How to Evaluate REITs

Real Estate Investment Trusts (REITs) are investments that earns high passive income and are also appealing to many investors because of their inflation fighting potential. However, with so many REITs available, its challenging to determine which REITs are worth investing in.

In this post, we discuss the metrics investors should use to evaluate REITs and how they may approach a potential REIT investment.

Rules for REITs

Before diving into the valuation metrics of REITs, it’s essential to understand the fundamental tax rules that all REITs must follow.

The most important point to remember is that REITs are not subject to income tax, if they meet the criteria outlined below. But, this also means that the tax burden is shifted directly to unitholders who pay the tax themselves. So, if you own a REIT investment, the REIT itself may not be subject to tax, but your income from the REIT will be.

Here are the main rules:

Firstly, REITs must earn at least 75% of their revenue from real estate operations. This is called the “income test”. REITs must earn income from owning, operating, or financing income-producing real estate properties. This income must be generated through rent, leasing, or interest payments from tenants and borrowers.

Secondly, REITs must distribute at least 90% of their taxable income to shareholders. This means that REITs cannot retain their income, they must distribute it to their unitholders to retain their tax-exempt status.

Lastly, a REIT must invest most of its assets into income producing properties. This is called the “asset test”. REITs must own income producing real estate properties, and not have any other substantial business interests.

Taken together, when REITs satisfy these three rules, they can remain tax exempt. However, this also means that REIT investors are taxed on their proportionate share of the REIT’s income directly.

The investors that benefit most from the way REITs are taxed are registered account investors (RSP, RIF, TFSA, RESP, etc) and other tax-exempt investors such as pension funds, insurance companies, and charitable foundations. Holding REITs in a non-registered account or inside a taxable corporation is not tax advantageous.

Valuation Metrics

Now that we have covered the rules for evaluating REITs let’s dive into the valuation metrics investors should consider. Four key metrics are worth discussing: Funds from operations, payout ratios, leverage, and REIT strategy.

FFO

Funds from Operations (FFO) is a measure of a REIT’s cash flow generated from its operations. It considers the REIT’s net income, depreciation, and amortization. FFO is a better metric than net income when evaluating a REIT because FFO excludes non-cash items. This makes a big difference for REITs under IFRS rules because REITs adjust the value of their underlying properties to match their estimated market values on a quarterly basis. By recognizing the changing value of their properties on a quarterly basis, REITs can show large gains or large losses that are unrelated to their underlying operations. By focusing on FFO, REIT investors can largely ignore earnings shown on a REIT’s income statement. REITs will report their FFO and AFFO (adjusted funds from operations) to unitholders as other businesses may report earnings per share (EPS).

Payout Ratio

As mentioned earlier, the payout ratio is the percentage of income that is paid out to shareholders in the form of distributions from a REIT. A lower payout ratio indicates that the REIT has more funds to reinvest in the business or pay down debt. However, a high payout ratio may indicate that the REIT is distributing too much income, which may not be sustainable over the long term. To determine the payout ration, simply divide the amount a REIT distributes to unitholders by their FFO or AFFO.

Leverage

REITs often use leverage, or borrowed money, to acquire new properties or make improvements to existing ones. Investors should pay attention to the REIT’s debt-to-equity ratio, which indicates how much debt the REIT has compared to its equity. A higher debt-to-equity ratio may indicate that the REIT is taking on too much debt, which could lead to financial difficulties if interest rates rise or if the economy experiences a downturn. REITs usually borrow in a few different ways including mortgages, debentures, and other term loans.

Strategy

Finally, investors should consider the REIT’s strategy when evaluating its potential for growth. Some REITs focus offices, apartments, industrial buildings, or shopping centres. Understanding the REIT’s strategy can help investors determine if its investment objectives align with their own.

In conclusion, evaluating REITs can seem like a daunting task, but by focusing on the rules for REITs and the key valuation metrics, investors can make informed decisions about which REITs to invest in.