Property types within the REIT market
Because REITs are unique types of companies, their performance is not measured by the same standards as other companies. Like any other publicly traded company, a REIT is required to file its earnings statements quarterly. However, standard accounting practices, like depreciation and amortization, can distort the performance of real-estate holdings. Therefore, earnings often aren’t a good way to measure a REIT’s true performance.
A better way to do this is to look at cash flows generated from the company’s operations. Cash flows can be measured three ways:
- Funds from operations
- Adjusted funds from operations
- Return on equity
The preferred method of measurement is funds from operations (FFO).
Basically, FFO measures a REIT’s operating cash flow—the cash generated by a company’s assets. Operating cash flow is an effective measure of profitability because it adjusts for some of the performance-distorting accounting figures, thereby providing a more accurate picture of the amount of cash a company brings in from its operations. Because dividends are ultimately paid from this cash, FFO is an important consideration for an income investor.
Another measure of a REIT’s cash flow is adjusted funds from operations (AFFO).
AFFO is simply FFO minus capital expenditures. Capital expenditures refers to the cash a REIT uses to purchase additional properties for future income. AFFO helps an investor understand a REIT’s current profitability, and whether the REIT is investing in future success as well.
The third cash flow measurement is return on equity (ROE).
As you learned in the dividend stock analysis lesson, ROE measures how effectively a company can generate returns. For REITs, ROE is crucial to understanding the limits of its resources, including both the returns on its assets and the amount of leverage a REIT uses.
The table below summarizes the equity analysis criteria and the state that produces a green-, gray-, or red-colored box.
The single entry rule is to buy REITs or funds with above-average yields that meet criteria up to your allocation limits. As with other income investing entry rules, market timing is not a factor.
