outline
When investing in REITs, one question arises. "Realty Income, a national dividend stock? Let's see... PER is 42 and dividend payout ratio is 223%??? Is this a good stock??" To avoid this awkward feeling while investing in REITs, you must know the concepts of FFO and AFFO.
It is commonly used as AFFO, P/AFFO, etc., but I will try to go through them step by step to help you understand.
Why is AFFO needed?
To define REITs in one line, it can be said to be 'a company that engages in the real estate (or facility) rental business that is exempt from corporate tax in exchange for dividends of more than 90% of the money it makes.' To shorten it a little further, it is a real estate rental business for profit sharing through dividends, and it is necessary to define indicators and terms that focus on this part.
Let's go back for a moment. Why are REITs’ PER calculated so high? This is because of accounting regulations that require depreciation of assets. Since the real estate of REITs, which are mostly real estate, are depreciated, the net profit is lower than necessary, resulting in a high PER of over 40 and a ridiculous dividend payout ratio of over 200%.
Let’s learn more
Before AFFO, the calculation formula for FFO is as follows.
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FFO = net profit + depreciation - profit on sale of assets
Depreciation refers to the loss of facilities or equipment invested in to make a profit over a certain period of time and deducted from the assets. For example, let's say a company purchased a business computer. Naturally, the value of the computer will decrease over time and one day it will be discarded or its value will converge to zero. Therefore, depreciation seems reasonable at first glance.
However, REITs that use real estate as their main source of revenue are different. Since depreciation is only a loss treatment on the ledger, net profit, which is the profit reflecting depreciation, has no significant impact on paying dividends, which is the most important thing for REIT investors. Rather, because real estate prices tend to trend upward from a long-term perspective (in many cases), depreciation is a bit awkward even in common sense.
This is because the profits from the sale of assets are not considered taxable profits, but it is convenient to think of this as being aimed at leaving only factors related to consistent dividend payments. Profit from real estate market capitalization is a one-time profit, so it affects dividends in the long run, but it can cause confusion in determining the dividend payout ratio or the company's ability to pay dividends.
AFFO is calculated by subtracting rent increases, capital expenditures, and maintenance costs to highlight related profits.
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AFFO = FFO + Rent Increase - Capital Expenditure - Maintenance Cost
The most important thing in paying dividends is real estate rent, so rent increases must be reflected in accurate profit judgments, and it is correct to exclude capital expenditures corresponding to large-scale renovation work and costs for regular maintenance as factors that affect rent. In the end, the series of processes to obtain this can be seen as deriving the indicator that best shows the company's dividend payment capacity.
So what about P/AFFO?
In the end, for REITs, FFO and AFFO can be seen as similar concepts to stock prices or net profit, which can be seen as the company's additional growth potential (although interpretation may vary) for general companies. Therefore, P/AFFO is a concept similar to the PER of a general company, which refers to the ability to pay dividends relative to market capitalization. The P/AFFO of U.S. listed REITs is approximately 10 to 15, and for reference, Realty Income's is 16, which is somewhat high.
conclusion
We learned about FFO and AFFO, which are important judgment indicators when investing in REITs. This indicator is a very useful tool for evaluating the value of REITs as it allows you to see the dividend capacity at a glance, but like all indicators, this indicator is also overvalued depending on stability and growth.
Since this is an indicator that has been cited and mentioned countless times, those who are interested in REITs should definitely understand it, but do not rely too heavily on it to select good stocks based solely on this indicator.
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REIT related article: Can I invest in Realty Income (O) now?