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.
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)
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.