Investing in real estate is usually associated with buying, renting and sale of the given property. It is a process that usually requires a lot of time and significant financial outlay. In reality however, investors have at their disposal a solution that makes it easier to get an exposure to the real estate market.
By saying that we mean investment in REIT, or Real Estate Investment Trust. It is a specific type of investment fund that allows investors to acquire shares in commercial real estate.
There are three types of REITs:
1. Equity REITs - Invest in real estate properties in order to rent them. It is the most popular business model among REITs.
2. Mortgage REITs - as the name suggests, they invest in mortgages. Their profits depend mainly on the interest rate at which the mortgages are repaid. This type of funds is much more risky than Equity REITs.
3. Hybrid REITs - created by combining Equity and Mortgage funds.
REITs usually focus on individual sectors (e.g. residential, industrial or commercial), however, there are also REITs that diversify their portfolios.
In compare to the other assets, REITs stand out in terms of dividends. This is due to the fact that they are required to pay a minimum of 90% (in some countries, at least 75%) of their profits to shareholders.
A considerable advantage of REITs is that investing requires a much smaller amount of capital than trading real estate. You can buy shares of such funds starting from a few dollars per piece.
Another important advantage is their liquidity - they can be bought and sold virtually at any time (as opposed to the actual property). There is a wide range of REITs on the market, which allows you to invest in real estate around the world. An investor from Europe can easily get exposure to the real estate market in Hong Kong or Singapore.
However, there are some drawbacks in regard to this asset class. It is not a risk free instrument and sometimes it has high management costs, which reduces profits or increases possible losses. It is worth adding that apart from investing in individual funds, it is also possible to buy ETFs for REITs on many markets. Such a solution improve our safetiness, because we do not have to rely only on one specific fund. Worse, if we want to invest in the market where REITs are just debuting, then we can not count on an investment through ETF.
Investors who want to invest in individual REITs should first make a valuation of a given fund. Therefore, the question arises: can we use the same indicators for their analysis as in the case of shares? Let's see.
How to properly value REITs?
Intuition suggests that since REITs are listed similarly to shares, then in their case the use of the common indicators will be the most appropriate. Unfortunately, this is not entirely true. Of course, the analysis should include factors such as P/BV, CAPE, etc., however, as we mentioned, REITs are specific funds and should be treated a bit differently. There are even indicators that are mainly intended for valuing REITs.
One such indicator is P/FFO, where FFO stands for Funds from Operations. In the nutshell, FFO measures the amount of money that REIT actually has brought from its business operations. FFO calculation looks as follows:
FFO = net profit + depreciation + amortization - profits from the sale of real estate
Now it’s time for two important comments.
When calculating net profit, depreciation and amortization need to be deducted from it. The authors of the P/FFO indicator believe, however, that depreciation not always occurs and they add it back to the net profit. Is it right? Sometimes we may have to deal with a situation in which the value of the real estate grows due to the infrastructure being built around it (roads, parking lots, stops). Generally this matter is debatable, but at this point we will not argue with the authors of the indicator.
The last part of the formula in which we subtract profits from the sale of real estate is very important. This aspect may be misleading when we pay too much attention to the Price/Earnings ratio, i.e. P/E. If REIT gets rid of the most of its properties, then its profit on the paper will look great (P/E ratio also). So what if the REIT simultaneously sells most of its wealth? Due to such one-off events, P/E is not necessarily applicable and the use of P/FFO is a better solution.
Let's calculate FFO using one example.
Let's assume that during the quarter the given REIT obtained 130 million USD from rent and incurred total costs of 15 million USD. Thus, the net profit was 115 million USD. In addition, the loss as a result of the depreciation amounted to 10 million USD and as a result of depreciation 60 million USD. In turn, 50 million USD of profit was generated on the sale of real estate.
In this case, FFO is calculated as follows: 115 million + 10 million + 60 million - 50 million = 135 million USD.
Unfortunately, FFO has drawbacks as well. REIT can take over real estate using a loan, which will increase profits in the following years, but at the same time we will face a significant increase in debt. For this reason, when analyzing P/FFO, we must also pay attention to whether the debt of the REIT is growing at a significant pace.
Interpretation of P/FFO ratio is similar as in the case of the P/E ratio, the lower the indicator, the better.
If REIT generates FFO of 10 USD per share, and the price of its shares is 100 USD, then P/FFO is 100/10, or 10. This means (to simplify) that our investment in REIT will "pay off" after 10 years .
Since we already know that in the case of REITs P/FFO Ratio is doing better than P/E Ratio, the question arises: Where the current levels of this indicator for individual funds can be found?
FFO values are published by issuers. Unfortunately, they rarely publish the value of P/FFO Ratio, so either we have to calculate it ourselves, or we use financial portals which does it for us. One of these portals is Gurufocus. In the graphic below, we’ve indicated where on the page the P/FFO value can be found using the example of Simon Property Group (red frame).
Each indicator, whether it is P/E, P/FFO or any other, is always worth referring to the average (or median) to get a better picture of the situation. Knowing the P/FFO of a specific REIT is a good idea to compare its value to the average of the market or the average of the sector in which it operates.
The graph below shows the average P/FFO (blue line) for the REIT market in the United States. The long-term average is marked in orange. Thus, we can see that at the end of January 2019 P/FFO Ratio for REITs in the US was slightly above the long-term average of 16.5.
As mentioned above, it is also worth checking the average P/FFO for particular sectors. The chart below presents the average P/FFO for Equity REITs in the US for the most important sectors, i.e. office, industrial, commercial and residential. Although the graph is not current, it still allows us to draw some conclusions.
Over the recent years, the average P/FFO level of the Equity REITs in the US (black line) has been moving in a relatively narrow range (between 14 and 18).
The average P/FFO for the office and retail sectors over the recent years usually took values lower than the average for the entire Equity REITs market. The opposite is true for the industrial and residential sectors, which have been above average for most of the time.
The table below presents examples of US Equity REITs. Each represents a different sector. What is particularly striking here is the large differences between the P/E and P/FFO values. Knowing more or less the P/FFO levels corresponding to particular sectors, we can choose from many REITs that are undervalued in relation to a given sector.
Source: own elaboration
Based on this table, we can conclude that Columbia Property Trust Inc, operating in the office sector, is expensive, because P/FFO Ratio for this fund (21.44) is higher than the average for the entire office sector (around 16). However, it must be noted that this is only a starting point for further analysis.
The P/FFO indicator is only one of the factors to be taken into account when evaluating REITs. Undoubtedly, this asset class is a good alternative to P/E Ratio. Unfortunately, as we have shown above, it also has drawbacks, which must be remembered. An example here can be the American REIT Equinix, which since Christmas has gone up by almost 30%. In its case, the P/FFO indicator currently fluctuates around 22, which in itself should raise concerns. The worst, however, is the fact that within 2 years the fund's debt has increased by over 80%. On the other hand, the Equinix cash level in relation to debt is only 5%. REIT focuses on the takeovers of subsequent properties, which may lead to a tragic end if the economic conditions deteriorates.
On the other hand, the enormous inflow of capital to US REITs that took place in early 2019 is most likely a reaction to the announcements of the FED representatives. Jerome Powell has already made it clear that the US central bank will soften their policy, and his deputy Richard Clarida has mentioned that in the event of problems, the FED will once again present ultra-soft monetary policy which can mean for example, negative interest rates and asset purchases. This is in theory good environment for the increase in property prices. Probably following this way of thinking, investors have already decided to expand their investment portfolios using REITs.
In our opinion, a further rise in property prices (even in the US) is possible. Of course, supported by currency printing and other tools in disposal of central bankers. Earlier, however, the markets will experience a greater or lesser shock associated with the emergence of a recession which already officially came to Europe and unofficially to China, also within a few months will also appear in the US.
Independent Trader Team