The Best Way to Predict a REIT’s Cash Dividend
In my article last week, I discussed why investors shouldn’t solely focus on a stock’s dividend yield. I mentioned that real estate investment trusts (REITs) feature a special metric that measures cash flow called funds from operations (FFO). I received reader requests to discuss FFO in further detail, so this week I’ll shed more light on the topic.
Firstly, even though REITs are mandated by law to distribute at least 90% of taxable income to shareholders, many REITs have low or negative earnings, which means taxable income often is not really a good indicator of dividend payout. Rather, the REIT’s FFO is a more important indicator.
Secondly, know that FFO is a non-GAAP measure.
What Is GAAP?
GAAP (generally accepted accounting principles) is a set of standards and procedures set by the Financial Accounting Standards Board that accountants must follow when they prepare financial statements for publicly traded companies and many private companies.
GAAP seeks to ensure a minimum level of consistency in a company’s financial statements, allowing investors and creditors to analyze them in a meaningful way.
Without GAAP, each company could decide what financial information to report and how to report it. Such information would not be very transparent or useful for someone trying to compare which company makes the better investment.
In practice, though, in addition to GAAP numbers, companies often show alternative figures that they feel better reflects actual financial performance. For example, they will usually report GAAP earnings and also report adjusted earnings for non-recurring items. And very commonly, they also report earnings before interest, taxes, depreciation, and amortization (EBITDA).
Because of the nature of the real estate business, looking at a REIT’s GAAP net income is not a way to see much cash they generate. Since investors typically choose REITs for their generous dividend, it’s important to get a clearer picture of how much cash flow they generate from their assets.
Consequently, REITs report FFO because they feel that it provides a more transparent view of their operational performance and cash flow.
The basic formula is:
FFO = Net Income – Interest Income + Depreciation + Amortization – Net Gains on Sales of Property
REITs can differ slightly from one another in how they calculate FFO. If you want to know how any REIT adjusts its net income to get FFO, look at that REIT’s 10-K. But no matter the minor differences in calculation, the goal is the same: to net out items that impact the GAAP net income but don’t affect the cash position.
For example, depreciation is a big deal since REITs typically own many properties. Even though the market value of real estate tends to rise in real life, a REIT has to mark down the carrying value of its properties over time. This reduces earnings, but it has no impact on cash flow because the REIT doesn’t actually have to pay out cash.
Accordingly, depreciation expense must be added back to the net income to arrive at the FFO. In fact, a REIT may have low or negative earnings, but as long as its FFO is strong, there’s no need to worry about a dividend cut.
FFO Should Cover the Dividend
The bottom line is, to analyze a REIT’s ability to sustain or increase its dividend, check out its FFO trends and how well the FFO covers the dividend. If a REIT’s FFO is consistently growing and it’s generating enough FFO to comfortably cover the dividend, then its dividend is safe and chances are good for continued increases.
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