Valuation Methods

This is chapter two of a guide
to REIT stocks. Begin here.

This is chapter four of a guide on REIT investing. Begin here.

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Funds From Operations

Funds from operations are the net income without non-cash or non-operating expenses. To the net income we add (1) depreciation and amortization, (2) gains and losses from real estate sales, (3) gains or losses from change in control and (4) impairment write-downs of real estate.

Because GAAP accounting requires an annual depreciation of real estate, while in reality real estate often appreciates in value, the intent behind FFO is to get us closer to the economic truth. Yet funds from operations do not include capital expenditures. Omitting this expense results in an inflated, optimistic measure of earnings.

So the real estate industry includes a second measure called adjusted funds from operations (AFFO). It is now often reported by management. In AFFO reporting, managements discusses the amount of cash spent on the maintenance of existing properties and on the development of new properties and acquisitions.

The FFO and AFFO definition

To calculate the adjusted funds from operations, we use the funds from operations less capital expenditures and less any gains on sale. We then adjust for straight-lining of rents and any one-time loss or gain. We then add back amortization related to stock compensation and other deferred costs.

AFFO is a superior measure to the FFO because the maintenance of real estate, whether it is renovating the lobby or replacing the roof, is a real and frequent cost that affects cash flow. To see the wide difference between net earnings, funds from operations and adjusted funds from operations, I will use Plymount Industrial Reit most recent annual report.

For 2017 Plymount reported a net loss of $14 million. But if we add back depreciation of $14 million and remove the gain of $231 thousand from real estate sale, we arrive at FFO of $260 thousand. To arrive at AFFO, we further deduct for the recurring capital expenditures, straight line rents and added back non-cash interest expense, acquisition costs and stock compensation. This results in AFFO of $818 thousand.

So we arrived at three numbers that tell a different story. Returning to Plymount, the 5-year average net loss was $25 million. The 5-year average loss from funds from operations was $17 million and the 5-year average loss from adjusted funds from operations was $9 million. In 2017, all three numbers improved, and the company showed a profit in AFFO.

FFO and AFFO multiple

Like the popular price to earnings ratio, investors in REIT companies often estimate whether a stock price is a bargain or expensive using multiplies such as price to FFO ratio or price to AFFO ratio. Observing these ratios over time provides a signal of how the stock market values the company. And it also allows us to see the relative value across companies. Judging by the price to FFO ratio for example, the stock market believes that Essex Property Trust is a superior to Mid-America Apartment Communities.

For Essex, between 2013 and 2017, funds from operations were as low as $7.6 (in 2013) and as high as $11.191 (in 2017). And during this time, the average price to FFO ranged between 20 and 23 times.

For Mid-America FFO was as low as $4.34 and as high as $6.15. The 5-year average price to FFO was 15 times. For over five years, the stock market felt ESS was worth 33% more than MAA. Let us move from the particular case of Essex versus Mid-America to the general case and ask what are some of the reasons that one REIT stock is priced higher than a different REIT stock.

There are three. The first, growth expectation. If REIT’s ABC portfolio of real estate is currently earning below-market rents, a case could be made that future earnings will grow. Another reason for a growth premium is that the portfolio of real estate is in areas in high demand. Consider apartment rents in San Francisco or Vancouver.

The second, risk associated with the real estate. If REIT's ABC portfolio of real estate consists of apartments, while REIT's XYZ portfolio of real estate consists of single, anchor-tenant shopping malls, then investors demand a discount for the additional risk they take (the risk is that if one tenant leaves, the shopping center is effectively shut down.)

The third, risk associated with capital structure. If REIT ABC carries more debt than REIT XYZ than investors will view REIT ABC to be riskier and will demand a discount to the net asset value. If REIT ABC has preferred stock holders who are paid a dividend prior to the common stock holders, then investors would demand a discount too.

The drawback

Funds from operations are not perfect earnings measure. They do not include the value of land for example. So, if a REIT has a substantial number of projects under development, which currently are not generating any income but are expected to generate income in the future, then the price to funds from operations may appear artificially rich.

Adjusted funds from operations are supposed to bring us closer to the true earnings of a REIT. But since for most real estate projects, the capital expenditure varies significantly each year, it is practically impossible to compare between a single year's AFFO of REIT ABC to AFFO of REIT XYZ. And since many REIT companies do not report AFFO measures - and since there is no standard calculation of the metric - for now at least, AFFO remains a subjective number.

Net Asset Valuation

Because real estate properties represent a large part of a REIT's assets, usually between 70% to 80%, comparing the value of a REIT’s real estate portfolio to the price of the stock allows us to answer: Is a REIT's stock price cheap or expensive?

The math behind net asset value calculation is straightforward. We look for the Net Operating Income as reported on the REIT's public filings. And based on the Capitalization Rate for similar assets, we then determine the value of the real estate by dividing the Net Operating Income by the Capitalization Rate.

To that number we add any cash the REIT holds and any other assets that represent a true economic value, such as receivables. Often REIT analysts add accounts receivable and the value of land. We then remove the total liabilities as well as the value of the preferred stocks. The result is the REIT’s Net Asset Value.

An illustration: Equity Office Properties Trust (EOP on Nasdaq), reported a Net Operating Income of $271,308 last year. Based on recent comparable transactions, we can estimate a capitalization rate of 7.0% and thus determine a value of $3.8 billion for the portfolio of real estate properties. We then add the reported cash balance of $65 million, the land held for future development of $34 million, the accounts receivable of $46 million and other prepaid assets of $23 million. We get $4.04 billion in estimated market value. The reported total liabilities were $1.2 billion, and so our net asset value is $2.9 billion or $52 per share (there were 55.6 million outstanding shares.)  

Whether a stock is trading at discount or premium to the calculated Net Asset Value has a few implications. First, if a stock historically traded at premium and is now trading at a discount, perhaps it merits an investment.

Let us return to EOP to examine that statement. During 201 the common stock of EOP traded hands as low as $44 and as high as $56. Read: During the quarter, the stock's discount was 15%, and the stock's premium was 7%.

The discount or premium to book value also allows us to compare among REIT companies and across industries. Using the math illustrated above, we see the stock market finds the ownership of retail higher than the risk of the ownership of industrial properties. For example, Rexford Industrial is trading at an implied capitalization rate of 3.4% while Weingarten Realty Investors (WRI on Nyse) is trading at 6.3% implied capitalization rate.

And we can see the gradual devaluation over the past few years. Specifically, because of the Amazon Scare, there is concern that retail sales will be eliminated, and thus we see a drop in the value of REITs that own and manage shopping centers.

Four years ago, Retail Properties of America (RPAI on Nyse) traded at an implied capitalization rate of 6.6% while today it is trading at an implied capitalization rate of 7.7%. Similarly, Weingarten Realty Investors (WRI) traded in 2013 at a capitalization rate of 5.4% while today it is trading at a capitalization rate of 6.3%.

How to calculate an implied capitalization rate? Let us use the public filings of Rexford Industrial Realty as an example.

Instead of estimating a capitalization rate to find the value of the real estate, let us name the market value of the real estate at X. To that we will add $6.6 million cash, $19.5 million of receivables and deduct total liabilities of $746 million and the $90 of preferred stock.

We find a value of $3.5 billion for the real estate portfolio. And since the company reported an NOI of $118.2 million, the implied capitalization rate is 3.4%. estimated implied capitalization rate is between 3% and 10%, it is a minuscule rate of return. An implied capitalization rate of 15% should pick our interest.

The issues with net asset value calculation

Because we determine the market value of the real estate by dividing the net operating income by the capitalization rate, we fail to see whether the rental rate is below- above- or at market. Seritage Growth Properties (SRG on Nyse) serves as an illustration.

As of its most recent public filing, the company average annual rental revenue that was, I estimate, about a quarter of the market rents. This occured because 54% of the rental is from Sears Holdings, which has a master lease.

The second issue was the non-linear sensitivity of the estimated value of the real estate portfolio to changes in the assumed capitalization rate. If the capitalization rate changes from 5% to 4%, a 20% difference, for a real estate portfolio that is generating $100 million in NOI, the value would increase from $2 billion to $2.5 billion, a 25% difference.

Inversely, the difference between a 5% capitalization rate and a 6% capitalization rate changes the value of the portfolio from $2 billion to $1.67 billion, a 16% difference. In short, the value of the real estate assets was highly sensitive to the the capitalization rate estimate.

The Qualitative (Intangible Value) 

To properly value REIT stocks, calculating numbers is not enough. There are intangible variables, such as management experience and corporate culture, which are at least as important as the variables that we can count.

Some authors believe that qualitative variables are unimportant. In the book The Intelligent REIT Investor, by Stephanie Krewson-Kelly and Brad Thomas, there is no mention of management's experience or franchise value. But just because this information is not easy to find, does not make it pointless. “Did you lose the keys here?” as the saying goes. “No, but the light here is much better.”


In searching for excellent management, we focus on four aspects. The first is to look at management's track record in real estate ownership and in communicating on the state of the business with shareholders. The second is to find out how much ownership stake management has. If you look at Simon Properties Group (SPG) on Yahoo Finance, for example, you will quickly learn that management owns less than 1% of outstanding shares.

The third aspect is how well management’s interest is aligned with the wellbeing of the investor, and that is to ask whether management has been buying or selling its own stock in the company.

Returning to the example of Simon Properties, over the past two years, executives of the company have sold 8,189 shares and did not purchase a single stock. A possible interpretation is that if management is not buying its own shares, then management expect the stock price to drop.

The real estate portfolio

To estimate future rental income and potential growth, we should look at the operations of each property in the REIT's portfolio. The most popular indicators of value are the location of the properties; i.e. how occupied are the properties compared to the market occupancy rates, whether the in-place rents are higher or lower than market rents, when the leases mature and whether there is a significant concentration to one tenant.

Consider the retail REIT Saul Centers (BFS on Nyse). BFS owns 49 neighborhood shopping centers and six mixed-use properties, and no single property consisted greater than 10% of the total portfolio of 9.2 million in square feet. Over 60% of the shopping centers were anchored by a grocery store. The portfolio was 94.3% leased as of 2018.

What these data points mean is that while the portfolio of real estate is well diversified, it is sensitive to how we will shop in the future; i.e. the more consumers use Amazon Prime, the harder it will be for BFS going forward. My point is that this information is not reflected in the reported FFO or in estimated NAV.

Balance sheet risk

Whether a REIT carries variable or fixed debt will affect its future financials. This information is readily available in the footnote section of the annual report filed with the Securities and Exchange Commission, and you should not overlook it.

With a dormant interest rate environment, as the one we experienced between 2008 and 2017, whether the REIT financed its operations using fixed or variable debt was not as important as it is today. As I type these words, the 5-year Treasury, an index often used to price commercial real estate loans, has increased from 2.25% to 2.85%, an almost 30% increase.

While the rising interest rate environment affects all REIT companies, interest expenses will increase for REITs that use variable debt. Returning to the above example, 99% of BFS’ current debt is fixed at a weighted average of 5.25%. Compare that to CBL & Associates (CBL on Nyse), which is paying a lower weighted average of 4.75% - but that is because a third of its outstanding debt is variable in nature.

Corporate governance

In The Corporate Governance of Listed Companies: A Manual for Investors, the CFA Institute writes that board members should be independent from management. That board members should have appropriate experience and expertise. That internal mechanisms, such as authority to hire external auditors, are required. And that the directors must have access to complete and accurate information about the company.

Simon Property Group serves has outstanding corporate governance. The company mandates that most of its directors be independent, and each member of the Board's audit, compensation and governance and nominating committees is independent; all directors are elected annually.

The 80/20 rule

While there are additional qualitative variables, such as franchise value and what I called the "capital expenditure biography," which aims to understand how well management has acquired and managed real estate, I would like to conclude this chapter with Seth Klarman's  80/20 rule. In his words:

"Some investors insist on trying to obtain perfect knowledge about their impending investments, researching companies until they think they know everything there is to know about them. They study the industry and the competition, contact former employees, industry consultants and analysts, and become personally acquainted with top management. They analyze financial statements for the past decade and stock price trends for even longer.”

He then continues: 

"This diligence is admirable, but it has two shortcomings. First, no matter how much research is performed, some information always remains elusive; investors must learn to live with less than complete information. Second, even if an investor could know all the facts about an investment, he or she would not necessarily profit...Information generally follows the well-known 80/20 rule: the first 80 percent of the available information is gathered in the first 20 percent of the time spent.”

Short Summary

This concludes our chapter on the valuation of REIT stocks. If I leave you with one thing it is to remember that a true understanding of the business requires both math-skills and thought-skills.

The math-skills require us to look for net asset value and to determine what are the funds from operations. The thought-skills require us to think about the business and the industry. The thinking should include a reading about the business philosophy of management, reviewing the corporate structure of the REIT and comparing what is said to what is done in practice.