Evaluating REITs and their Intrinsic Value

Real Estate Investment Trusts (REITs) aren’t your typical stocks. While most companies live or die by profits and growth, REITs are like landlords. Their worth hinges on rental income and property values. I will try to cut through the jargon, and break down the fundamentals of what’s important when analysing REITs in zero fluff language, so that you can also do this for yourselves!.

(I’ve also included a free tool at the end to crunch these numbers for you. No spreadsheets needed.)

We will also apply these techniques to assess three popular REITs: Realty Income (O), Simon Property Group (SPG), and Prologis (PLD).

REITs vs Regular Stocks: The Landlord Test

REITs (Realty Income, Prologis):

• Legally required to pay 90% of income as dividends.
• Growth? Think tortoise, not hare. Your focus: Can they keep tenants paying?

Regular stocks (Apple, Tesla):

• You care about innovation, profits, and CEO charisma.
• Metrics like P/E ratios and EPS matter.

Why this matters: REITs ignore property depreciation in their cash flow math. Why? because buildings lose value on paper but often gain real-world value.

Here is a quote by Investopedia.com

“Average annual returns in long-term real estate investing vary by the area of concentration in the sector. Average 20-year returns in the commercial real estate slightly outperform the S&P 500 Index, running at around 9.5%. Residential and diversified real estate investments do a bit better, averaging 10.6%. Real estate investment trusts (REITS) perform best, with an average annual return of 11.8%.”

4 Metrics That Actually Matter for REITs

1. Adjusted Funds from Operations (AFFO)

Think of it as: The cash left over after fixing leaky roofs and signing new tenants.

AFFO is an important way to measure a REITs ability to generate cash flow, while adjusting for capital expenditures (CapEx) and leasing costs. It excludes non-cash generating items that depreciate (which within REITs is not very important in valuing them)

• Formula:
• AFFO = FFO - (Property Repairs (Capital Expenditures) + Lease Costs (Leasing Costs)
• Example:
  A REIT earns 10M in FFO but spends 10M in FFO but spends 3M on upgrades/fixes. AFFO = $7M →
  A REIT’s FFO is 10M.They spend 10M.They spend 3M fixing elevators and signing leases. AFFO = $7M → That’s the real cash for dividends.
• Red flag: If AFFO barely covers dividends, brace for cuts.

2. Funds from Operations (FFO)

What it tells you: How much cash the properties actually generate.

FFO is a critical metric to measure cash flow from a REITs real estate operations. It adds back depreciation and amortisation  (incurred by an intangible asset by obtaining expenses that arise from a decline in value as a result of use or the passage of time), as these are non-cash expenses that do not impact cash flow.

• Formula:
  FFO = Net Income + Depreciation + Amortization
• Example:
  A REIT reports 5M net income but “lost” 5M net income but “lost” 2M to depreciation (a paper loss). FFO = $7M → That’s the real cash flow.

3. Net Asset Value (NAV)

What it tells you: What the REIT’s properties are worth, minus debt.

NAV represents the total value of a REITs real estate holdings minus its liabilities. This is essential for assessing whether a stock is undervalued or overvalued.

• Formula:
• NAV per share = (Property Value(Total Real Estate Assets)- Debt(Liabilities) / Shares
• Example:
  A REIT owns $100 million in properties but has $40 million in liabilities, with 10 million shares outstanding. We can determine the NAV per share to be:
  NAV = ($100M – $40M) / 10M = $6/share

4. Dividend Yield

What it tells you: Income potential—but don’t get greedy, high yields can be traps.

As income generation is a core feature of REITs, dividend yield is a critical metric. It measures the annual dividend payout relative to the stock price.

• Formula:
  Dividend Yield = (Annual Dividend per Share/ Stock Price per Share) x 100
• Example:
  If a REIT pays $2 in annual dividends and the stock trades at $20, the dividend yield would be:
  Dividend Yield = ($2 / $20) × 100 = 10%
• Warning: Yields above 8% often mean tenants are fleeing.

How to Calculate What a REIT is Really Worth

Assessing intrinsic value helps investors determine if a REIT stocks price is underpriced or overpriced. Key methods include:

Method 1: Price-to-AFFO (P/AFFO)

The P/AFFO ratio compares stock price to AFFO per share. A high ratio suggests the stock is overpriced relative to its cash flow.

• What it is: Like a P/E ratio for landlords. Lower = cheaper.
• Example:
  Stock price = 100 ∣ AFFO per share = 100 ∣ AFFO per share = 8 → P/AFFO = 12.5.

Method 2: Discounted Cash Flow (DCF)

DCF involves projecting future AFFO and discounting it to the present value using a chosen discount rate.

Steps:

1. Guess AFFO for 5-10 years (use past growth as a guide).
2. Calculate a “terminal value” (value beyond the projection period).
3. Discount the projected AFFO and terminal value to present value. (use 8-10% as your rate).

Real-life example:

• If a REIT’s DCF value is 1B but trades at 1B but trades at 700M, it’s a bargain.

Real-Life Evaluation of Popular REITs

Let’s try using these figures to calculate and examine how they fare against each other with some popular REITs: Realty Income (O), Simon Property Group (SPG), and Prologis (PLD).

Price-to-AFFO (P/AFFO) Calculations

• Realty Income (O):
  P/AFFO = $63.25 / $2.56 = 24.7
• Simon Property Group (SPG):
  P/AFFO = $117.80 / $9.50 = 12.4
• Prologis (PLD):
  P/AFFO = $130.20 / $4.65 = 28.0

The Takeaway After Examining the Comparison:

• Realty Income (O): Looks cheap vs. NAV (63vs.63vs.114), but P/AFFO of 24.7 screams “overpriced cash flow.” and is overpriced relative to its cash flow potential. Tread carefully.
• Simon Property (SPG): Low P/AFFO (12.4) + 6.1% yield. NAV close to its stock price suggest it might be fairly priced, offering a balance of income and value.
• Prologis (PLD): Warehouses are hot, but P/AFFO of 28 means you’re paying for hype and are therefore paying for a premium with limited potential upside.

3 Mistakes I’ve Made (So You Don’t Have To)

Forgetting taxes: REIT dividends are taxed like income, not qualified dividends. A 6% yield might feel like 4% after taxes.

Ignoring debt: A REIT with 1B in properties but 1B in properties but 800M in loans is a ticking bomb. Stick to debt-to-asset ratios below 40%.

Chasing yield: I bought a REIT with a 12% yield once. Tenants fled—dividend got slashed 6 months later.

Feel free to check out the tools I made for helping you to evaluate the intrinsic value of stocks