Beginner’s Guide to Real Estate Investment Trusts (REITs): Structure Valuation & Taxation

Real Estate Investment Trusts are similar to private equity firms. The main difference is that the trusts acquire properties rather than companies. Usually, the trusts buy and sell …

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Real Estate Investment Trusts are similar to private equity firms. The main difference is that the trusts acquire properties rather than companies. Usually, the trusts buy and sell these properties, but there have been instances where they develop new properties as well. REITs can also be diversified. Properties don’t only have to be homes; they can be commercial, retail, industrial and so on. On top of this, property value is different per location.

The interesting aspect of REITs is that they usually have minimal cash on hand. This is because they are basically required to issue nearly 90% of their taxable income as dividends so that they can avoid high corporate level income tax. Due to the minimal cash on hand, REITs require large financing needs and constantly have to issue debt and equity to keep up their operations.

From an industry point of view, it is crucial to pay attention to the demand for houses. Demand for homes is the strongest indicator of where the real estate sector is trending. According to CNN Money, due to the 2008 crash in the real estate market, there was a spike in unemployment and ultimately led to the financial crisis.[1] In that scenario, homebuilders were the biggest losers.

At most large banks, the real estate groups mainly focus on REITs and companies that own chains of hotels and resorts. They very rarely focus on individual properties. Individual properties are more for real estate brokers.

Valuation of Real Estate for REITs

There are many different valuations for real estate. The valuation heavily depends on the sub-sector or a REIT. In general, real estate valuation is very different from the general company valuation methods because the metrics are very different. However, it is somewhat similar to financial institutions.

For individual properties, Net Operating Income (NOI) is one of the key metrics and is similar to EBITDA. NOI divided by the property value is equal to the cap rate and this usually is within the range of 5-10%. The cap rate is very significant because is shows how much income they get for every dollar of the property value.[2]

REITs valuation methods are somewhat similar. Technically, you can still calculate NOT and Cap Rate but the most important metric is Funds from Operations (FFO). FFO is defined as Net Income + Depreciation & Amortization – Gain/Loss on sale. In other words, the goal is to find how much earnings are the REITs generating on a normal recurring basis.

It is important to remember that gains and losses are non-recurring, and that is why they are subtracted. Additionally, depreciation and amortization is extremely large but it’s non-cash. From an industry point of view, it is sometimes deceptive because real estate properties increase in value over time.

There are other valuation methods as well including Adjusted Funds from Operations (AFFO). This is where you subtract Maintenance Capital Expenditures to closely estimate the cash flow. Usually all REITs place FFO in their filings but it is also important to pay attention to the dividend yields and dividend payout ratios.

Dividend yields and dividend payout ratios are also important to analyze for REITs due to the fact that REITs need to issue 90% of their taxable income as dividends. The reason they need to do this is to avoid high corporate level income taxes.

The Dividend Analysis, also known as the dividend discount model, is a approach where you create a five year projection period with discount rates as well as terminal value. The terminal value is calculated by a multiple or perpetuity growth approach.

Another valuation method is the discount cash flow, however it is a bit different from the approach taken with the general corporations. The Stream of Funds available for distribution is equal to FFO minus the normalized recurring capital expenditures. Then determine the cost of capital and discount the streams to present value.

In the case of REITs, the DCF and Dividend Discount Model can often give similar values because FFO – Recurring Capital Expenditures tend to be close to actual dividends issued.

A third valuation method is Net Asset Value. This is very specific to real estate and a bit different from what one could expect from other types of NAV models. The basis of the model is to project NOI and divide it by the appropriate Cap Rate to figure out the gross real estate assets. Then, you add other assets, exclude Accumulated Depreciation and subtract Liabilities, which equals net asset value. NAV can also be used to calculate NAV per share, which can identify if the company is overvalued or undervalued.

The most common multiples are FFO and AFFO multiples because they are both Equity Value based. In the case of a merger or acquisition, it is extremely common to use contribution analysis, accretion/dilution, and some firms do prospective buyer analysis.

Since 2008, according to Yahoo Finance, there has been a strong upward trend in terms of the economy as well as the real estate sector. It is also important to note that REITs are not specific to the United States. Many REITs are heavily invested in the BRIC countries (Brazil, Russia, India, and China). With the diversity of investments in developing countries, real estate is still a very promising and consistently growing investment.[3]

According the Goldman Sachs Real Estate Group investments page, the group holds many REITs, hotel and gaming (casino) companies, public sector entities and many retail properties including golf courses etc. In addition, they have offices in five continents and they are heavily expanding into the real estate sector within the BRIC countries.[4]

Since many REITs have a heavy need of financing, the trusts reach out to Investment Banks, such as SunTrust Robinson Humphrey, who offer debt and equity financings. According to SunTrust’s investments page, the bank also covers retail, storage, residential and nearly all types of real estate.[5]

About The Author

Nate Nead is a Principal at InvestmentBank.com and Deal Capital Partners, LLC. A licensed investment banker with a focus in real estate, Nate works with clients on solidifying capital markets transactions for private equity and private debt deals in commercial real estate. He resides in Seattle, WA

  1. Matt Egan, 2008: Worse than the Great Depression? (2015) http://money.cnn.com/2014/08/27/news/economy/ben-bernanke-great-depression/index.html (last visited November 8, 2017)
  2. Luis Ochoa, Real Estate Investment Banking 101: Location, Location, Location (2017) https://www.mergersandinquisitions.com/real-estate-investment-banking/ (last visited November 8, 2017)
  3. Stacy Curtin, 2008 Financial Crisis Cost Americans $12.8 Trillion: Report (2012), https://finance.yahoo.com/blogs/daily-ticker/2008-financial-crisis-cost-americans-12-8-trillion-145432501.html (last visited November 8, 2017)
  4. Goldman Sachs, Investment Banking Real Estate (2017) http://www.goldmansachs.com/what-we-do/investment-banking/industry-sectors/real-estate.html (last visited November 8, 2017)
  5. SunTrust Robinson Humphrey, Real Estate Investment Banking Group (2017) https://www.suntrustrh.com/industry-coverage/real-estate-reib (last visited November 8, 2017)

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