Note: This is part four of an eight-part series on Realty Income. Previous articles have covered its history, its business model, and the industry as a whole.

The best way to find out how a company makes its money, how much it makes, and how much debt it has is to look at its income statement and balance sheet. In the case of Realty Income (NYSE: O), the biggest retail real-estate investment trust in the industry, it's extra important to know how to read the information on these documents: Some of the metrics investors use to evaluate other types of companies don't necessarily apply to REITs.

How does Realty Income make its money?
It's tough to imagine a company with a more straightforward income stream than Realty Income's. The company simply acquires properties and leases them to tenants -- there are no substantial revenue-generating activities other than that.

In the most recent quarter, Realty Income brought in approximately $247 million in revenue, and the vast majority of this (95%) was rental income from its portfolio of properties. Most of the remainder is from tenant reimbursements for various property improvements and expenses the company has already paid for.

The numbers to pay attention to -- and the ones to ignore
When evaluating most companies, net income is a common (and valid) way to assess how much profit is being generated and how easily the company can cover debts and pay dividends. However, when evaluating REITs, net income is not a particularly useful metric.

When net income is calculated, the depreciation of the company's real estate holdings is deducted as a business expense. This can be a substantial number -- it came to $98 million for Realty Income in the recent quarter, which represents almost 40% of the company's revenue. Thus Realty Income's net income (and therefore its earnings per share) is a metric you can ignore.

What you should pay attention to is funds from operations, or FFO. This includes the company's net income as calculated on its income statement, adds the depreciation expenses back in, deducts any gains from the sale of investment properties, and makes a few other adjustments. As you can see from the chart below, FFO paints a different picture of Realty Income's profitability than its net income, and it better explains how the company can afford to pay out more than $130 million in quarterly dividends.

Adjustment Amount (Q1 2015)
Net Income $60.5 million
Depreciation/amortization $98 million
Depreciation (furniture, fixtures, equipment) ($185,000)
Provisions for impairment $2.1 million
Gain on sale of properties ($7.2 million)
Other FFO adjustments ($315,000)
Funds from operations (FFO) $152.9 million

However, for the most accurate measure of Realty Income's ability to pay dividends, consider its adjusted FFO, or AFFO. Basically, this takes the company's FFO and adjusts it to compensate for certain recurring capital expenditures. It's important to note that the methods used to calculate AFFO can vary from one company to the next, so AFFO alone won't give you an apples-to-apples comparison of two REITs. Having said that, here's how Realty Income calculates its AFFO.

Adjustment Amount (Q1 2015)
FFO $152.9 million
Amortization of share-based compensation $2.6 million
Amortization of deferred financing costs $1.3 million
Amortization of net mortgage premiums ($1.9 million)
Gain on early extinguishment of mortgage debt ($78,000)
Loss on interest rate swaps $1.1 million
Capitalized leasing costs and commissions ($313,000)
Capitalized building improvements ($1 million)
Straight-line rent ($4.2 million)
Amortization of above- and below-market leases $1.7 million
Other adjustments $74,000
Adjusted FFO $152.1 million

Another metric that isn't very useful in the case of Realty Income (or any REIT, for that matter) is book value. On Realty Income's balance sheet, the company's assets are computed by taking the cost of its properties (the price the company paid) and subtracting the accumulated depreciation "expense" that I referred to earlier. Then the company's liabilities are deducted, and we arrive at "stockholders' equity," or book value.

The problem with this when analyzing a company like Realty Income is that nearly all of its assets are in the form of real estate, which tends to increase in value over time.

Net asset value, or NAV, is a better measurement than book value, but it can be tough to calculate, as it involves a subjective valuation of the company's individual properties. However, with REITs, the value of the properties and the market capitalization of the company should be pretty close. In Realty Income's case, its market cap of $10.5 billion should be approximately equal to the market value of the company's properties minus its liabilities -- far greater than the $5.7 billion in equity you see on the balance sheet.

Responsible use of debt makes for a healthy balance sheet
Like most REITs, Realty Income uses debt to help fund its operations, but it does so in a responsible and effective manner.

The company has a total of $5.4 billion in debt, most of which is in the form of notes payable (bonds) with staggered maturities ranging from 2015 all the way to 2035. The vast majority (92%) of its debt is fixed-rate, and it pays an average interest rate of 4.48%.

Now, I referred to Realty Income's use of debt as responsible and effective, so let me explain. As a percentage of the total value of its properties, debt represents just 29.2% (31.6% if you include preferred stock). As of the most recent quarter, the company's revenue is 3.9 times the cost of its debt payments. What this means is that if the real estate market crashed again, or if several major tenants went bankrupt, Realty Income would still be "in the black."

Because the company's debt is at a relatively low interest rate, it is an effective way to boost profitability. During the 2014 fiscal year, Realty income acquired or developed 506 new properties at an average capitalization rate (first-year operating income divided by the property's cost) of 7.1%. Well, if it can borrow money at 4.48% to acquire properties thanks to its investment-grade credit rating, the "spread" between those rates is Realty Income's profit.

One struggle for REITs is finding a balance between responsible use of leverage and using just enough of it to produce decent returns. Given Realty Income's 17.4% average total return over the past two decades, I'd say the company has done just that.

The takeaway
Now that you know how Realty Income makes its money, as well as the proper metrics to evaluate the company, you have a better idea of where it stands and how to evaluate its future performance and valuation. Realty Income has a solid and predictable income stream, a strong balance sheet, and more than enough money to keep up its dividend -- and there's no reason to expect anything different for the foreseeable future.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.