My friend, a commercial real estate agent, insists that real estate investment trusts (REITs) will be the next pillar of the real estate industry to correct.  And, sure enough, in one of those “I told you so” moments, H & R REIT, who are constructing Encana’s new HQ in Calgary (aka the Bow), announced last week it would have to sell assets and cut back costs in order to obtain construction financing to finish the project.

However, others think that REITs have hit historically low prices relative to the value of underlying assets and rental incomes and now is the time to buy REITs as a value play.

So which is it? A value trap or a value play?

Every REIT is built a little bit differently. I have been looking at REIT’s lately as purely a cash flow vehicle.  My analysis is two-fold:

Can a REIT maintain its distributions?

In a typical dividend analysis, you would look at the dividend payout ratio of a REIT (recall that a dividend payout ratio is annual dividends paid per share/annual earnings per share). If it was approaching or above 100%, then you have an issue since you have a very small margin of error to work with in a down economy. However, you cannot apply a conventional dividend payout analysis when looking at a REIT;s ability to maintain its distribution.

Real estate companies write down a great deal of depreciation which is an expense for accounting reasons, reducing earnings, but a non-cash entry (in other words, it is a paper loss and not a cash loss). As a result, earnings tend to be dragged down which, in turn, artificially increases the dividend payout ratio. Thus, you see REITs with dividend payout ratios over 100%.

The more accurate measure of a REIT’s ability to maintain its distributions is determing funds from operations (FFO) which is an industry agreed upon term (but not GAAP approved). FFO is calculated by taking net income and adding back in non-cash items (primarily depreciation and amortization); again, the reason why you do this is that depreciation and amortization are accounting losses and not cash losses and you want to compare cash in to cash distributed. Then divide FFO by the number of shares outstanding and you have FFO per share.

Once you have FFO per share divide that number by distributions paid and you have a FFO payout ratio which is the REITs’ version of a dividend payout ratio. If this sounds confusing, don’t worry, Every REIT publishes its FFO per share in its quarterly reports so you don’t have to do this calculation.

For example, RioCan REIT reported that its FFO for the first 9 months ending Sept. 30 are $1.09/share and declared distributions of $1.015/share for the same period (the September distribution is paid in October but I have assumed it as part of the calculation). This gives RioCan a FFO Payout ratio of 93% (1.015/1.09) (this is not a recommendation to purchase RioCan).

Morningstar, the publisher of all things investing, recommends that a FFO payout ratio should ideally be no more than 85% (if you are wondering why this ratio is so high it is because REITs by law have to pay out most of their cash to maintain their REIT status; the % of cash to be paid out varies according to jurisdiction but it is typically quite high).

Is the REIT overly sensitive to leverage?

This point is contextually obvious. With the financial institutions not willing to lend freely, REIT’s have an issue as their debt becomes due- who will renew their debt obligations and on what terms (remember that loan to value is based on appraised value of a falling asset group; REITS have to worse of both words- unwilling lenders and falling asset base to borrow on)? If a REIT can’t refinance, it has to divest of assets which reduces FFO and endangers a payout to investors.

The analysis on debt is two-fold. The quick back of a napkin analysis is to simply look at quarterly reports and see when long term debt is coming due (this is usually found in the notes to the financial statements). If a majority is maturing in the next 12-24 months, there is an issue.

The quantitative analysis is to look at interest coverage ratio. This ratio measures operating profit/interest expense. The higher it is, the better since the higher the ratio, the more cash a company has to service debt. Even if interest costs increase due to higher costs of borrowing, a high interest coverage ratio indicates that a company can absorb these costs with undue hardship.

Again, most REIT’s report interest coverage ratio in their financials and MSN Money calculates it for you as well. Morningstar recommends an interest coverage ratio of at least two (i.e. profits are at least twice the costs of interest expenses) to maintain sufficient financial flexibility (this applies for all stocks other than financial stocks).

To use the same example, RioCan reported that its interest coverage ratio is 2.6 which means its operating profit is 2.6 times their interest expense. Its good but not great.

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Underlying both of the above are the obvious factors you have to look at in a REIT: who are the tenants, what type of tenants (commercial or residential), how long are rental revenues locked in for, what is the default rate on rental income, how quickly is it turning over property (many REITs made money flipping commercial properties quickly during the boom; this business model is probably dormant for the next couple of years).

But to determine whether a REIT is a value play or a value trap, one has to dig into the financials and determine whether the distribution is safe and whether the REIT is overly exposed to leverage and debt.