4

When buying REITs, one essentially looks for the dividend yield (last dividend vs. current share price). If it's an established fund, does it really matter what's the P/E ratio if one capitalizes on the dividend yield?

For example, if I buy a REIT which at the time of purchase has a divyield of, say 5%, should I care if the P/E ratio is high? (assuming I'm ok with consistent 5%)

5

Real Estate Investment Trusts (REITs) are required by law (at least in the U.S.) to maintain a dividend payout ratio of at least 90%. In other words, they are required to pay out at least 90% of their earnings as dividends. The dividend per share is almost the same as the earnings per share.

As a result, the dividend yield (dividends per share / price per share) is related to the price/earnings ratio (P/E ratio). Any REIT that has a favorable dividend yield will also have a favorable P/E ratio.


Allow me to explain further, in a different way:

  • Dividend yield = dividend per share / price per share
  • P/E ratio = price per share / earnings per share
  • In a REIT, dividend per share is almost equal to earnings per share.

With these three facts, we can see that, for a REIT, the dividend yield and the P/E ratio are related to each other.

Using your example, let's say that you find a REIT with a dividend yield of 5%. With no further information on the REIT, we know that the P/E ratio will be between 18 and 20. (It will be 18 if the REIT is paying out 90% of the earnings as a dividend, and 20 if the REIT is paying out 100% of the earnings as a dividend.)

If you find a REIT with a better dividend yield, it will have a better P/E. Let's say you find one with a dividend yield of 10%. The P/E ratio for that REIT will be between 9 and 10. (A lower P/E ratio is better.)

  • I'm not sure what you mean. Do you mean the P/E ratio of a REIT predicts future dividend performance? In other words, if I buy a REIT which at the time of purchase has a divyield of, say 5%, should I care if the P/E ratio is high? (assuming I'm ok with consistent 5%) – Sparkler Nov 17 '16 at 1:09
  • @Sparkler It's not that the P/E ratio predicts future dividend performance, it's that the two are related. You can derive one from the other. I've added to my answer to try to explain further. Please let me know if it is still not clear. – Ben Miller - Reinstate Monica Nov 17 '16 at 1:22
  • P/E ratios are not used to value REITs, see my answer below – public wireless Nov 17 '16 at 19:19
3

I believe the accepted answer is at best misleading, and at worst entirely incorrect. The P/E ratio is based on EPS, but for REITs, EPS is not very meaningful since it includes depreciation, which is a non-cash expense. The REIT dividends are paid from cash flow, not EPS. When you add back depreciation to EPS and subtract gains on the sale of property (since these are considered 1-time events and dividends are assumed to be recurring), you get closer to actual cash flow. This is referred to as Funds from Operations (FFO). When you subtract out the capital expenditures needed to maintain the REIT's buildings, you get Adjusted Funds from Operations (AFFO). These are the two most common REIT metrics.

According to Market Realist, the most common way to calculate the relative value of a REIT is the price-to-FFO multiple (you can think of price/FFO as the REIT version of the P/E ratio). According to Market Realist, the price-to-FFO multiple for REITs has a 10 year average of around 16x (this will vary for REIT subsectors, as hospitals may receive a premium over say, hotels).

So in conclusion, you want to ideally find REITs with high dividends trading at price-to-FFO of around 16x or lower.

References:

http://www.investopedia.com/articles/04/112204.asp

http://marketrealist.com/2015/08/methods-used-determine-reits-valuation/

http://www.dividend.com/dividend-education/understanding-reit-valuation/

  • Where do I get the FFO data? – Sparkler Nov 17 '16 at 19:24
  • 1
    @Sparkler I'd start by checking your online brokerage account. If they don't have it, then you may need to upgrade to a better stock screener. You can also manually calculate using the links I provided. Another is here: fool.com/investing/general/2015/07/20/… – public wireless Nov 17 '16 at 19:49
  • +1. I like your answer better than mine. Thanks for posting. – Ben Miller - Reinstate Monica Nov 18 '16 at 3:04

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