How to value REITs: FFO instead of profit
A REIT is a company that owns and rents out real estate and pays out most of its income. Its profit is misleading, because it depreciates its buildings year after year, even though they often do not lose value. That is why REITs are valued by FFO – the money the properties really bring in.
What a REIT is
REIT stands for Real Estate Investment Trust. These are companies that own and rent out offices, apartments, warehouses, shopping centres or data centres. They enjoy tax advantages and in return must pay out most of their income – in the US at least 90% of taxable income. That is why many investors buy REITs for their regular payouts.
The problem with profit
Accounting treats a building like a machine: it loses a bit of its value every year, and that loss is deducted from profit as depreciation. For a machine that is true. For a well-located building often not – land and location rarely lose value, and sometimes they even rise.
The result: a REIT's profit is often far smaller than the money the rents actually bring in. The P/E ratio then looks absurdly high, even though the company earns well.
The solution: FFO
FFO stands for funds from operations. The industry has a fixed definition for it:
- Depreciation
- the loss in value of the properties as accounting records it
- Gains on sales
- one-off gains from selling properties
Depreciation is added back because no money left the company. Gains on sales are subtracted because they are one-off – a REIT cannot sell its buildings every year.
The worked example
The made-up Example REIT costs €72 per share.
| Item | Amount |
|---|---|
| Net income | €2.00 |
| + Real estate depreciation | €3.00 |
| − Gain on a property sale | €0.50 |
| = FFO | €4.50 |
By profit, the REIT would have a P/E of €72 ÷ €2 = 36. That would look expensive. By FFO, it costs €72 ÷ €4.50 = 16 times FFO. That is a very different story – and the more realistic one.
P/FFO instead of P/E
Share price divided by FFO per share is called P/FFO and is the REIT counterpart to the P/E ratio. As with the P/E, there is no fixed good value. Compare with REITs of the same kind – apartments with apartments, warehouses with warehouses – and with the REIT's own history.
More precise: AFFO
Buildings need upkeep too: new roofs, heating systems, renovations after a tenant moves out. Subtract these recurring maintenance costs from FFO and you get AFFO (adjusted FFO). It is closer to what can really be paid out. For Example REIT with €0.80 of maintenance per share, that would be €4.50 − €0.80 = €3.70. A payout of €3.20 would then be about 86% covered. There is no uniform definition of AFFO, though – every REIT calculates it a little differently.
Three common mistakes
Dedicated models for REITs.
Delta Metron recognises REITs and values them with three dedicated models based on FFO per share: P/FFO, FFO growth and the dividend model. Every assumption is visible and adjustable by you. Sign up for free: The first 100 on the waitlist pay €5 instead of €10 a month at launch, for life.
Frequently asked questions
Where do I find FFO?
Most REITs report it themselves in their quarterly and annual reports, usually with a reconciliation from net income. Data services often simplify the calculation and, for example, do not subtract gains on sales. So compare figures from the same source where possible.
Are there REITs outside the US?
Yes, many countries have similar structures, for example the G-REIT in Germany. They too must pay out most of their income. For real estate companies that are not REITs, the FFO logic still applies.
Why are REITs sensitive to interest rates?
For two reasons: they finance themselves heavily with loans, and their payout competes with safe interest. When rates rise, both get harder.
Can I use the dividend model?
Yes, REITs suit it particularly well because they pay out reliably. More on this in the article The dividend discount model.
Not investment advice. All content is for informational and educational purposes only. Example REIT is made up.