Most real estate investors likely have some familiarity with real estate investment trusts (REITs). They know that a REIT is a company that holds a portfolio of income-producing real estate, which allows most REITs to pay attractive dividends to investors. However, there is a lot more to REITs than that.
Investors also need to know how REITs report their earnings as well as how they fund their operations, since it differs from most publicly traded companies. Once investors have a better understanding of those aspects, they can better analyze whether a REIT can continue paying its investors generous dividend income even as it invests money to grow its commercial real estate portfolio.
Making sense of how REITs make money
The business model of most REITs is easy to understand. The company will own a portfolio of real estate property, like office buildings, which it leases to tenants who pay rent. REITs use this money to cover expenses on the property, such as the mortgage. Anything left over is known as that property’s net operating income (NOI).
Corporately, however, REIT financial reporting can get a bit more complicated. That’s because they use Generally Accepted Accounting Principles, or GAAP, when reporting their earnings as well as several non-GAAP, REIT-specific metrics. As a result, investors need to pay attention to the right set of numbers when gauging a REIT’s performance.
GAAP financial metrics keep REITs in compliance with tax rules. One of the requirements for a REIT is that it must distribute at least 90% of its taxable income to investors to maintain its special tax status.
However, the taxable income of a REIT is typically much less than the actual cash flow it produces in a reporting period due to large write-offs like depreciation. While this keeps its taxable income low, it masks the true earnings power of a REIT, which is why most use several non-GAAP metrics to show investors a more accurate picture of their cash flow. The most common is funds from operations (FFO), which adds back depreciation while subtracting any gains on the sale of real estate. As such, it serves as a good proxy for the cash flow a REIT generated that it could have paid out to investors via a dividend.
Source: Million Acres