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When you analyze the recent result of most companies, you’ll probably look at metrics such as net income or earnings per share (EPS). And there’s a good reason for this.
In most cases, a company’s earnings tell you how fast its profits are growing. Earnings also affect how much money is available to pay dividends, buy back shares, or reinvest in the business.
But traditional methods of calculating earnings don’t translate well to real estate investment trusts (REITs). A far better metric to use is funds from operations (FFO). Let's look at
- why EPS and net income aren’t accurate for real estate businesses,
- why FFO does the job better, and
- a real-world example of how it works.
Why net income and EPS are misleading metrics for REIT investors
Traditional ways of expressing "earnings" don’t translate well to REITs. The same is true of other businesses with substantial real estate assets. It's because of a simple tax deduction known as depreciation.
Here’s depreciation in a nutshell: If you buy an investment property, you can deduct the cost of the building (but not the land) over a certain number of years. 27.5 years for residential properties and 39 years for nonresidential properties.
In other words, if you spend $200,000 to acquire a rental condo, you can deduct $7,273 every year for the next 27.5 years. If your rental income after expenses for the property in a given year is $12,000, you can use a $7,273 depreciation expense to lower your rental income to just $4,727 for tax purposes.
This is a big advantage of investing in real estate. Wouldn’t everyone rather pay taxes on less than $5,000 of income as opposed to $12,000? The depreciation deduction allows real estate investors to keep more of their profits.
However, it makes your stated profit misleading. In this case, you didn’t really earn $4,727 for the year. Your profit was $12,000 and the depreciation deduction made your profits look deceptively low.
The same concept applies to REITs, only on a larger scale. REITs generally have massive depreciation "expenses" that reduce their net income. The problem is that depreciation is reflected in a REIT’s net income as an expense -- even though it doesn't cost anything. So a REIT's net income and earnings per share don’t give an accurate picture of the company’s profits.
Also, it’s worth mentioning that all companies that own real estate for business purposes can use the depreciation deduction. But a REIT’s primary business is owning real estate. That's why depreciation meaningfully distorts REIT earnings.
How funds from operations (FFO) is determined
The biggest adjustment FFO makes to a company’s net income is adding back the depreciation expense. After all, this isn’t an actual business expense, so it shouldn’t be reflected in any useful profitability metric. FFO also makes a few smaller adjustments, such as subtracting preferred dividends and distributions. But depreciation is typically the largest change by far.
To give you an idea of how this works, here’s the first-quarter 2019 FFO calculation for leading residential REIT Equity Residential (NYSE: EQR).
|Net income||$107.69 million|
|Depreciation (net)||$203.05 million|
|Net gain on sale of real estate||$0.02 million|
|Total FFO||$310.76 million|
As you can see, depreciation makes a big difference. Equity Residential carries roughly $20.7 billion in depreciable property on its balance sheet. Even if only a small fraction of this can be depreciated each year, it’s still a large sum of money. In Equity Residential’s case, it shows that the company’s actual profit for the quarter was nearly triple the "net income."
Variations of FFO
Going a step further, many REITs calculate one or more company-specific FFO measurements. The three most common are adjusted FFO, core FFO, and normalized FFO.
One important thing to know is that there aren’t universal ways to calculate these. In other words, the method one company uses to calculate adjusted FFO may be different from the method another REIT uses (although they're generally quite similar). Some use just one additional metric, some use more, and some just report the traditional FFO calculation.
These are designed to give the best possible picture of a REIT’s ongoing profitability. They may adjust for one-time items or unusual expenses.
Let’s look at how this may work. We'll use Equity Residential again. The company’s quarterly report shows FFO as well as normalized FFO, mainly to adjust for one-time expenses. In the first quarter of 2019, here’s how Equity Residential’s normalized FFO was calculated:
|Write-off of pursuit costs||$1.45 million|
|Non-operating asset losses||$0.23 million|
|Other miscellaneous items||$1.58 million|
|Normalized FFO||$314.01 million|
Don't worry if you don’t completely understand what all of these line items mean -- that’s not the point. All you really need to understand is that these are unique expenses the first quarter of 2019. They aren’t expected to have an ongoing effect on profitability. In other words, if this had been a quarter with only "normal" income and expenditures, this is what the company would have made.
Using FFO to make investment decisions
As a REIT investor, it’s a good idea to ignore net income, EPS, and any metrics based on those figures like the price-to-earnings ratio. Consider FFO the REIT version of "earnings" and use it in your analysis accordingly.
When comparing the valuation of REITs, you may want to use the price-to-FFO (P/FFO) ratio to make comparisons and decide if a REIT is cheap or expensive. However, like any other investment metric, FFO is best used in conjunction with other metrics such as growth rates, dividend history, and debt ratios. Together, these measures form a well-rounded picture of a REIT’s valuation and investment merits.
Unfair Advantages: How Real Estate Became a Billionaire Factory
You probably know that real estate has long been the playground for the rich and well connected, and that according to recently published data it’s also been the best performing investment in modern history. And with a set of unfair advantages that are completely unheard of with other investments, it’s no surprise why.
But those barriers have come crashing down - and now it’s possible to build REAL wealth through real estate at a fraction of what it used to cost, meaning the unfair advantages are now available to individuals like you.
To get started, we’ve assembled a comprehensive guide that outlines everything you need to know about investing in real estate - and have made it available for FREE today. Simply click here to learn more and access your complimentary copy.