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3 Things to Look Out for When Assessing a REIT

Real Estate Investment Trusts, or REITs, are tradable funds which manage a portfolio of properties. The properties are leased out to generate income. Since REIT’s debut on SGX in 2002, they have been gaining popularity amongst investors. This is because of their high dividend yield and relatively strong performance as a group.

However, REITs can be a difficult instrument for new investors to analyse due to traditional metrics like Price-to-Earnings (P/E) and Price-to-Book value (P/B) ratios not accurately reflecting a REIT’s performance or value.

In this article, we will look at three metrics that may be more useful for analysing a REIT.

Funds From Operation

Funds From Operation (FFO) is a measure of cash earned by a REIT.

It gives a more accurate representation of a REIT’s performance than earnings. This is because earnings count depreciation and amortisation as a cost. In reality, adding property depreciation figures into income statements are accounting routines but do not actually affect income. Property also tends to rise in value and not depreciate.

FFO takes this into account and adds this depreciation cost back into earnings to give a more realistic look at the REIT’s performance.

Gains on sales of property are also deducted from earnings so that this does not inflate the amount earned from day-to-day operations.

Therefore, we can calculate FFO using the following formula:

Funds from Operation = Net Income + Depreciation + Amortization – Gains of sales of Property

By comparing a REIT’s FFO per share to the current price per share, we can find out if a REIT is reasonably priced.

Debt-to-Equity Ratio

The next two metrics will analyse how strong a REIT’s balance sheet is. REITs are usually highly leveraged, which allows them to buy properties valued higher than its shareholder’s equity. But it is important that REITs do not incur too much debt along the way making them susceptible to default.

The most basic metric we can use to assess this is the debt-to-equity ratio. This is calculated by dividing total debt by shareholder’s equity as illustrated below:

Debt-to-Equity Ratio= Total Debt/Shareholder Equity 

Ideally, this metric should be low. This would mean that a REIT is financing its investments mostly with shareholder’s equity and less debt. This will give the REIT more leeway in case of unforeseen circumstances or interest rate hikes.

A low ratio can also indicate that a REIT has the financial muscle to expand its portfolio of properties in the future.

Interest Coverage

The third metric looks at how easily a REIT uses its profits to pay off debt interest. Interest coverage is measured by dividing FFO by interest expense. This is shown below:

Interest Coverage= FFO/Interest Expense

This can give investors an idea if profits from its rental income are sufficient to pay back short-term interest expense.

A high interest coverage ratio usually indicates that the REIT’s profit is able to withstand any fluctuations in interest rates in the future.

Foolish Bottom Line

REITs give investors an opportunity to invest in real estate with relatively little capital. However, because of the unique structure of REITs, new investors may find assessing a REIT a daunting task. Hopefully, these three simple metrics will give investors a good first step to analyse a REIT’s performance and balance sheet.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn't own shares in any companies mentioned.