Before committing capital to a real estate investment trust (REIT), it’s essential to understand the potential return on investment. Without evaluating performance metrics or yield, an investor risks making uninformed decisions. REITs typically generate returns through dividends and capital appreciation, and knowing how to evaluate and compare these returns can help you make more strategic investment choices.
While a common method for evaluating publicly traded REITs is to divide the annual dividends by the share price (commonly referred to as dividend yield), this only tells part of the story. Share prices can fluctuate significantly, and yield alone doesn’t reflect the full performance or risk profile of a REIT. This article outlines how to calculate REIT returns, interpret performance metrics like Funds From Operations (FFO) and Adjusted Funds From Operations (AFFO), and use that knowledge to maximize your potential return.
REITs: A Quick Overview
A real estate investment trust (REIT) is a company that owns, manages, and finances income-producing real estate. Property types can include commercial, residential, or industrial real estate. Rather than owning physical properties directly, investors purchase shares of the REIT and receive a portion of the income it generates.
REITs receive special tax treatment, provided they meet specific IRS requirements. Most notably, they must:
- Be a corporation, trust, or association
- Be taxable as a domestic corporation
- Not be a financial institution or insurance company
- Be managed by at least one trustee or director
- Have at least 100 shareholders after the second year
- Have no more than 50% of shares held by five or fewer individuals
- Pay dividends of at least 90% of taxable income to shareholders annually
- Derive at least 75% of gross income from rents, real estate sales, or interest on real estate-secured loans
By distributing a large portion of their income, REITs avoid corporate-level taxation—meaning income is taxed only at the shareholder level.
What is REIT Rate of Return?
The rate of return measures the percentage change in the value of an investment over time. For REITs, this total return is generally composed of:
- Dividends: Ongoing income paid to investors, typically quarterly or monthly
- Capital Appreciation: Growth in the share price over time
Dividends and Payout Ratios
REITs are required to distribute a majority of their taxable income to shareholders as dividends. The dividend yield—calculated by dividing annual dividends by the REIT’s share price—is a key metric for evaluating cash returns.
For example:
- A REIT pays $3.00 in annual dividends
- The current share price is $60
- Dividend Yield = ($3.00 ÷ $60) × 100 = 5%
The payout ratio reflects what percentage of a REIT’s earnings are returned to shareholders. For REITs, this is commonly calculated using Funds From Operations (FFO), not net income, because FFO better captures real cash flow. A payout ratio of 75% would mean that the REIT pays $0.75 in dividends for every $1.00 of FFO.
It’s important to note that while a higher payout ratio increases short-term income for investors, it may limit the REIT’s ability to reinvest in future growth.
Capital Appreciation
REIT share prices can appreciate over time. Factors like real estate market conditions, REIT management, and the broader stock market may drive REIT share price changes. However, the REIT market has proven to be resilient. For example, it has maintained lower leverage rates since recovering from the Great Financial Crisis.
Calculating REIT Rate of Return
Funds From Operations (FFO) Calculation
FFO is a non-GAAP metric designed to provide a clearer picture of a REIT’s operating performance by adjusting for non-cash expenses like depreciation.
Basic FFO Formula:
FFO = Net Income + Depreciation + Amortization – Gains from Property Sales
Note: Interest income is not always subtracted; that adjustment only applies when isolating core real estate operations in specific variations like Core FFO.
Example:
- Net Income = $100,000
- Depreciation = $100,000
- No property sales during the year
FFO = $100,000 + $100,000 = $200,000
Because depreciation is a non-cash expense, adding it back gives a better sense of the REIT’s cash-generating ability.
Adjusted Funds From Operations (AFFO) Calculation
AFFO refines FFO by subtracting recurring capital expenditures and leasing costs. This gives a better view of the REIT’s sustainable cash flow.
AFFO Formula:
AFFO = FFO – Capital Expenditures – Leasing Costs ± Rent Adjustments
Key adjustments may include:
- Capital Expenditures (repairs, improvements)
- Leasing Commissions
- Straight-line rent adjustments
AFFO is often used to assess dividend coverage. If AFFO per share exceeds the dividend per share, the payout is generally sustainable.
Price to FFO (P/FFO)
This ratio is akin to the Price-to-Earnings (P/E) ratio used for traditional stocks but substitutes FFO for earnings.
P/FFO = Share Price ÷ FFO per Share
Lower P/FFO values may suggest undervaluation, while higher values could reflect growth expectations.
Dividend Yield
Here’s a step-by-step and formulaic breakdown of how to calculate REIT dividend yield:
- Add up the total annual dividends per share:
- Example: $0.75 per quarter × 4 = $3.00 annually
- Divide by the current share price:
- $3.00 ÷ $60.00 = 0.05
- Convert to percentage:
- 0.05 × 100 = 5% Dividend Yield
Dividend yield offers a snapshot of income potential, but it should be evaluated in the context of payout ratio, AFFO, and expected capital appreciation.
Analyzing REIT Rate of Return
Transparency in Reporting
Publicly traded REITs offer a high level of performance transparency due to SEC reporting requirements. While private and non-traded REITs may not be subject to the same level of scrutiny, many still provide offering materials, performance reports, and audited financials. Investors should carefully review these disclosures before making an investment.
Risk-adjusted Returns
To compare REITs with different risk profiles, investors can use metrics like the Sharpe ratio, which measures return per unit of risk (volatility). This is especially useful when choosing between higher-yield, higher-risk REITs and more stable options.
Factors Affecting REIT Returns
- Economic Conditions: Interest rates, inflation, and economic growth influence REIT performance. However, in periods of rising interest rates, research shows that REIT returns have generally been positive and often outperformed the S&P 500.
- Property Type: Returns can vary across the real estate sector (e.g., industrial, residential, commercial).
- Leverage: Debt financing allows REITs to borrow money to buy properties, which can boost returns when used wisely. If properties earn a higher return than the cost of the debt (interest payments), the REIT can amplify profits. This is known as positive leverage.
Strategies to Maximize REIT Rate of Return
Use these strategies to help ensure positive returns.
- Diversification: Diversifying across REIT sectors and geographic locations can enhance returns and reduce risk.
- REIT Selection: Aim to select REITs with strong fundamentals, solid management, and growth potential.
- Use Tax-Advantaged Accounts: When possible, consider holding REITs in tax-advantaged accounts to help maximize after-tax returns.
- Reinvest Dividends: If available and appropriate for your situation, reinvesting dividends can help compound growth over time.
Informed REIT Investing for Optimal Returns
All investments come with potential benefits and risks. Calculating the rate of return for REITs can help you find an investment that meets your financial needs and goals. At 1031 Crowdfunding, we aim to help investors like you make better-informed decisions about their investments.
Our extensive online marketplace of vetted real estate properties can give you an idea of the type of asset you’re looking for and what suits you best. From REITs to DSTs to Qualified Opportunity Funds, our experienced team will support you along the way.
This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary. Securities offered through Capulent, LLC Member FINRA, SIPC
This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary. Securities offered through Capulent, LLC Member FINRA, SIPC.
