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.
