How do you value a REIT? The standard P/E ratio doesn't seem to work because of depreciation.

You're correct that traditional P/E is misleading for REITs because accounting depreciation of real estate often overstates the actual decline in property value. REITs use specialized metrics that adjust for this.

Key REIT Valuation Metrics:

1. Funds From Operations (FFO):

FFO = Net Income + Depreciation/Amortization (real estate) - Gains on Property Sales

FFO adds back the non-cash depreciation charge and removes one-time gains from asset sales to show recurring operating performance.

2. Adjusted FFO (AFFO):

AFFO = FFO - Recurring Capital Expenditures - Straight-line Rent Adjustments

AFFO is more conservative — it deducts the maintenance capex needed to keep properties in good condition. Think of it as the true 'free cash flow' of a REIT.

3. Price/FFO and Price/AFFO Ratios:

Similar to P/E but using FFO or AFFO as the earnings metric. Compare to sector peers:

• Office REITs: typically 12-16x FFO
• Industrial/Logistics REITs: 20-30x FFO (higher growth)
• Residential REITs: 15-20x FFO

4. Net Asset Value (NAV) Analysis:

Estimate the market value of all properties owned, subtract liabilities, and compare to the REIT's market cap.

NAV = Estimated Market Value of Properties + Other Assets - Total Liabilities

NAV per share vs. market price tells you if the REIT trades at a premium or discount:

• Premium to NAV: market expects growth or superior management
• Discount to NAV: market is skeptical about portfolio quality or management

Worked Example:

Summit REIT owns 15 office buildings. Financial data:

• Net income: $85 million
• Real estate depreciation: $62 million
• Gain on property sale: $8 million
• Maintenance capex: $18 million
• Shares outstanding: 50 million
• Current share price: $42

FFO = $85M + $62M - $8M = $139M ($2.78/share)

AFFO = $139M - $18M = $121M ($2.42/share)

P/FFO = $42 / $2.78 = 15.1x

P/AFFO = $42 / $2.42 = 17.4x

If comparable office REITs trade at 14x FFO, Summit appears slightly expensive. But if its buildings are newer (lower capex needs) and in better locations, the premium may be justified.

NAV for Summit:

If independent appraisals value the 15 buildings at $2.4 billion and total liabilities are $1.1 billion:

NAV = $2.4B - $1.1B = $1.3B

NAV/share = $1.3B / 50M = $26/share

Summit trades at $42 — a 62% premium to NAV. This suggests the market values the management platform and growth pipeline significantly above liquidation value.

Practice REIT valuation in our CFA Level II question bank.