How do you calculate a REIT's 90% distribution requirement?

The 90 per cent rule is applied to a tax number that sits far below FFO, so it is almost never the constraint that sets a REIT's dividend.

Julian R. Sterling · from REIT Analysis and Valuation

A US REIT must distribute at least 90 per cent of its REIT taxable income, computed before the dividends-paid deduction and excluding net capital gain. That base is a tax number, not FFO: on an illustrative REIT with 400.0m of FFO, taxable income excluding gains is 90.0m, so the legal minimum is 81.0m, $0.506 a share, only 26.1 per cent of AFFO. The dividend that matters for valuation is set by cash flow and by the wish to pay no corporate tax, not by the 90 per cent rule.

Worked in full in REIT Analysis and Valuation by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →

Why the rule is rarely the binding constraint

Analysts often read "REITs must pay out 90 per cent" as "REITs must pay out 90 per cent of their earnings". The base is narrower than any earnings measure in the supplemental package. Tax depreciation, the timing of straight-line rent and the treatment of gains all push REIT taxable income below FFO, and capital gains are outside the 90 per cent base altogether. The worked case shows how far apart the numbers sit. It is an illustration of the mechanics, not tax advice. A UK REIT faces a different test again: it must distribute 90 per cent of the profits of its property rental business, computed on corporation tax principles and excluding gains, within 12 months of the period end. The worked case below follows the US rule.

The assumptions

Illustrative US REIT, $ millions
Item	Amount
GAAP net income	180.0
Real estate depreciation, book	260.0
Gain on sale, GAAP	40.0
Depreciation, tax	290.0
Straight-line rent in GAAP revenue	20.0
Net capital gain, tax (lower tax basis)	70.0
Recurring capex, TIs and leasing commissions	70.0
Dividend paid	250.0
Shares, millions	160.0

FFO is net income plus real estate depreciation less the gain: 180.0 + 260.0 − 40.0 = 400.0, or $2.500 a share. AFFO deducts the 20.0 of straight-line rent and the 70.0 of recurring capital: 310.0, or $1.9375 a share.

The calculation, step by step

1. Remove the GAAP gain, which is replaced by the tax gain outside the base: 180.0 − 40.0 = 140.0.

2. Swap book depreciation for tax depreciation: 140.0 + 260.0 = 400.0, then − 290.0 = 110.0.

3. Remove straight-line rent, which is GAAP revenue the tax return has not yet recognised: 110.0 − 20.0 = 90.0 of REIT taxable income excluding net capital gain.

4. Minimum distribution = 90% × 90.0 = 81.0, or 81.0 / 160.0 = $0.506 a share.

5. To pay no corporate tax at all, the REIT must distribute all of its taxable income including the gain: 90.0 + 70.0 = 160.0, $1.000 a share.

The minimum is 20.2 per cent of FFO and 26.1 per cent of AFFO. Even the tax-neutral level, 160.0, is only 51.6 per cent of AFFO. The REIT actually pays $1.56 a share, 250.0 in total, which is 80.6 per cent of AFFO and 90.0 more than its taxable income. That excess is a choice driven by the market's appetite for income, not a legal requirement.

What each level of distribution costs

Retained taxable income is taxed at the 21 per cent corporate rate, so paying the bare minimum is legal but not free.

Distribution choices on the same year, $ millions
Distribution	Amount	Per share	Corporate tax	AFFO retained	Payout of AFFO
90% minimum	81.0	0.506	16.59	212.41	26.1%
All ordinary taxable income	90.0	0.563	14.70	205.30	29.0%
All taxable income, with the gain	160.0	1.000	0.00	150.00	51.6%
Dividend actually paid	250.0	1.563	0.00	60.00	80.6%

The minimum keeps 212.41 of AFFO in the company but costs 16.59 of tax that a full distribution of taxable income avoids. That is why most REITs treat 100 per cent of taxable income as the practical floor. The question for dividend safety is the other way round: how much of the 250.0 is covered by recurring cash, which is the AFFO payout, and how much headroom there is above the tax floor if the dividend has to be cut.

What if: tax depreciation

Minimum distribution at different levels of tax depreciation
Tax depreciation	Taxable income excl. gain	90% minimum	Per share
230.0	150.0	135.0	0.844
260.0	120.0	108.0	0.675
290.0	90.0	81.0	0.506
320.0	60.0	54.0	0.338

Every 30.0 of extra tax depreciation cuts the floor by 27.0, or about 17 cents a share. A REIT that acquired its assets through contributions with a low carried-over tax basis has less tax depreciation and a higher floor; one with fresh, stepped-up basis has more room to cut in a downturn.

The common mistakes

Applying 90 per cent to FFO. That gives 360.0, $2.250 a share, more than the REIT pays and more than its AFFO. A model that holds the dividend at 90 per cent of FFO overstates the payout and the yield.
Applying it to GAAP net income. 90 per cent of 180.0 is 162.0, double the true floor, because net income still carries the GAAP gain and book rather than tax depreciation.
Forgetting the gain is outside the base. Net capital gain is not in the 90 per cent calculation, but if it is retained it is taxed. Either pay it out or plan for the tax.
Reading the floor as dividend support. The rule sets a minimum, not a target. A dividend far above the floor can be cut a long way without losing REIT status.

Takeaway

Minimum distribution = 90 per cent of REIT taxable income, before the dividends-paid deduction and excluding net capital gain: 81.0 here.
Tax-neutral floor = all taxable income including gains: 160.0, 51.6 per cent of AFFO.
Judge the dividend on its AFFO payout, 80.6 per cent here, not on the 90 per cent rule.

The dividend on one line, with the FFO and AFFO bridges that feed it, is in the free workbook for this case. For the cash measure the dividend should be tested against, see how to calculate AFFO from FFO, and for the starting point, how to calculate FFO from net income.

Questions readers ask

Is the REIT 90 per cent rule based on FFO or net income?

Neither. It is 90 per cent of REIT taxable income, computed before the dividends-paid deduction and excluding net capital gain. Tax depreciation, straight-line rent and gains make that base smaller than both. In the illustration, net income is 180.0m and FFO 400.0m, but the base is 90.0m, so the minimum distribution is 81.0m.

What happens if a REIT distributes only 90 per cent of its taxable income?

It keeps its REIT status, but the retained taxable income is taxed at the corporate rate, 21 per cent. In the illustration, paying the 81.0m minimum leaves 79.0m of taxable income including the gain, and 16.59m of tax. A 4 per cent excise tax can also apply if distributions fall below 85 per cent of ordinary income plus 95 per cent of capital gain net income.

Why do REITs pay out more than their taxable income?

Because the dividend is set by cash flow and investor demand for income, while taxable income is reduced by tax depreciation. The illustrative REIT pays 250.0m against 160.0m of taxable income, 80.6 per cent of AFFO. Distributions above the REIT's earnings and profits are generally treated as a return of capital for shareholders.

Read the whole case

This article is one calculation from REIT Analysis and Valuation. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.

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Also on this site

How do you calculate AFFO from FFO?Remove non-cash items from FFO, then deduct recurring capex, leasing commissions and TIs. Here FFO of 410 becomes AFFO of 300, and the payout rises to 88.0%.
How do you calculate a REIT's FFO from net income?Add back real estate D&A, deduct gains on sale, add impairments, adjust for JVs: 180.0M of net income becomes 461.0M of FFO, $2.744 a share at 13.85x.
How do you value a REIT using the P/FFO multiple?Justified P/FFO is AFFO conversion over cost of equity less growth: 75% over 8.5% less 3.0% gives 13.64x, $32.73 a share against a $30.00 price.
Can a REIT trading at a discount to NAV still acquire accretively?A REIT still acquires accretively down to a 6.2 per cent NAV discount — 11.6 per cent funded at the target mix. Break-even price $40.32, NAV $42.97.
How do you calculate EPRA NTA, NRV and NDV?Start from IFRS equity and adjust for deferred tax, derivatives, goodwill, purchasers' costs and the debt mark: 20.00 a share becomes 24.95, 21.50 and 20.80.
How much does external management cost a REIT?A 0.75% fee on assets plus residual costs takes 15.0% of NOI against 7.5% internally; capitalised at 16.7x, the excess is $3.00 a share, 12.5% of NAV.

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