Updated on November 22nd, 2024 by Bob Ciura
Investing in real estate can be daunting with its myriad of responsibilities like maintenance and tenant issues. However, real estate investment trusts, or REITs as they’re often called, offer a convenient way for investors to enjoy the financial upsides of real estate without the usual landlord headaches.
This makes REITs particularly attractive for long-term investors aiming for both income and property value appreciation. With over 200 REITs on the market, there’s a prime opportunity for investors to engage in meticulous, fundamental analyses to select the best options.
To assist in this endeavor, we’ve compiled an exhaustive list of over 200 REITs. Grab your free copy, packed with vital metrics like dividend yields and payout ratios, by clicking the link below.
With so many REITs available on public exchanges, investors can pinpoint the cream of the crop. But sorting out the best requires a keen understanding of how REITs work, which isn’t as straightforward as traditional stock analysis due to unique accounting practices and valuation methods. Let’s dive into the value assessment of REITs, providing two detailed examples using an actual REIT.
Understanding REITs
Before delving into analysis, it’s crucial to grasp what REITs are. Unlike corporations that own real estate, REITs are structured as trusts. This distinction affects their taxation, making them more tax-efficient for investors.
In exchange for complying with specific regulations to maintain their status, REITs aren’t taxed at the corporate level. One key requirement is distributing 90% or more of their net income as dividends.
Structurally, REITs differ from common stocks. They function as trusts, issuing units rather than shares. Consequently, unit holders receive distributions instead of dividends, which are taxed differently. These distributions are categorized as follows:
- Ordinary income: Taxed at the usual rate, up to 37%.
- Return of capital: Viewed as deferred taxes, reducing your cost basis.
- Capital gains: Taxed either as short-term or long-term gains.
On average, a typical REIT distribution consists of about 70% ordinary income, 15% return of capital, and 15% capital gains. Because of these tax nuances, REITs usually fit well within retirement portfolios but can also be suitable for taxable accounts if the investment is sound.
Tax Efficiency of REITs Explained
REITs boost after-tax income by minimizing double taxation, a common corporate pitfall. Despite not being as tax-efficient as Master Limited Partnerships, they offer a compelling advantage over regular corporations. To illustrate, consider a hypothetical company earning $10 pretax and distributing everything to investors. The accompanying image illustrates the returns depending on whether the entity is a corporation, REIT, or master limited partnership.
Due to their tax-friendly structure, REITs hold appeal for those looking beyond traditional corporations. Next, let’s explore how investors can identify REIT bargains through valuation strategies.
Non-GAAP Metrics and Valuation Strategies
We’ve explored the tax benefits of REITs. Now, let’s discuss how traditional valuation metrics fall short for REITs and introduce alternative methods for evaluating their worth.
REITs own long-term assets, leading to significant depreciation on their financial statements. While depreciation is crucial for acknowledging the capital costs of real assets, it doesn’t affect cash flow and shouldn’t influence dividend safety evaluations.
Traditional price-to-earnings ratios don’t hold much weight for REITs due to variable depreciation over time. Instead, investors should apply methods that account for actual cash earnings and capability for income generation.
Two primary techniques exist:
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Price-to-FFO Ratio: Here, analysts use the price-to-Funds From Operations (P/FFO) ratio, which omits non-cash expenses like depreciation for a clearer picture of cash earnings.
- Dividend Yield Comparison: This method compares a REIT’s current dividend yield to its historical average. A yield higher than the average indicates potential undervaluation, while a lower yield suggests possible overvaluation.
Let’s walk through detailed examples illustrating these valuation strategies.
Example #1: P/FFO Valuation with Realty Income
This section provides a step-by-step guide on using the price-to-FFO ratio to assess REIT value. We’ll use Realty Income (O), a popular choice among dividend investors due to its monthly payouts.
Unlike quarterly dividends, monthly payments better accommodate expenses, a rare benevolence. For investors, choosing between past or forecasted FFO when calculating P/FFO can influence the outcome.
Historical FFO comes from company-announced earnings releases. Adjusted FFO is preferable, stripping away one-time items that could skew results. Forward-looking estimates, like Realty Income’s expected $4.17 per share in 2024, are also useful. With current trading at $58 per share, the P/FFO ratio stands at 13.9.
Investors should now assess this against Realty Income’s decade average of 18.6. A current ratio lower than average suggests undervaluation. Comparisons with peer REITs, defined in standardized SEC filings, also guide investment decisions.
Example #2: Dividend Yield Valuation
The dividend yield method, our other valuation approach, involves comparing current to historical yields. Realty Income’s annual dividend of $3.16 per unit, at a $58 unit price, yields 5.5%, above its 10-year average of 4.5%, underscoring undervaluation.
While this method lacks the depth of FFO analysis, it’s expedited and adaptable across investment types, making it a handy tool for REITs and beyond.
Concluding Thoughts
REITs stand out for their ability to combine real estate income potential with a hassle-free investment style. Plus, their tax efficiency and usually higher yields make them a favorite for income-focused portfolios.
However, evaluating REITs requires a nuanced approach beyond typical stock analyses. The P/FFO ratio and dividend yield comparison, as discussed, offer strategic insight into REIT valuations and should be staples for anyone serious about dividend growth investing.
Thank you for reading, and feel free to reach out with feedback or questions at [email protected].
