Why Are REIT P/E Ratios So Darn High?

Sitting on an airplane in front of two elderly couples, I overheard some interesting conversations about everything from grandkids to retirement planning.

Not surprisingly, much of their financial conversation revolved around low interest rates and how CDs just weren't cutting it any more.

This was a financial writer's goldmine. It sure beat perusing SkyMall for the 20th time. I listened intently.

At one point, the couples shared their favorite income investments. REITs were among them. But they had a big concern: REITs might be overvalued since their price-earnings ratios are massive. High P/Es are, in general, a sign of a very overvalued, not-so-attractive stock.

I began to think if these seniors didn't "get" REITs, then surely there are many other investors just like them -- people confused with the ins and outs of accounting. So, here I am to explain REITs for all those interested in this high-yield asset class.

REIT P/E ratios and why they don't matter
We learn over time that it's all about the bottom line. Businesses are all about turning a profit and posting positive earnings.

But earnings don't matter in some industries like real estate; what matters is cash. And in many cases, a company's ability to generate cash is substantially different than its ability to generate earnings.

Source: 401k 2013.

On their accounting statements, REIT earnings are much lower than their actual cash income. The reason is fairly simple: their income statements are loaded with non-cash charges -- expenses that don't actually require a company to spend money.

For REITs, that big, non-cash expense is depreciation. You see, the IRS says a commercial real estate building depreciates over time, over 39 years. That is to say that a building valued at $1 million in 2013 should be valued at $0 by 2052.

So, if you own a commercial building worth $1 million, each year you'll depreciate it by $25,641 until the value falls to zero. This depreciation is recorded as an expense on the income statement. Remember, though, that this is a non-cash expense. You aren't just throwing $25,461 into the trash can every year. In fact, that $1 million property is probably going up, not down, in value.

Deprecation is subtracted from revenue (rents) to get to bottom line income. This is why REITs have very little income to report -- depreciation erases much of their income in the eyes of the IRS.

When you think about REITs and their profitability, I want you to almost completely forget about earnings. Earnings don't matter for a REIT because they make way more money than what they report on the income statement.

REIT ratios that matter
If you want a very simple ratio to value REITs, you should replace "earnings" with "funds from operations," often shortened to FFO. A REIT's FFO is essentially its earnings.

Naturally, one good way to value a REIT would be to divide the price of the REIT by its funds from operation. This gives us a really good valuation ratio of P/FFO, which is to REITs what P/E ratios are to other stocks.

Let's use a table and include many different REITs, their P/E ratios, and their P/FFO ratios to put the numbers in perspective:

As you can see, these REITs appear pricey when compared on the basis of price to earnings. But once you break out their price to FFO, you find they aren't nearly as expensive as they once appeared. In fact, if you're used to staring at REIT P/E ratios of 30-50, you'd probably think REITs are downright cheap when you look at P/FFO.

A REIT's P/FFO is a really good way to work out a theoretical return. If a REIT has a P/FFO of 15, you can divide 1 by 15 to get 6.67%, your theoretical return holding everything constant.

So that's the short explanation for why REITs trade at super-high multiples of earnings but aren't as overvalued as they may seem. Once you understand the quirks of REIT accounting, you can make a much better judgment call about what a REIT is actually worth. Forget P/E ratios -- the proper ratio for REITs is P/FFO.

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The article Why Are REIT P/E Ratios So Darn High? originally appeared on Fool.com.

Fool contributor Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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