If you read this article, you should have previously read FFO Vs AFFO in order to understand those 2 concepts. They are crucial in the Canadian REIT analysis since they replace the commonly used Dividend Payout Ratio for “regular” stocks.
Both FFO and AFFO must be brought down on a per unit basis. You basically have to divide the number by the number of units and compare it to the distribution per unit. Then again, those numbers are provided in the company’s financial statement.
Number of units: 100,000
Distribution: $1.00 per units
Proceeds of sales & Capital expenditures: $20,000
AFFO would be:
$100,000 (earnings) + $35,000 (depreciation) – $20,000 (proceeds of sales & capital expenditures) = $105,000
AFFO per unit would be: $1.15 ($105,000/100,000 units)
So if you would have looked at the payout ratio (distribution/earnings), you would have seen a 100% payout ratio. However, if you look at the percentage of distribution on the AFFO, you get an 87% ratio. The company could technically distribute up to $1.15 per units without being cash flow negative but would then show a 115% payout ratio.
The FFO and AFFO per unit should be lower than 100% in order to keep a healthy distribution over time. So the magic number will be high, but should be under 100%. That’s normal as REITs are required to distribute most of their income. One thing to consider is that if the REIT is distributing 100% of its cash flow, it leaves very little room for flexibility (unless the company accesses additional financing). However, it is also possible that the number exceeds the 100% mark. So is a 110% distribution rate dramatic? Not at all. Say what?
If the company distributes more than 100% of its AFFO, that means that it distributes more money than it receives. A negative cash flow position could eventually lead to a distribution cut or less attractive overall financial position. This is a similar rationale to the one that we apply on a dividend stocks with a payout ratio over 100%. However, there are 2 situations where a REIT can have a negative cash flow position and still be a good investment:
Consider the amount of units in DRIP. If you take the 2011 Q3 financial statement of RioCan (REI.UN), it shows a 104.5% distribution rate of AFFO. This technically means that the company is distributing more money than its cash flow. RioCan also shows 22.9% of its units to be part of the DRIP (Dividend Reinvestment Plan). Those investors don’t receive payouts, but more units on a monthly basis. When considering the distribution net of DRIP as a percentage of AFFO, the company shows a healthy 79.5%. REITs count a lot of investors participating in their DRIP which allows them more flexibility in regards to their liquidity.
Future income growth. If the company recently purchased an important complex, chances are that its distribution percentage will be higher than usual. You will then rely on the management’s ability to raise rents and improve profitability of the newer complex. If the future income should be higher due to better management on the recent acquisition, you can tolerate a higher distribution rate. As you can see, analyzing the payout ratio of a Canadian REIT incurs a lot more gray areas than dividend stocks!