A REIT's FFO expressed as a multiple of the interest it pays on its debts.
Interest coverage of 5:1 means that a REIT is earning five times the amount of money it needs to pay the interest on its debts.
This tells you how much cushion a REIT has before it runs into serious financial trouble. A REIT with 5:1 earnings coverage could meet its debt obligations if its FFO dropped by 80%. A REIT with 2:1 earnings coverage could only survive a 50% FFO drop before running into serious trouble.
A company with a high debt-to-EBITDA ratio might pay little interest on its debts, giving it a sustainable interest coverage multiple. Another REIT might have an impressively low debt-to-EBITDA, but have a low credit rating and pay high interest rates to borrow money. In this case, it could have a dangerously low interest coverage multiple. It's important to look at both.
Capitalization (cap) rate
The amount a REIT (or investor) pays for a commercial property relative to its annual income.
Imagine that you buy an office property for $1,000,000. That property is expected to generate a profit of $60,000 in its first year. You bought the property at a 6% cap rate.
Here's why this is important from a valuation standpoint. Let’s say a REIT invests in class-A urban office buildings, and the market average cap rate for this property type is currently 6.10% (CBRE publishes a semi-annual cap rate survey that’s useful for this purpose).
We can use this information, along with the REIT’s net operating income, to get a ballpark idea of what it should be worth.
For example, let’s say that a particular class-A office REIT had net operating income of $100 million in 2018. By dividing that amount by the market average cap rate of 6.10%, we see that the theoretical value of the business should be about $1.64 billion. We can compare that with the market capitalization to see if it’s trading at a premium or a discount.
This isn’t a perfect method, so use it in conjunction with other valuation metrics on this list.