If you invest in real estate investment trusts (REITs), or are thinking about starting, one of the smartest things you can do is to take the time to learn how these companies work. With that in mind, here are 10 important terms all REIT investors should know before they start the search for their first REIT. Not all of these terms are REIT-specific, but they are highly relevant to the industry and to people who invest in it.
1. Funds from operations (FFO)
This is perhaps the most important term you need to know to be able to properly evaluate REITs. Most other stocks are judged based on "earnings" or net income, and ratios based on earnings, such as the price-to-earnings multiple. However, net income doesn't accurately reflect a REIT's profits because of a real estate-specific accounting metric known as depreciation. In a nutshell, the REIT version of earnings is "funds from operations" (FFO), so you should consider it as such when reading a REIT's financial results.
2. Adjusted funds from operations (AFFO)
Going a step further, most REITs emphasize adjusted or normalized FFO figures in their reporting. Simply put, this is a company-specific way of expressing FFO in a way that's most relevant to shareholders and analysts. Keep in mind, however, that this is not a standardized accounting metric, and its calculation can be slightly different between companies.
3. Capitalization rate (cap rate)
This is the net operating income generated by a property, relative to its purchase price. A property that costs $1 million and generates $60,000 in net operating income would have a cap rate of 6%. When evaluating properties to buy, an REIT looks for the highest cap rates available for the desired level of risk the REIT's management is comfortable taking on.
4. Funds available for distribution (FAD)
This is similar to FFO or AFFO, but subtracts recurring real estate expenditures and some other items to express how much money is available to pay out as dividends.
5. Cost of capital
REITs have two basic ways to finance the acquisition of new properties -- issuing equity, or taking on debt. The cost of capital refers to the dividend rate and expected growth of issued stock, or to the interest expense incurred on debt. Lower costs of capital generally translate to more favorable environments for acquisitions. As an example, a low cost of capital allowed retail REIT Realty Income Corp. to roughly double its initial acquisition goal for 2016.
Also known as net operating income (NOI), EBITDA is a common financial metric, and stands for "earnings before interest, taxes, depreciation, and amortization." In evaluating REITs, the debt-to-EBITDA ratio is often used for assessing a company's debt level.
7. Equity REIT
This refers to a real estate investment trust whose primary business is owning and renting properties. This is as opposed to a mortgage REIT, which is a company that invests in mortgages and/or mortgage-backed securities. A hybrid REIT invests in a combination of properties and mortgages.
Simply put, leverage refers to debt. Specifically, REIT leverage is often expressed as either a percentage of total capitalization or a percentage of equity capitalization. For example, if a REIT reports leverage of 30% of total capitalization, this means that 30% of the REIT's total capitalization is made up of debt, with the other 70% made up of the market value of its equity capital.
9. Net asset value (NAV)
This refers to the total market value of all of a company's assets. For a REIT, this means the market value of its properties, plus the value of any other assets it owns. Admittedly, this is a somewhat subjective metric, because there are several ways to assess the value of the same property.
10. Total return
REITs are "total return" investments, which means that their goal is to produce a combination of income and share-price growth. Total return refers to the combination of the two, and is generally expressed on an annualized basis. For example, a stock that pays a 4% dividend yield and rises in price by 6% in a year would have generated a total return of 10% for that year.