DIV 203Lesson 3 of 90 of 9
How to Analyze a REIT: FFO, AFFO and More
Why earnings mislead for property owners, and the numbers to check instead.
What you’ll learn
- Why earnings per share mislead for REITs
- How FFO and AFFO are calculated and what each tells you
- The other numbers that matter: occupancy, same-store growth, debt and lease length
- How to value a REIT with price to FFO and net asset value
Run the ordinary stock checklist on a healthy REIT and it can look like a disaster: a payout ratio of 150% or 200% of earnings. That’s not because REITs are reckless. It’s because the accounting rules that work for most companies work badly for buildings. REIT investors use a different set of numbers, and once you know them, REITs become much easier to judge.
Why earnings mislead
Accounting rules make a company spread the cost of a building over its useful life as an expense called depreciation. For a factory machine that wears out, that makes sense. But well located buildings usually hold or grow their value over time. So a REIT reports large depreciation expenses that shrink its earnings, while no cash actually leaves the business. Judging a REIT on earnings per share is like judging a landlord by pretending their building loses value every year.
FFO: funds from operations
The industry fixes this with FFO, defined by the REIT industry association, Nareit:
Adding back depreciation removes the paper expense. Taking out property sale gains stops a REIT from flattering a quarter by selling buildings. Every listed REIT reports FFO, usually on the first page of its quarterly results.
AFFO: closer to the cash
FFO still ignores money a landlord really does spend to keep its properties rentable: new roofs, parking lots, heating systems, and fitting out space for new tenants. AFFO (adjusted funds from operations) subtracts those recurring costs and makes a few other adjustments, such as removing “straight-line” rent accounting that books future rent increases early.
AFFO isn’t standardized, so each REIT calculates it slightly differently. It’s still the best single measure of the cash available to pay dividends, so the dividend as a share of AFFO is the payout ratio that matters most.
A worked example
The other numbers that matter
| Measure | What it tells you | Healthy looks like |
|---|---|---|
| Occupancy | Share of space that's rented | Above 93% to 95% for most types, and stable |
| Same-store NOI growth | Income growth from properties owned a full year, before acquisitions | Positive, ideally above inflation |
| Weighted average lease term | How long current leases have left | Long for net lease (8+ years), short is normal for apartments |
| Tenant concentration | Share of rent from the biggest tenants | No single tenant above roughly 5% to 10% |
| Net debt to EBITDA | How heavily borrowed it is | Around 5× to 6× or lower for most REITs |
| Debt maturities and rate type | How much must be refinanced soon, and at what rates | Spread out, mostly fixed rate |
| Credit rating | Lenders' view of the balance sheet | Investment grade (BBB− or better) lowers borrowing costs |
Valuing a REIT
Price to FFO (or price to AFFO) is the REIT version of the P/E ratio. Divide the share price by the yearly FFO per share. Comparing it with the REIT’s own history and with peers of the same property type tells you whether it looks cheap or expensive.
Analysts also estimate net asset value (NAV): what the REIT’s properties would sell for, minus its debt, per share. A REIT trading well below NAV may be a bargain, or a sign the market doubts the values. A REIT trading well above NAV can issue new shares cheaply to buy more buildings, which is one reason the best run REITs keep growing.
Check your understanding
4 questionsA REIT reports net income of $1.00 a share, real estate depreciation of $2.20 and a $0.20 gain from selling a building. What is its FFO per share?
Why is AFFO usually a better guide to dividend safety than FFO?
A REIT trades at $60 with FFO of $4.00 per share. What is its price to FFO multiple?
Which combination is the strongest warning sign for a REIT dividend?
Related lessons
This lesson is for education only and isn’t financial, investment or tax advice. Tickers are used as examples of how things work, not as recommendations. Figures marked as live come from Dividend Duel’s market data and change daily. See our disclosure.