About a year ago Financial Jungle, dearly departed from the world of blogging, raised the question of how a real estate investment trust (REIT) or utility income trust could pay distributions when its dividend payout ratio was above 100% (in other words, it paid out more in distributions than earnings). The same question was recently raised by a reader so I thought it best to look into this question for those interested in buying REITs and utility trusts. Please feel free to add anything if you think I missed it since this became a blog homework item for me this week (credit to Preet from Where Does My Money Go for his assistance).

In REITs and utility trusts, where there is a large amount of depreciation occurring on capital assets, the traditional dividend payout analysis is not an accurate measure to determine whether the distribution is safe. Instead, you have to calculate adjusted funds from operations (AFFO) per share to determine the payout ratio . Funds from operations is a non GAAP measure which adds back depreciation and subtracting gains from sale of depreciable property to earnings.

AFFO takes this step one further and is generally (because there is no uniform definition of AFFO) calculated as funds from operations minus capital expenditure.

This is all a bunch of tax mumble jumbo but let’s break this down. Depreciation is an accounting term which records the cost of a capital asset over its useful life. For example, a REIT acquires a building for $1 million and has a useful life of 10 years. The depreciation is $100,00/year. Since this is an accounting, and not a cash entry, it is, in some senses, a fictional (but accounting supported) entry  so you add this back to earnings to get a true reality on earnings.

But you subtract capital expenditures for an obvious reason. Assets like buildings and power plants need to be maintained and this, obviously, costs money to do. Even if a REIT did not collect a penny in rent it would need to spend money to keep the buildings up to code.  Thus, subtracting capital expenditures gives you a true indication of how much money is actually on hand.

Here is a simplified example. Assume REIT has issued 1,000,000 shares and pays $1.00 of distributions  per share every year. Assume the following accounting entries:

earnings: $1 million

depreciation: $300,000

capital expenditures: $100,000

APPO would be calculated then as:

($1,000,000 in earnings +$300,000 of depreciation) – $100,000 of cap ex = $1,200,000

AFFO per share would be $1,200,000 in AFFO/1,000,000 shares = $1.20/share

In other words, the REIT could pay up to $1.20 in distributions a year but only pays $1.00 meaning it is paying out 83% of AFFO which is a comfortable payout ratio for a REIT’s (remember that by law REITs have to pay out most of earnings so you can’t compare REIT payout ratios to non-REIT payout ratios). Compare this with traditional dividend payout ratio analysis which would get you a payout ratio of 100% ($1 million in earnings/$1 million in distributions).

However, as Preet does point out, distribution per shares which is higher than AFFO per share (i.e. it pay out more than it makes) is not necessarily a bad thing IF the reason is that it spent a lot of money in a particular year is to add assets which will pay out going forward. Thus, care must be paid as to why a company is in a negative cash flow position.

How do you find AFFO? Most REITs and utilities state their funds from operations in their financial statements as a non GAAP discussion item. Take capital expenditure from the cash flow statement and subtract from funds from operations. Divide by number of shares issued and you have AFFO per shares. Distributions per share or always stated in financial statements so take that number and divide by AFFO per share

…OR many analysts reports now summarize it for you (thank god for the internet!).

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The reader did ask how REITs and utility trusts continue to pay distributions for long periods of time if, in fact, it distributes more per share than it should. There are a wide variety of ways to do this which should be danager signs to all dividend stock and income trust purchasers. I will address this topic next week.