Real Estate Investment Trusts

by Obaidullah Jan, ACA, CFA

Real estate investment trusts (REIT) are investment companies whose shares are publicly traded and whose main function is to own and operate income-producing real estate. They allow investors to obtain well-diversified tax-efficient and liquid exposure to real estate.

Real estate typically has high unit size which makes it harder for smaller investors to add them to their portfolios. Even if their investment portfolio is large enough, they can’t diversify their real estate holding on their own with reference to real estate type and location. Further, directly owning real estate is not efficient because it requires significant active management. REITs bridge this gap by allowing individual investors to pool resource to invest in a range of real estate properties.

REITs help investors avoid double taxation, but it must meet certain requirements laid out by the IRS, the US tax agency to maintain tax exemption principal being the obligation to pay 90% of their income to its unitholders.

Types of REITs

REITs typically specialize in a real estate segment such as homes, hotels, warehouses, etc. or a location. This enables an investor to better structure his investment portfolio by obtaining the right exposure to the constituent segments of the real estate market. There are retail REITs, residential REITs, office REITS, hotel REITS, healthcare REITs etc. whose investments are solely in shopping malls, homes, office buildings, hotels and hospitals respectively.

With respect to the nature of their investment holding (i.e. equity vs debt), there are three major categories of REITs: equity REITs, mortgage REITs and hybrid REITs

Equity REITs

Equity REITs are real estate investment trust which obtain equity stake in properties and their income stems from the difference between the rental income of the properties, the costs incurred on managing them and any associated financing costs. Equity REITs are the most popular.

Mortgage REITs

Mortgage REITs are REITs which hold mortgages or mortgage-backed securities and their income comprises of the interest earned on those mortgages. Mortgages are loans advanced to owners for real estate which are backed by the real estate property purchased or constructing using the loans.

Hybrid REITs

As the name shows, hybrid REITs are real estate investment trusts which obtain both ownership stake in real estate and also obtain debt-side exposure to the real estate market by investing in mortgage-backed securities, etc. Their income is a composite of both rental income and interest income.

Valuing REITs

REITs behave like stocks because they pay periodic dividends and represent residual interest in real estate, hence they can be valued using approaches used for equity valuation with some modifications.

The three most common approaches used to value REITS include (a) the net asset value approach, (a) the relative valuation approach using P/FFO and P/AFFO ratios and (c) discounted cash flow approach.

NAV approach

The net asset value approach is a popular approach in which the net asset value per share is worked out using the following formula:

$$ NAVPS=\frac{V_A-V_D}{n} $$

Where VA is the market value of assets, VD is the market value of debt and n is the weighted average number of shares. If the market value of debt is not directly observable it can be worked out by capitalizing the net operating income (NOI) based on an appropriate cap rate.

Relative valuation: FFO and AFFO

Instead of the price to earnings ratio (P/E) ratio, REITs are valued using a similar approach called P/FFO or P/AFFO ratios.

FFO stands for funds from operations and is a measure of the cash flows from operations of the REIT, calculated as net income plus depreciation and amortization plus any deferred tax expense and plus (minus) any losses (gains) on sale of properties.

$$ FFO=NI+D+DT+L-G $$

Where NI is net income, D is depreciation, DT is deferred tax expense, L is losses on sale of property and G is any gains.

AFFO stands for adjusted funds from operations and it equals funds from operations minus adjusted to remove the effect of revenue accruals minus required capital expenditures. This concept is similar to the concept of free cash flow in stock valuation;

$$ AFFO=FFO-S-C $$

Where FFO is funds from operations, S is accrued revenue adjustment and C is required capital expenditures required to be incurred to maintain or grow the earning capacity of the REIT.

Dividend discount models can also be used because REITs typically pay very high dividends.


Consider an REIT that invests in warehouses: the book value of its assets is $200 million, its NOI is $21 million per annum and appropriate cap rate is 9%; book value and market value of debt are $120 million and $140 million respectively and weighted average number of shares are 3 million.

Net income is $13 million after depreciation charge of $4 million; required capital expenditures are $2 million per annum and $1 million is the effect of accounting adjustment made to recognize the revenue on straight-line. If comparable properties have P/FFO and P/AFFO ratio of 5.5 and 6.2, find out intrinsic value of the REIT.


We can find out the NAVPS by capitalizing the earnings stream, subtracting market value of debt and dividing the net assets value by weighted average number of shares.

$$ V_A\ =\frac{$21\ million}{9\%}=$222.22\ million\ $$

$$ NAVPS=\frac{$222.22\ million-$140\ million}{3\ million}=$27.401 $$

Relative valuation: P/FFO and P/AFFO

Another approach is find funds from operations (FFO) and adjusted funds from operations for the REIT and then use them to value the REIT using relative valuation:

$$ FFO=$13\ million\ +$4\ million=$17\ million $$

$$ FFO\ per\ share=\frac{$17\ million}{3\ million}=5.67 $$

$$ REIT\ unit\ value=FFO\times P/FFO=$5.67\times5.5=$31.18 $$

$$ AFFO=$17\ million-$1\ million\ -$2\ million=$14\ million\ $$

$$ AFFO\ per\ share=\frac{$14\ million}{3\ million}=4.67 $$

$$ REIT\ unit\ value=AFFO\times P/AFFO=$4.67\times6.2=$28.95 $$