For those who understand the unique advantages of REIT investing, the question of which REITs to own requires careful consideration. There are many ways to compare REITs that investors can use to populate their portfolios. One classic method uses the metrics that determine Economic Value Added (EVA), which expresses a REIT’s true economic profit. You can think of it as the value a company generates from the funds invested in it.
EVA is best suited for companies like REITs, which are asset-rich and rely on invested capital. The challenge in evaluating EVA is to remove the skewing effect of depreciation. At its simplest, EVA is equal to the Return on Invested Capital (ROIC) minus the Weighted Average Cost of Capital (WACC).
Let’s look at these two factors from a REIT perspective. That perspective includes the fact that REITs don’t pay taxes so that their Net Operating Profit After Taxes (NOPAT) equals their Net Operating Profit (NOP) except for the operating taxes already included in Net Operating Income (NOI).
In addition, we should assume that Invested Capital (IC) refers to the capital invested in operating assets.
Weighted Average Cost of Capital
WACC is the blended cost of capital across all sources – debt, preferred shares, common shares, and undistributed (or retained) cash flow. The cash flow source is essentially free, but it is small because of how REITs must distribute their earnings.
Cost of Debt
Debt is the next cheapest, equal to Total Interest Expense / Total Debt, which we’ll call the Interest-to-Debt Ratio.
You might be able to find a REIT’s current and projected cost of debt by examining its latest 10-K. Alternatively, you can use industry data (for example, from Bloomberg).
Cost of Equity
Equity is the most expensive source of capital, mainly due to the future claims additional sold shares have on REIT cash flows and dividends. Generally, the cost of equity is the same as the rate of return required by equity investors. For REITs, the cost of equity is best approximated by AFFO Yield, where AFFO is Adjusted Funds from Operations.
You can calculate AFFO starting with unadjusted Funds from Operations (FFO), which is approximately equal to Net Operating Profits + Depreciation – Interest. To obtain AFFO, subtract Capital Expenditures (CAPEX) from FFO and add back adjustments for accrual items. Finally, AFFO Yield is AFFO per Share / Price per Share.
It’s apparent that a REIT receives a long-term benefit from being able to issue shares at high prices, thus driving down its AFFO Yield (the cost of equity capital). High share prices require less additional dilution to grow a REIT’s cash flow through the purchase of more rental properties.
We should comment that AFFO can be approximated by Free Cash Flow to Equity minus Net Borrowing (i.e., FCFE – NB).
In simplified terms, REIT WACC is the (% of capital that is equity x AFFO Yield) + (% of capital that is debt x Interest-to-Debt Ratio).
An alternative way to estimate cost of equity is to use the Capital Asset Pricing Model (CAPM), which we’ve written about in the past.
Return on Invested Capital
The Return on Invested Capital equals Net Operating Profit / Invested Capital (i.e., ROIC = NOP – IC).
We can use NOP instead of NOPAT because of the 0% tax rate for REITs.
To add economic value to a REIT, we want ROIC to exceed WACC. Moreover, we want some assurance that this spread will continue over time.
A low WACC compared to ROIC helps to ensure the growth of AFFO per Share, which allows for future growth while securing the dividend and reducing the percentage of debt capital on the balance sheet. When share prices are high, REIT management can afford to fund growth with new equity capital raises.
If and when share prices fall, management can tap the debt markets to continue growing AFFO per share and the dividend.
Economic Value Added
As stated earlier, EVA = ROIC – WACC.
We want to compare the EVAs of competing REITs as part of our investment analysis. The analysis should be sophisticated enough to incorporate unusual conditions that may be temporarily skewing results.
We also want to compare Value/Share. To that end, we can make some assumptions regarding the basic sources of REIT value.
- Assume that ROIC and the Investment Rate (IR) are constant.
- Assume that Free Cash Flow to the Firm (FCFF) and Net Operating Profit (NOP) grow at a steady rate, g.
Based on these assumptions, you can show that Growth g = ROIC x IR. You can also show that the value of operating assets = [NOP x (1-g / ROIC)]/[WACC-g].
From this, you can calculate the NOP multiple = [(1-g / ROIC)]/[WACC-g].
We can define Invested Capital (IC) = Total (Net) Property / Plant / Equipment – (Land + Construction in Progress) + Net Receivables – Net Payables.
Net Income (NI) is simply the change in IC
We now know the inputs we need to calculate Value/Share:
- Calculate the 5-year average of ROIC and NI, and use them to estimate the value of g.
- Calculate the NOP multiple using WACC.
- Calculate value of REIT = NOP x multiple + Book Value of other assets from Balance Sheet.
- Subtract market value of debt.
- Divide by number of shares.
You can perform this for each REIT you are analyzing and compare results. Only compare REITs in the same sector.
Any fundamental analysis of REIT companies should include an examination of their Economic Value Added, given by Return on Investment Capital minus Weighted Average Cost of Capital. You can also calculate and compare Value/Share for REITs in the same sector.
These metrics can supplement other important ones, such as dividend yield and Price/AFFO. They have value as long as you compare apples to apples – the REITs should be in the same sector and the timeframes must be equal. Over time, you can develop a box of analytical tools that will help you select the REITs that currently present the most attractive buying opportunities.