-term, floating-rate debt, even at an identical loan-to-value ratio.
Do it on a real 10-K
- Open the supplemental financial package, not just the 10-K, and find the FFO reconciliation from net income.
- Check whether the company also reports an adjusted FFO, and read what it subtracts.
- Find the disclosed net operating income and, if stated, a capitalisation rate, and use them to estimate a property value.
Check yourself
Why does GAAP net income tend to understate a REIT's operating performance?
- Rental income is recognised too late
- Straight-line depreciation charges the building every year, even when its value is not falling on that schedule
- REITs are not required to file audited statements
Show the answer
Answer: B.
Depreciation assumes a steady decline in value. A well-maintained, well-located property often does not decline that way, so the charge understates the property's real economic performance.Why must most REITs pay out nearly all of their taxable income?
- It is required by their corporate charter
- Internal Revenue Code sections 856 to 857 require distributing at least 90 percent of taxable income to keep REIT tax status
- Shareholders vote on the payout every year
Show the answer
Answer: B.
The 90 percent distribution requirement is a condition of the tax election, not a discretionary dividend policy.A REIT reports net income of $100 and funds from operations of $160, and pays a dividend of $150. What does the payout ratio against FFO show that the payout ratio against net income does not?
- That the dividend is unsustainable
- That the dividend is covered by FFO, before the recurring capital spending FFO leaves out
- That the REIT has understated its debt
Show the answer
Answer: B.
Against net income the payout looks like 150 percent. Against funds from operations, the figure most REITs and their analysts size the dividend against, it is 93.8 percent. Against adjusted FFO of $130, after recurring capital spending, the same $150 dividend is 115.4 percent.Sources
- Nareit, Funds From Operations White Paper, 2018 restatement.
- Internal Revenue Code sections 856 to 857: REIT qualification and the 90 percent distribution requirement.
What this leaves out
- Adjusted FFO, which subtracts recurring capital spending, is defined differently by every REIT that publishes it, so it is not comparable across companies the way the Nareit FFO definition is.
- US REITs report property at depreciated cost, not fair value; a value built from net operating income and a capitalisation rate moves a great deal with a small change in that rate.
- The waterfall and payout table use round invented numbers so the arithmetic can be checked by hand.
- Nothing here is advice about any security.