Pricing REITs: FFO Multiple

One of the common tools that investors use to price a company is a pricing multiple. In simple terms, this is a ratio that links the company’s price to a financial measure that drives value, such as its earnings. A popular example is the price-to-earnings ratio, or P/E ratio. This ratio tells us how much investors are willing to pay for each dollar of a company’s earnings. By using this pricing multiple, we can compare one company to its peers, to the industry average, or to its own past performance. The beauty of this method is in its simplicity. The idea is that similar assets should be priced in a uniform way. If one asset seems mispriced compared to others, it might create an opportunity for profit—or serve as a warning sign to avoid buying something overpriced.

Why Traditional Earnings Don’t Work for REITs

Now, let’s move to REITs, or Real Estate Investment Trusts. These companies are a bit different from the usual businesses. Unlike other companies, REITs invest in properties, which include things like shopping centers, office buildings, and apartments. Since real estate is their main business, the traditional way of measuring earnings doesn’t quite work.

Here’s why: In the U.S., REITs must include depreciation in their earnings. Depreciation is an accounting rule that lowers the value of an asset over time, assuming it wears out or becomes less useful. The problem is, real estate usually increases in value over time, not decreases. On the other hand, in most other countries, REITs report asset revaluation profits. This is when they adjust the property value up or down based on the current market. This, too, can be misleading as it doesn’t reflect the real cash flow coming in.

To get around this issue, investors look at a different measure called Funds From Operations (FFO) and Adjusted Funds From Operations (AFFO). These are published in REITs’ financial reports and are much better indicators of the cash flow a REIT generates for its shareholders. FFO is calculated by taking the REIT’s revenues and substructing operating and financial expenses. But FFO still has a flaw: it doesn’t take into account the money spent to maintain the properties. This is where AFFO, or Adjusted Funds From Operations, comes in. AFFO subtracts the maintenance costs from FFO, giving a clearer picture of the cash flow available to shareholders.

Using FFO and AFFO Multiples to Price REITs

To price a REIT, we use the FFO and AFFO multiples. These are similar to the P/E ratio but use FFO or AFFO instead of earnings. The calculation is as follows:

FFO Multiple = Share Price / FFO per Share

AFFO Multiple = Share Price / AFFO per Share

Once we calculate these multiples, we can compare them to other REITs in the same sector, like office REITs, retail REITs, or residential REITs. We can also compare the multiples to the REIT’s own historical averages.

If the FFO or AFFO multiple is higher than that of other REITs in the same sector, or higher than the REIT’s past figures, it could mean the REIT is overpriced. Conversely, a lower multiple might indicate a bargain. However, pricing isn’t that simple. We need to dig deeper and understand why the multiple is higher or lower. Maybe the REIT owns better-quality properties than its peers. Or perhaps changes in interest rates have affected how much return investors demand. These factors can justify a higher or lower multiple.

Making a Smart Investment Decision

The FFO or AFFO multiples are just the starting point in evaluating a REIT. A high multiple isn’t automatically bad, and a low one isn’t automatically good. It’s crucial to dig deeper into the underlying factors that drive these multiples before making an investment decision. Here are some key questions and considerations to help guide your analysis:

• Asset Quality: Are the REIT’s assets of higher quality compared to its peers? High-quality assets, such as properties in prime locations or newer buildings with modern amenities, often command higher rents and have lower vacancy rates. Investors may be willing to pay a premium for a REIT with such assets, which can justify a higher FFO or AFFO multiple. On the other hand, if a REIT has older properties or assets in less desirable locations, a lower multiple might be appropriate.
• Market Demand: Is the REIT operating in a market with strong demand for real estate? The geographic focus of a REIT can significantly affect its valuation. For example, industrial REITs with properties near major transportation hubs may have strong demand due to the growth in e-commerce, while residential REITs in urban centers may benefit from population density and rental demand. A REIT positioned in high-demand markets is likely to generate stable and growing cash flows, which could support a higher multiple.
• Interest Rate Environment: How do changes in interest rates affect the REIT’s valuation? As discussed earlier, FFO multiples are inversely related to interest rates. If interest rates rise, the required yield increases, potentially driving multiples lower. It’s essential to consider how sensitive the REIT is to interest rate fluctuations, particularly for those with significant debt. A REIT with a high level of fixed-rate debt might be less affected by rising rates, which could influence its multiple compared to others.
• Growth Prospects: Does the REIT have a solid strategy for growth? Investors often pay higher multiples for REITs with promising growth prospects, such as strategic acquisitions, property developments, or expansion into new markets. Conversely, a REIT with stagnant or declining growth might trade at a lower multiple. Understanding the REIT’s management strategy, future investment plans, and the potential for rent increases or occupancy growth can give insight into whether its multiple is justified.
• Risk Factors: What risks might the REIT face that could affect its cash flow? Factors like property type, tenant quality, lease terms, and geographic concentration all influence the risk profile of a REIT. A diversified REIT with long-term leases to creditworthy tenants may be perceived as less risky, supporting a higher multiple. Conversely, a REIT with concentrated exposure to a single market or a tenant base in financially unstable industries might trade at a lower multiple due to higher perceived risk.

By considering these factors, investors gain a more complete picture of a REIT’s true value. This thorough analysis helps in assessing whether a high multiple is a reflection of quality and growth potential, or if a low multiple signals an overlooked opportunity. Ultimately, understanding the story behind the numbers allows investors to make more informed, strategic investment decisions.

Analyzing the Pricing of REIT ETFs

The same technique used for individual REITs can also be applied to REIT Exchange-Traded Funds (ETFs). A REIT ETF is a collection of various REITs, offering diversified exposure to the real estate market. To analyze the pricing of a REIT ETF, we look at its FFO or AFFO multiple, based on the combined financials of the REITs it holds. One effective way to assess whether the ETF is fairly priced is to compare its current multiple to its past multiples, allowing us to gauge how the ETF is valued compared to its historical figures. However, it’s important to note that the ETF’s multiple can be affected by the composition of the sectors of the REITs it holds. If the ETF’s holdings shift more towards sectors with higher multiples, like data centers or industrial properties, its overall multiple may increase. Understanding how these sector changes influence the ETF’s multiple over time can help investors make informed decisions about whether the ETF presents a good opportunity or if it’s overpriced.

Which FFO to Use

When analyzing REIT pricing, it’s usually best to use the trailing 12 months (TTM) FFO rather than just a single quarter’s FFO (annualized). Quarterly FFOs can vary due to seasonal factors, one-time events, or temporary market conditions. The TTM FFO provides a more stable and representative measure of the REIT’s performance, smoothing out short-term fluctuations and giving a clearer picture of its overall earning power.

Summary

Pricing Multiples:

• A common tool for valuing companies is a pricing multiple, which compares a company’s price to a key financial measure, like its earnings.
• The price-to-earnings (P/E) ratio is an example of a pricing multiple used to compare a company to its peers, industry averages, or its own historical figures.

Why Traditional Earnings Don’t Work for REITs:

• Traditional earnings measures like net income are not effective for REITs because they include depreciation in the U.S. and asset revaluation profits in other countries.
• For REITs, better measures of value are Funds From Operations (FFO) and Adjusted Funds From Operations (AFFO), which give a clearer picture of the cash flow available to shareholders.

FFO and AFFO Multiples:

• FFO and AFFO multiples are used to price REITs and can be compared to other REITs in the same sector, industry averages, or the REIT’s historical multiples.
• A higher multiple could indicate that the REIT might be overpriced, while a lower multiple might suggest it is undervalued. 
• When comparing FFO multiples, it’s crucial to identify if the variance in the multiple is due to shifts in the real risk-free rate or changes in the REIT’s risk profile or asset quality.

Analyzing REIT ETFs:

• REIT ETFs, which hold a collection of various REITs, can also be priced using FFO and AFFO multiples.
• When analyzing a REIT ETF, it is essential to compare its current multiple to past figures to assess its valuation.
• The ETF’s multiple can be influenced by the composition of the sectors it holds. A shift toward sectors with higher multiples can raise the ETF’s overall multiple.

A bit more: The Connection Between FFO Multiples and Interest Rates

FFO multiples are closely tied to the interest rate environment because they are essentially the inverse of the yield that investors expect from a REIT. This yield consists of two parts: the risk-free rate (like the yield on government bonds) and the risk premium, which is the extra return investors demand for taking on the additional risk of investing in assets such as equities or real estate. When the risk-free rate decreases, the overall yield that investors expect from REITs also falls. Since the multiple is the inverse of the yield, a lower yield leads to a higher multiple.

For example, if the risk-free rate is 3% and investors require a 7% risk premium for real estate companies, they will expect a total yield of 10%. In this case, the FFO multiple would be 10 (1 divided by 10%). Now, if interest rates rise by 2%, making the risk-free rate 5%, investors would require a 12% total yield (5% risk-free rate + 7% risk premium). This change would cause the FFO multiple to drop to about 8.3 (1 divided by 12%). This is how changes in the interest rate environment impact REIT pricing: as interest rates go up, the risk-free rate increases, leading to a higher required yield and a lower multiple. Conversely, when rates drop, the required yield decreases, pushing the multiple higher.

It’s important to note that both yield and multiples are in real terms because earnings or cash flow are expected to grow with inflation. Therefore, the appropriate risk-free rate to use is the real government bond yield. When comparing current FFO multiples to past figures, consider whether changes in the multiple are due to shifts in the real risk-free rate.

Connection Between FFO Multiples and Interest Rates:

• FFO multiples are inversely related to the yield investors expect from REITs, which consists of the risk-free rate (e.g., government bonds) and the risk premium.
• When the risk-free rate decreases, the expected yield from REITs drops, leading to a higher FFO multiple. Conversely, when interest rates rise, the required yield increases, causing the FFO multiple to decrease.
• Both yields and multiples are in real terms, considering that earnings or cash flow are expected to grow with inflation. Thus, the real government bond yield should be used as the risk-free rate.

A Real-World Example: Quick Multiple Analysis

Following are the Market Capitalization and FFO Multiples of REITs in the industrial and residential sectors:

• Let’s take a look at two REITs: Prologis and Mid-America Apartment Communities. Prologis, an industrial REIT, has an FFO multiple of 21.1, while Mid-America Apartment Communities, a residential REIT, has a multiple of 16.5. To assess whether these REITs are fairly priced, we first compare their multiples to the averages in their respective sectors.
• Prologis’s multiple is slightly above the industrial REIT sector’s median of 20.8 and very close to the average of 21.2. This suggests that Prologis is valued in line with market expectations for industrial properties, reflecting strong growth prospects and demand for logistics and warehouse assets. The close proximity of the average and median multiples in this sector indicates a relatively balanced distribution, where most industrial REITs are valued similarly by the market.
• On the other hand, Mid-America’s multiple of 16.5 is lower than the residential REIT sector’s average of 19.6 and median of 18.3. This lower valuation could imply that the market views Mid-America as having more risks or less growth potential compared to its peers. However, it might also suggest an undervalued opportunity if its fundamentals remain strong. Interestingly, around 25% of residential REITs trade at a multiple below that of Mid-America, indicating that while it is priced on the lower side of the sector, there are still a number of residential REITs valued even more conservatively. This distribution highlights that while some residential REITs command a premium, others are viewed more cautiously, potentially due to various factors like market conditions, asset quality, or growth outlook.
• Conclusion: In both sectors, the relationship between the average and median multiples provides insight into market valuations. For industrial REITs, the average and median multiples are very close, suggesting that most REITs in this sector are similarly valued by investors. In contrast, the residential sector shows a wider gap between the average and median, indicating more variation in valuations. This variance suggests that some residential REITs command higher multiples due to perceived quality or growth prospects, while others, like Mid-America, are priced more conservatively.

Disclaimer: The information provided in this post is for informational purposes only and reflects my personal opinions. It should not be considered as professional financial, legal, or investment advice. Please consult with a professional before making any investment decisions. I am not responsible for any actions taken based on this information. For more details, please refer to our full disclaimer.