REITs need capital, just like any other corporation. The way a publicly traded REIT (real estate investment trust) does that is by IPO -- initial public offering. This is just like selling any other stock to the public, who are investing in the corporation's income-generating real estate. The people who buy IPOs are investing in real estate which is managed like a stock portfolio. These external funds that raise capital enable the REIT to buy real estate, develop and manage it, for the purpose of generating profits. REITs generate income, and 90 percent of that taxable income must be distributed to the shareholders on a regular basis. REITs make money from the properties they purchase by renting, leasing or selling them. The shareholders choose a board of directors, who are the ones responsible for choosing the investments and for hiring a team to manage them on a daily basis.
The way REIT profits are usually measured is called FFO, which stands for funds from operations. According to the National Association of Real Estate Investment Trusts (NAREIT), FFO is defined as a calculation of net income from rent and/or sales of properties after deducting the cost of administration and financing. The NAREIT calculations of net income are based on GAAP -- generally accepted accounting principles. The problem is that in GAAP calculations, the depreciation of assets is assumed to be a predictable given, which actually skews the true measure of a REITs revenue in a negative way because real estate, which is what REITs deal in, retains its value or even increases over time. For this reason, FFO does not include depreciation in the net income.
Investors who want an accurate calculation of a REITs FFO, must look to other sources, such as a company's quarterly report and other supplemental information. The formula for measuring a REITs operating cash flow based on net income calculated according to GAAP is not always accurate. The true measure of a REITs FFO should also take into account factors such as repairs, maintenance and other costs.
Originally Published: Mar 16, 2011