Real estate investment trusts, or REITs, have become a popular investment choice in recent years. Many investors are drawn to their stability and the consistent income they provide. But how do you know how much to pay for a REIT? In this guide, we will walk you through the steps of how to value a REIT so that you can make an informed decision about whether or not it is the right investment for you.
What is a REIT, and what are the benefits of owning one?
Real estate investment trusts are companies that own or finance income-producing real estate. REITs can be publicly traded on major exchanges, or they can be private. The benefits of owning a REIT include the following:
- Consistent income: Most REITs pay out the majority of their earnings to shareholders in the form of dividends, so you can expect to receive regular payments from your investment.
- Stable values: REITs tend to be less volatile than other assets, which can provide a source of income that is relatively consistent.
- Potential for capital appreciation: While REITs are often thought of as being more stable than other investments, they can still offer the potential for capital appreciation if the underlying real estate assets increase in value.
- Diversification: By investing in a REIT, you can add another asset class to your portfolio, which can help to diversify your holdings.
Now that we've answered the question, "What is a REIT?" let's move on to how you can value one.
How do you value a REIT, and what factors should you consider?
Valuing a REIT is similar to valuing any other publicly traded company, with a few differences. The most common methods are the following.
Net Asset Value Valuation Method
The net asset value or NAV valuation method is the most straightforward way to value a REIT. It simply takes the market value of all the assets owned by the REIT and subtracts all the liabilities. This gives you the company's net asset value, which is then divided by the number of outstanding shares to give you the NAV per share.
For example, let's say that a REIT owns $100 million in real estate assets and has $50 million in liabilities. The net asset value would be $100 million – $50 million or $50 million. If the REIT has 20 million shares outstanding, the NAV per share would be $50 million / 20 million, or $2.5 per share.
The key part of the calculation is calculating the NAV of the REIT. Typically this is done by taking the REIT's operating income and dividing this number by a capitalization rate. A different cap rate might be used depending on the quality of the REIT's real estate assets and the type of asset (residential, office, self-storage, etc.).
The easiest way to get the cap rate to use is to google the type of real estate followed by the word "cap rate report." For example, if you are looking at Boston Properties, a U.S. Office-focused REIT. All you need to do is Google "Office cap rate report U.S." A report like this will provide you with the cap rate information you need to perform this calculation.
Something you can do to make this process faster when looking at many REITs is to develop a spreadsheet like this where you use a tool like Wisesheets to get the operating income of any REIT and then simply divide that value by the CAP rate you want to use.
However, the NAV valuation method has a few drawbacks. First, it does not consider that real estate assets are often illiquid and may be difficult to sell at their stated market value. Second, it does not consider the management fees and other expenses associated with owning and operating real estate assets.
The Funds From Operations Valuation Method
A more commonly used method to value a REIT is the funds from operations, or FFO, valuation method. This method starts with the company's net income and adds back any non-cash expenses, such as depreciation and amortization. The resulting number is then divided by the number of shares outstanding to give you the FFO per share.
For example, let's say that a REIT has a net income of $30 million and depreciation and amortization expenses of $20 million. The FFO would be $30 million + $20 million, or $50 million. If the REIT has 20 million shares outstanding, the FFO per share would be $50 million / 20 million, or $2.5 per share.
The best way to find a REIT's FFO is to look in the quarterly or annual report, where this metric is always reported and highlighted as a benchmark.
The FFO valuation method is a more accurate way to value a REIT because it takes into account the non-cash expenses associated with owning and operating real estate assets. However, it still does not consider the fact that real estate assets are often illiquid and may be difficult to sell at their stated market value.
The Price to Earnings Valuation Method
Another common method to value a REIT is the price to earnings, or P/E, valuation method. This method simply takes the stock price of the REIT and divides it by the FFO per share. For example, let's say that a REIT has a stock price of $30 per share and FFO per share of $10. The P/E method indicates that the price per share would be $3 ($30 per share / $10 per share).
The P/E valuation method is a commonly used method to value a REIT because it considers both the company's earnings and the stock price. However, it does not consider the fact that real estate assets are often illiquid and may be difficult to sell at their stated market value.
The Discounted Cash Flow Valuation Method
The discounted cash flow or DCF valuation method is one the most accurate ways to value a REIT. This method can be made to take into account the fact that real estate assets are often illiquid and may be difficult to sell at their stated market value, depending on the assumptions.
The DCF valuation method starts with the cash flow from operations of the company. This is then adjusted for any non-cash expenses, such as depreciation and amortization. The resulting number is free cash flow.
Based on various assumptions, which can be both historical and forward-looking, the cash flow of the REIT is projected several years into the future, and then a discount is used to bring the cash flows back to the present. This is done because cash in the future is worth less than cash today. The discount rate that is used is typically the weighted average cost of capital, or WACC, of the company.
If you would like to automatically get the stock data you need for the DCF, check out this article on a free stock DCF template you can download.
Dividend discount method
The Gordon Growth Model is another common method to value a REIT. This model assumes that there is consistent growth in the REIT dividend payments and uses the present value of the dividends expected to determine the value of the REIT.
The formula for this method is as follows:
Present value of the REIT = (annual dividend payment)/(discount rate – growth rate).
The discount rate is similar to the cap rate, which is the rate of return you expect from your investment.
The growth rate is the annual expected growth rate that will take place in perpetuity.
Using Wiseesheets, you can calculate the value of a REIT very easily in this way by setting up your spreadsheet in this way where all you need to do is enter the discount rate and expected growth rate, and the value of the REIT will be automatically calculated, for you.
The Gordon Growth Model is a more simplified method to value a REIT and does not take into account appreciation in the underlying real estate assets.
Comparable companies analysis method
The comparable companies analysis or CCA valuation method is another common method to value a REIT. This method looks at other companies in the same industry and compares their financial ratios to the REIT being valued. For example, if a list of REITs that hold similar real estate asset classes shows that there is a REIT with better metrics such as ROIC, ROE, debt to EBITDA, etc., and is traded at a lower price than its peers, this can be an indicator the REIT is undervalued.
Using Wisesheets, you can create lists of REITs and quickly compare them across the metrics that most matter to you.
The downside of this method is that it doesn't take into account the factors that could be driving the lower stock price, such as a bad management team, low-quality real estate holdings, etc.
While there are several different methods to value a REIT, the most important thing for individual investors to remember is that real estate assets are often illiquid and may be difficult to sell at their stated market value. This fact should be taken into account when using any of the valuation methods.
What are some common mistakes people make when valuing a REIT, and how can you avoid them?
Some common mistakes people make when valuing a REIT are:
- Not taking into account the fact that real estate assets are often illiquid and may be difficult to sell at their stated market value
- Using the wrong valuation method for the type of REIT being valued
- Not understanding the limitations of the valuation methods
- Using unreasonable cap rate or discount rate assumptions
- Overestimating growth in the real estate assets and REITs income.
To avoid these mistakes, individual investors should:
- Research different valuation methods and understand how to use them correctly
- Be aware of the limitations of each valuation method
- Use multiple valuation methods to get a more accurate picture of the value of a REIT.
- Sanity check your assumptions with other successful investors
How do you know whether a particular REIT is undervalued or overvalued, and what should you do if it is the latter?
The best way to know whether a REIT is undervalued or overvalued is to use multiple valuation methods and compare the results. If the results from one method are significantly different from the others, it may be an indication that the REIT is either undervalued or overvalued. In this case, it is important to do additional research to determine which valuation method is most accurate.
If a REIT is overvalued, individual investors should consider selling their shares. Overvalued REITs are more likely to experience a price drop in the future, so selling now can help investors avoid losses. On the other hand, if a REIT is undervalued, investors may want to consider buying shares. Undervalued REITs have the potential to generate good returns if their stock prices and or dividend payments rise in the future.
What are some other things to keep in mind when investing in REITs?
When investing in REITs, it is important to keep in mind that real estate assets are often illiquid and may be difficult to sell at their stated market value. This fact should be taken into account when using any of the valuation methods.
In addition, REITs are subject to changes in economic conditions, so investors should monitor the market carefully and be prepared to sell their shares if the market turns against them. Finally, it is important to diversify one's portfolio by investing in a variety of different types of REITs. This will help to mitigate the risk of losses if one particular type of REIT underperforms.
By following these tips, individual investors can become more informed and make better decisions when investing in REITs.
In summary, how to value a REIT is an important question for individual investors to consider before making any investment decisions. There are several different methods that can be used to value a REIT, but it is important to understand the limitations of each method. In addition, using multiple valuation methods can help investors get a more accurate picture of the value of a REIT. Finally, if a REIT is overvalued, investors should consider selling their shares, and if it is undervalued, they may want to buy shares.
Do you have any questions or comments about how to value a REIT? Let us know in the comments below.