Why Are REIT P/E Ratios So Darn High?

Sitting on an airplane in front of two elderly couples, I overheard some interesting conversations about everything from grandkids to retirement planning.

Not surprisingly, much of their financial conversation revolved around low interest rates and how CDs just weren't cutting it any more.

This was a financial writer's goldmine. It sure beat perusing SkyMall for the 20th time. I listened intently.

At one point, the couples shared their favorite income investments. REITs were among them. But they had a big concern: REITs might be overvalued since their price-earnings ratios are massive. High P/Es are, in general, a sign of a very overvalued, not-so-attractive stock.

I began to think if these seniors didn't "get" REITs, then surely there are many other investors just like them -- people confused with the ins and outs of accounting. So, here I am to explain REITs for all those interested in this high-yield asset class.

REIT P/E ratios and why they don't matter
We learn over time that it's all about the bottom line. Businesses are all about turning a profit and posting positive earnings.

But earnings don't matter in some industries like real estate; what matters is cash. And in many cases, a company's ability to generate cash is substantially different than its ability to generate earnings.

Source: 401k 2013.

On their accounting statements, REIT earnings are much lower than their actual cash income. The reason is fairly simple: their income statements are loaded with non-cash charges -- expenses that don't actually require a company to spend money.

For REITs, that big, non-cash expense is depreciation. You see, the IRS says a commercial real estate building depreciates over time, over 39 years. That is to say that a building valued at $1 million in 2013 should be valued at $0 by 2052.

So, if you own a commercial building worth $1 million, each year you'll depreciate it by $25,641 until the value falls to zero. This depreciation is recorded as an expense on the income statement. Remember, though, that this is a non-cash expense. You aren't just throwing $25,461 into the trash can every year. In fact, that $1 million property is probably going up, not down, in value.

Deprecation is subtracted from revenue (rents) to get to bottom line income. This is why REITs have very little income to report -- depreciation erases much of their income in the eyes of the IRS.

When you think about REITs and their profitability, I want you to almost completely forget about earnings. Earnings don't matter for a REIT because they make way more money than what they report on the income statement.

REIT ratios that matter
If you want a very simple ratio to value REITs, you should replace "earnings" with "funds from operations," often shortened to FFO. A REIT's FFO is essentially its earnings.

Naturally, one good way to value a REIT would be to divide the price of the REIT by its funds from operation. This gives us a really good valuation ratio of P/FFO, which is to REITs what P/E ratios are to other stocks.

Let's use a table and include many different REITs, their P/E ratios, and their P/FFO ratios to put the numbers in perspective:

REIT

Last Reported Quarterly FFO per Share

Annualized FFO per Share

Price/FFO Ratio

P/E Ratio From Last Quarterly Earnings

Realty Income Corp.  (NYSE: O  )

$0.60

$2.40

 16.5  35.4

National Retail Properties (NYSE: NNN  )

$0.45

$1.80

 17.72  29.5

American Realty Capital Properties (NASDAQ: ARCP  )

$0.17

$0.68

 18.3  N/A

Washington Real Estate Investment Trust (NYSE: WRE  )

$0.47

$1.88

 13.3  79.2

As you can see, these REITs appear pricey when compared on the basis of price to earnings. But once you break out their price to FFO, you find they aren't nearly as expensive as they once appeared. In fact, if you're used to staring at REIT P/E ratios of 30-50, you'd probably think REITs are downright cheap when you look at P/FFO.

A REIT's P/FFO is a really good way to work out a theoretical return. If a REIT has a P/FFO of 15, you can divide 1 by 15 to get 6.67%, your theoretical return holding everything constant.

So that's the short explanation for why REITs trade at super-high multiples of earnings but aren't as overvalued as they may seem. Once you understand the quirks of REIT accounting, you can make a much better judgment call about what a REIT is actually worth. Forget P/E ratios -- the proper ratio for REITs is P/FFO.

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  • Report this Comment On October 08, 2013, at 9:36 PM, neamakri wrote:

    Jordan; thank you!

    This also explains something that has bothered me for a while, that some REIT's have a payout ratio of 200% or more. Thus, because the "earnings" hinge on depreciation, the payout ratio is also skewed.

    HOWEVER, what happens when the REIT sells a property? Don't they have to account for a big profit (sale price - depreciated price)? I would like you to expand on this paradox, please.

  • Report this Comment On October 09, 2013, at 5:16 PM, TMFValueMagnet wrote:

    neamakri - I'm glad you found this article helpful. REITs can be an accounting mess that goof up everything from ROE to payout ratios.

    When a REIT sells a property, the IRS recaptures the depreciation.

    Here's how that works: depreciation from straight-line depreciation is taxed at a 25% rate for everyone.

    Additional depreciation in excess of straight-line depreciation is taxed at ordinary tax rates. Because the real estate REITs hold is depreciated in a straight line, you won't see much additional depreciation, if any.

    Of course, REITs are in the business of real estate. They're always buying and selling. And because they're doing so many transactions, they can do 1031 exchanges to avoid recapture and complicating their unitholders' (shareholders') taxes. A 1031 exchange basically allows you to sell a property, buy another, and avoid paying back depreciation. Thus, REITs can delay paying back depreciation benefits forever. And if a "loan" never comes due, it really isn't a loan at all. Accountants may not like that explanation, but as a finance guy, that's how I see it. This is why FFO is a much better measure of profitability than net income.

    This is a great question and I'm really glad you asked it. I'll get in touch with a few IR people at the bigger REITs and hopefully get some historical breakouts that explain the tax consequences of holding the many REITs on the market. As someone who doesn't currently own a REIT, I can imagine that would be very interesting for people in a similar situation -- people who don't own a REIT but would like to know just how tax efficient REITs have been through their history.

    Stay tuned. If you click my profile you can "follow" me, and you should be able to see each article I publish.

  • Report this Comment On December 26, 2013, at 1:24 PM, EricTheRon13 wrote:

    This is a good article, as far as it goes. Property REITs are a good substitution for owning a share of actual commercial property, except for one thing--debt structuring. If you owned a commercial property (or a share in one), it most likely would be covered by a mortgage. If interest rates go up, or if there is a debt crisis like in 2008, your debt is not directly affected usually. But REITs use both bonds and short-term debt financing in addition to mortgages, and the short-term debt is immediately subject to both the lack of re-financing and even a possible immediate call during a debt crisis. And it can be quite hard to research exactly how exposed an individual REIT may be to such liquidity problems. And this dependence on bonds and short-term debt is only getting worse, since investors were burned on the asset-backed bonds (i.e. mortgage securities) during the last crisis.

    This is of course in addition to the risk you always have when investing in commercial properties, that a downturn will affect the businesses who lease your properties and cause you to have lease-losses from bankruptcies--then have vacancies just when no one is looking for a new location to lease. But in the case of property REITs this prospect represents the second half of a double-whammy which may take them down and out.

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