Why REITs Don't Use EPS

Look up almost any REIT and the payout ratio against earnings per share may look alarming. Often above 100%.

The problem may be the measure.

Accounting rules require a company to depreciate its buildings on a fixed schedule, writing down their value a little each year. Real estate does not necessarily lose value on that schedule, and well-located property may gain it.

Depreciation is a noncash charge. That does not mean the building is costless to maintain. It does mean reported net income, and therefore EPS, can sit well below the cash the properties produced.

So the sector uses a different number.

FFO adds the depreciation back

FFO (Funds From Operations) starts with net income, adds back real estate depreciation and amortization, and removes certain gains and losses on property sales. It is defined by Nareit, the industry body, which makes it reasonably comparable from one company to the next.

AFFO subtracts what the buildings consume

AFFO (Adjusted Funds From Operations) goes one step further. It subtracts recurring capital needs required to keep the property earning what it already earns. New roofs. Elevator work. Tenant improvements, leasing commissions, and allowances required to sign the next tenant.

AFFO often comes closest to the recurring cash available to support the dividend. It carries one catch worth remembering: there is no standard definition. Each company decides what to deduct, so two REITs reporting the same AFFO payout ratio may have counted different things.

A payout ratio is only as reliable as the denominator underneath it.