Why NOI isn’t the strongest metric for evaluating a REIT’s growth?

The majority of investors often look for investments that offer great benefits without much risk. Individual real estate investments do provide many benefits, but they also expose investors to great financial risks as well. However, a REIT or Real Estate Investment Trust allows investors to own large income-producing properties without the burden of owning or managing the properties. A Real Estate Investment Trust is a company that owns and in most cases, operates income-producing properties. Most REITs receive income in the form of rents by leasing spaces to tenants. A REIT can be divided into two categories –

Equity REITs – Equity REITs are responsible for purchasing, managing, renovating, and administering real estate properties. They lease out spaces to tenants and then receive income in the form of rents.
Mortgage REITs – Unlike Equity REITs, Mortgage REITs (mREITs) invest in mortgages and mortgage-backed securities. A mortgage REIT lends money to real estate developers and earns interests on the mortgages. The profit of a mortgaged REIT is the spread between the interest they earn on the mortgages and the cost of financing the loan.

How Equity and Mortgage REITs make money?

Let’s consider the equity REIT first. Suppose ‘APC’ is an equity REIT. APC owns a couple of large income-producing properties and puts them on lease. Now, the rent received by APC from the rented properties is the company’s profit.

Say PAC is a mortgage REIT. Suppose, PAC raises $10 million from its investors and borrows another $40 million at 2% annual interest. Now, the company invests $50 million in mortgages that pay 5% interest. In this case, the company’s annual interest expense is $0.8 million or 2% of $40 million. Whereas, its annual interest income will be $2.5 million, which is 5% of $50 million.

Therefore,

PAC’s net income = (annual interest income – annual interest expense)
= $(2.5-0.8) million = $1.7 million

How to evaluate a REIT’s growth?

Some investors often use net operating income as a metric to determine a REIT’s potential growth. However, since depreciation expenses are subtracted from net operating income, it isn’t a precise metric for evaluating a REIT’s growth. Qualified Investors use FFO (Funds From Operations) and AFFO (Adjusted Funds From Operations) for evaluating a REIT’s growth. FFO is calculated by adding depreciation expenses and subtracting any gain or loss from the sale of the property. Let’s consider an example.

Let’s assume a REIT’s net operating income in the year 2018 was $545,989 and the depreciation expense was $414,565. Whereas, the profit obtained from the sale of the property was $330,450.

FFO = (Net operating income + Depreciation expense – profit on property sale)
= $(545,989 + 414,565 – 330,450)
= $630,104

Now, the company will use this residual income to fund dividend payments. As per the rules, a REIT must distribute 90% of its income among its shareholders as dividends.

Undoubtedly, FFO is more precise metric than net operating income for evaluating a REIT’s growth. However, it doesn’t include capital expenditure, which is also important. Once the tenure of a lease ends and a REIT leases out the property to a new tenant, they need to carry out improvement works in the property. This increases the capital expenditure and the REIT can use a portion of its income for carrying out improvement works. Therefore, qualified investors prefer AFFO over FFO for evaluating a REIT’s growth. Though there is no particular method for calculating AFFO, investors calculate it by subtracting the capital expenditure from FFO. Let’s assume the capital expenditure in this case to be $160,212.

Adjusted Funds From Operation = (Funds From Operation – Capital Expenditure)
= $(630,104 – 160,212)
= $469,892 As you can see, AFFO gives a more precise value, and that’s why it’s used by experts for calculating a REIT’s growth over the years.

Innovative ways to plan a REIT Investment

A REIT generally has large investment properties in their portfolio. A REIT usually leases properties to tenants and earns income in the form of rent, which is then divided among its shareholders. In order to qualify as a REIT, a company must comply with the following rules –

The company must invest 75% of its assets in real estate, cash or treasuries.
It must receive 75% of its income from property rents, sale of its real estate or from the interest on the mortgages.
The company must distribute 90% of its income among its shareholders. The remaining 10% can be reinvested in new properties or assets.
A REIT must have at least 100 shareholders after one year of its existence.
Not more than 50% of the shares are owned by its five or fewer shareholders during the last half of the taxable year.
The company must be taxable as a corporation.
The company must be managed by a board of directors or trustees.

How a REIT generates revenue?

Most REITs lease properties to tenants and make money from the rents, which is then divided among the shareholders as dividends. The majority of REITs trade on the National Stock Exchange and can be easily bought or sold. On the other hand, some REITs lend money to investors and earn interests on the loan. As you can see, a REIT’s source of income varies depending upon the sector in which that particular REIT operates.

Varieties of REITs

Equity REIT – Equity REITs buy, own and sell investment properties. These REITs generate revenue through rents and not by selling real estate properties. They are publicly traded on the stock exchange.
Mortgage REIT – As the name suggests, Mortgage REITs lend money to investors and earn interests on the loan. They also borrow money at low-interest rates and then buy mortgages that could pay a higher return. The spread between the two interest rates is the REIT’s profit. For example, let’s say a REIT raises $20 million through its investors. It borrows another $50 million at an interest of 2% per annum or $1 million, which is the annual interest expense of borrowing. Now, it uses this $70 million for buying mortgages that pay 5% interest or $3.5 million, which is the annual interest income generated from the mortgage. The spread between these two interest rates will be the REIT’s profit, which in this case is –

Profit = (Annual interest income – annual interest expense)
=$(3.5-1) million
= $2.5 million.

Hybrid REIT – Hybrid REITs are the ones that own and lease investment properties as well as fund mortgage loans to real estate investors. Basically, it’s a mixture of Equity and Mortgage REITs.
Publicly Traded REITs – These REITs are listed with the Securities and Exchange Commission (SEC), and trade on the National Stock Exchange. The shares of these REITs can be easily bought and sold. These REITs are regulated by the U.S. Securities and Exchange Commission.
Publicly Non-Traded REITs – These REITs are also registered with Securities and Exchange Commission but don’t trade on the National Stock Exchange. They are more illiquid than publicly traded REITs but could be more stable, as they are not subject to market fluctuations.
Private REITs – These REITs are neither listed with the Securities and Exchange Commission nor do they trade on the National Stock Exchange. They are accessible to only a few selected investors.

The majority of REITs are equity REITs. However, trusts like mortgage REITs or publicly traded REITs also have their own benefits. Therefore, it’s important that you speak to an experienced REIT advisor, who can guide you through each of these REITs more deeply. We do have a team of highly qualified advisors for you. In no time, you could speak to up to three advisors.