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 –

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)
        = $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 –

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

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

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.