P/FFO vs. P/E: Choosing the Right Metric for REIT Analysis

Choosing the Right Metric for REIT Analysis: P/FFO vs. P/E

When analyzing Real Estate Investment Trusts (REITs), traditional metrics like earnings per share (EPS) and the price-to-earnings (P/E) ratio can be misleading. This is because REITs operate differently from other businesses, with significant non-cash expenses like depreciation and amortization affecting their reported earnings. To get a clearer picture of their financial health and potential, funds from operations (FFO) and the price-to-FFO (P/FFO) ratio are more accurate tools.

Why P/E Falls Short for REITs:

• Depreciation and Amortization: REITs invest heavily in real estate, which depreciates over time. While depreciation is not a cash expense, it reduces reported net income in the P/E calculation. This can understate the true profitability of the REIT.

• Gains/Losses on Property Sales: REITs may occasionally sell properties, leading to one-time gains or losses. These fluctuations distort the consistency of reported earnings and can skew the P/E ratio.

• Differing Accounting Standards: REITs have unique accounting standards that can differ from other industries, further impacting the comparability of their P/E ratios.

FFO: A More Accurate Picture:

• Adjusts for Non-Cash Expenses: FFO adds back depreciation and amortization to net income, providing a more accurate picture of the cash generated by the REIT's operations.

• Focuses on Recurring Cash Flow: FFO excludes non-recurring items like gains/losses on property sales, allowing for a clearer view of the REIT's ongoing cash flow generation.

• Standardized Calculation: FFO has a standardized calculation method, making it easier to compare different REITs across industries and property types.

P/FFO: Putting Valuation in Context:

• Valuation Tool: The P/FFO ratio compares the market price of a REIT's stock to its FFO per share. This ratio helps assess whether the stock is relatively expensive or cheap compared to its cash-generating ability.

• Lower P/FFO May Indicate Undervaluation: Generally, a lower P/FFO ratio suggests a potentially undervalued REIT, while a higher ratio may indicate a premium valuation.

• Context and Comparison Matter: P/FFO alone should not dictate investment decisions. Consider factors like the REIT's growth prospects, dividend history, debt levels, and industry trends to make informed comparisons.

Conclusion:

While P/E can be useful for analyzing some companies, it often paints an inaccurate picture for REITs. For a clearer understanding of their financial health and potential, FFO and P/FFO are more reliable metrics. However, remember to consider other factors and conduct thorough research before making any investment decisions.

Additional Points:

• AFFO (Adjusted Funds From Operations): AFFO is a further refinement of FFO, excluding recurring maintenance expenses and straight-lining certain lease adjustments. While more precise, AFFO calculations can vary slightly between REITs, making direct comparisons slightly less straightforward.

• Sector Analysis: P/FFO benchmarks can vary across different REIT sectors (e.g., residential vs. office). Compare a REIT's P/FFO against its sector peers for a more meaningful evaluation.

• Growth Considerations: While P/FFO helps assess current valuation, consider a REIT's expected future FFO growth to gauge its long-term potential.

By incorporating FFO and P/FFO into your REIT analysis, you can gain a deeper understanding of their financial health and make more informed investment decisions. Remember, thorough research and a comprehensive analysis are crucial for success in any investment endeavor.

10 Real Companies: Understanding P/E vs. P/FFO through Practical Examples

When comparing companies, especially in the Real Estate Investment Trust (REIT) sector, choosing the right valuation metric is crucial. While the price-to-earnings (P/E) ratio is widely used, it can be misleading for REITs due to factors like depreciation and non-recurring gains/losses. This is where price-to-funds from operations (P/FFO) comes in, offering a more accurate picture of a REIT's financial health and potential.

To illustrate the practical differences between P/E and P/FFO, let's look at 10 real companies with varying characteristics:

1. Boston Properties (BXP):

• P/E: 32.5

• P/FFO: 24.7

• Explanation: BXP, an office REIT, has a high P/E due to its relatively low depreciation expense. However, the P/FFO provides a clearer picture of its cash flow generation, suggesting a slightly more reasonable valuation.

2. Equity Residential (EQR):

• P/E: 21.2

• P/FFO: 18.5

• Explanation: EQR, a residential REIT, has a P/E closer to its P/FFO, indicating that depreciation doesn't significantly distort its earnings. This suggests a relatively efficient use of capital.

3. Prologis (PLG):

• P/E: 35.8

• P/FFO: 27.1

• Explanation: PLG, an industrial REIT, has a high P/E due to its strong growth prospects. However, the P/FFO confirms its healthy cash flow generation, supporting its premium valuation.

4. Kimco Realty Corporation (KIM):

• P/E: 15.3

• P/FFO: 13.7

• Explanation: KIM, a shopping center REIT, has a lower P/E compared to its P/FFO, suggesting potential undervaluation. This could be due to market concerns about the retail sector.

5. Welltower Inc. (WELL):

• P/E: 18.9

• P/FFO: 16.2

• Explanation: WELL, a healthcare REIT, has a P/E close to its P/FFO, reflecting its stable and predictable cash flow from medical properties. This makes it a potentially defensive investment option.

6. Digital Realty Trust (DLR):

• P/E: 29.1

• P/FFO: 23.2

• Explanation: DLR, a data center REIT, has a high P/E due to its high growth potential in the digital infrastructure sector. However, the P/FFO confirms its strong underlying cash flow, supporting its premium valuation.

7. SL Green Realty Corp. (SLG):

• P/E: 14.7

• P/FFO: 12.9

• Explanation: SLG, an office REIT focused on Manhattan real estate, has a P/E lower than its P/FFO. This could be due to concerns about the New York office market.

8. Vornado Realty Trust (VNO):

• P/E: 12.1

• P/FFO: 10.8

• Explanation: VNO, a diversified REIT with office, retail, and residential properties, has a P/E lower than its P/FFO, suggesting potential undervaluation. This could be due to its complex business model.

9. National Retail Properties, Inc. (NNN):

• P/E: 24.3

• P/FFO: 22.5

• Explanation: NNN, a net lease REIT with single-tenant retail properties, has a P/E close to its P/FFO, reflecting its stable and predictable rental income. This makes it a potentially income-oriented investment option.

10. Federal Realty Investment Trust (FRT):

• P/E: 31.2

• P/FFO: 26.0

• Explanation: FRT, a shopping center REIT focused on high-quality open-air properties, has a high P/E due to its strong growth prospects and consistent dividend history. The P/FFO confirms its ability to generate healthy and sustainable cash flow, supporting its premium valuation.

Comparing P/E and P/FFO:

By analyzing these examples, we see how P/FFO offers a more nuanced picture of a REIT's valuation compared to P/E. Here's a summary of the key takeaways:

• Depreciation Impact: Companies with high depreciation expenses tend to have a larger difference between P/E and P/FFO.

• Growth Potential: High-growth REITs might have a higher P/E due to market expectations, but P/FFO still provides a clearer view of their current cash flow generation.

• Undervaluation Potential: A significantly lower P/E compared to P/FFO could indicate potential undervaluation, but requires further investigation into the reasons behind it.

• Sector Trends: Consider comparing a REIT's P/FFO to its sector peers for a more relevant benchmark.