REIT values are a function of their cash flow returns.
There are 3 drivers of returns for REITs:
- Funds From Operations (FFO) Yield - similar to earnings or cash flow yield1
- FFO Growth - similar to earnings growth
- FFO multiple (contraction or expansion) - similar to P/E ratio
The FFO yields tells you roughly what dividend yield the REIT could afford to pay out each year.
For example, as of 11/1/2023 net lease casino owner VICI Properties ($VICI) trades at a healthy 7.7% FFO yield. Because they don’t operate the buildings (the casino tenants do) and pass through all expenses to the tenants, they generate a ton of cash.
They are currently paying a 6% dividend that has room to grow, which we love. They are reinvesting the remaining cash flow (not paid via dividend) back into growing the portfolio.
To recap, REIT FFO multiples:
1. are historically low today (including similar periods with higher interest rates)
2. are discounted relative to the private market
3. and are likely to increase when Fed cuts interest rates
But since we don’t know when that will happen, we focus on REITs and real estate stocks that can continue growing cash flow in the face of higher (for longer) interest rates and a softer economy (possible recession).
- FFO Yield + Growth = Expected Return from Earnings
- FFO Yield + Growth + Change in Multiple = Total Expected Return
So in other words, if the multiple is fixed, the return of a REIT is similar to real estate returns. That is just cash flow + the appreciation (which is a function of the cash flow growth).
This framework is a lot easier to forecast and stick to than trying to peg REIT multiples (or stocks P/E ratios for that matter).
Trying to guess the change in multiple requires one to triangulate and predict: interest rates, inflation, fiscal deficits, market sentiment, money supply, oil prices, and foreign wars.
So instead of trying to assign a higher multiple to value a REIT, you can keep the current multiple constant and just look at the current yield and estimate cash flow growth.
To estimate cash flow earnings, you really only have to estimate demand. Future supply is obvious given we can track new construction permits and completions well in advance.
Below is historical stock market data supporting our long-term cash flow focused strategy.
Multiples and rates move stocks over the short term, earnings growth moves stocks over the the long-term.
Footnote (1): FFO is a reasonable proxy for cash flow for low capital intensive real estate. This is not true for REITs that require high, ongoing capital expenses such as office and hotels. For those sectors an adjusted FFO (AFFO) figures that adds back in capital expenses should be used.