1 Thing to Remember About Realty Income and American Realty

Looking to invest in companies with massive dividends? It turns out there are two numbers that grab all the investing headlines that may actually be lying to you.

American Realty Capital Properties (VER) and Realty Income (O -0.01%) each offer great dividends. But a quick glance at the earnings per share and corresponding price to earnings ratio -- the oft-cited means to check the value of a company -- presents a rather troubling reality:

Source: Company Investor Relations and Yahoo! Finance.

Realty Income looks monumentally expensive, with its price to earnings hovering near 50 -- which is more than many of the better known and supposedly "expensive" technology companies -- and American Realty Capital Properties can't even be valued because it keeps reporting losses.

But it turns out, a simple glance at the numbers available on many investing websites doesn't actually provide any clue as to what the relative valuation of these companies is.

Source: www.taxrebate.org.uk.

Beyond the first glance
It's important to remember both of these companies are real estate investment trusts -- REITs -- owning properties that are in turn leased out to different companies across a variety of industries. As a result, Realty Income has $10.5 billion worth of real estate sitting on its balance sheet, and American Realty Capital Properties is even larger, with $17.3 billion in real estate investments.

But the IRS requires that when these companies do their accounting to report their income, one of the expenses that must be included when calculating their bottom lines is depreciation. This is the "annual allowance for the wear and tear, deterioration, or obsolescence of the property." 

And as you might suspect, for companies with such enormous real estate positions, this cost is massive. Through the first three months of the year, ARCP saw $151 million in depreciation and amortization costs, and Realty Income's stood at $90 million.

Yet the thing about this depreciation expense is there's no cash that actually flowed out of the businesses; it's simply just an accounting mechanism. As a result, it's critical to consider not the net income, but instead the funds from operations (FFO), which makes adjustments by adding back depreciation and other costs to provide a better glimpse into the actual ability of the REITs to earn cash (which is, of course, what investors receive).

The true number to watch
While FFO isn't often discussed, this is the number to monitor when attempting to gauge how a REIT is performing. And when you also take a look at adjusted fund from operations (AFFO) -- which factors out $222 million of one-time acquisition costs for American Realty Capital Properties as well as other amortization adjustments -- you can see just how radically things change:

Source: Company Investor Relations & author calculations.

The relative price or value shouldn't be the only consideration when making an investment, but it is undoubtedly one that must be considered. But in the case of REITs, it turns out the most commonly cited measure of a company's value doesn't really tell you anything at all.