Reverse the dividend discount model, then split the growth the price requires into what retained AFFO can fund and what the rent roll must deliver.
Solve the Gordon growth model for g: implied growth = (required return × price − dividend) / (price + dividend). For a REIT at $34.50 paying $1.72 a share, a 9 per cent required return implies 3.82 per cent a year of perpetual dividend and AFFO growth. Of that, about 1.24 points can be funded by the cash the REIT retains; the remaining 2.59 points has to come from rents.
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 →
The case is Meridian Industrial Trust, the fictional REIT analysed in Chapter 19 of REIT Analysis and Valuation, with the figures as its companion workbook computes them. The required return of 9 per cent is an illustrative assumption, chosen because it is roughly the workbook's own base-case total return: a 4.99 per cent dividend yield plus 4.0 per cent AFFO growth.
| Input | Value |
|---|---|
| Share price | $34.50 |
| Annual dividend, D0 | $1.72 |
| AFFO (381.0 million over 180 million diluted shares) | $2.1167 |
| Dividend yield | 4.99% |
| AFFO yield | 6.14% |
| Payout of AFFO | 81.3% |
| Retained cash, per share and in total | $0.397 / 71.4m |
| Development yield on cost | 6.6% |
| Required return, k (illustrative) | 9.0% |
The constant-growth dividend model prices a share at next year's dividend over the required return less growth. Next year's dividend is this year's grown once, so the unknown appears on both sides. Rearranged:
P = D0(1 + g) / (k − g)
g = (k × P − D0) / (P + D0)
Excel, with price in B1, dividend in B2 and required return in B3: =(B3*B1-B2)/(B1+B2)
With the Meridian figures: k × P = 0.09 × 34.50 = 3.1050. Subtract the dividend: 3.1050 − 1.72 = 1.3850. Divide by 34.50 + 1.72 = 36.22, and g = 3.82 per cent.
Check it by running it forward: next year's dividend is 1.72 × 1.0382 = 1.7858, a forward yield of 5.18 per cent. Add 3.82 per cent of growth and the return is 9.00 per cent, which reprices the share at exactly $34.50.
A REIT's dividend can grow from two sources. The first is reinvested cash: Meridian keeps 71.4 million a year after the dividend, 18.7 per cent of AFFO. Invested in its development pipeline at a 6.6 per cent yield on cost, that adds about 4.71 million of income a year once stabilised, or 1.24 per cent of AFFO. The second is organic growth from the existing buildings: rent reviews, lease-up and re-leasing spreads.
| Source | Growth a year |
|---|---|
| Retained cash reinvested at 6.6%: 71.4 × 6.6% / 381.0 | 1.24% |
| Organic growth the price requires | 2.59% |
| Implied total growth | 3.82% |
Meridian discloses same-store cash NOI growth of 5.4 per cent. The market, at a 9 per cent required return, is pricing in 2.59 per cent organic growth forever, 2.81 points less. That is not a contradiction: no landlord keeps a 5.4 per cent same-store rate in perpetuity, and the price says investors expect today's leasing spreads to fade towards inflation. Were 5.4 per cent to last forever, total growth of 6.64 per cent would justify a price of $77.61, which is the clearest sign that the perpetuity formula must never be fed a peak growth rate.
The implied growth is the market's answer only once you have chosen k. It is better read as a pair: at this price, a 9 per cent return requires 3.82 per cent growth. If you think the REIT can deliver more, you think the share is cheap at a 9 per cent required return.
| Required return | Price $30.00 | Price $34.50 | Price $40.00 |
|---|---|---|---|
| 8% | 2.14% | 2.87% | 3.55% |
| 9% | 3.09% | 3.82% | 4.51% |
| 10% | 4.04% | 4.78% | 5.47% |
One point on the required return moves implied growth by almost exactly one point. A $5.50 rise in the price, from $34.50 to $40.00, moves it by about 0.7 points. When two analysts disagree about whether a REIT is cheap, the disagreement is usually about k, not about the rents.
Pick the required return, solve for g, then split g into what retained cash funds and what the rent roll must deliver. At $34.50 and 9 per cent, Meridian needs 3.82 per cent growth, 2.59 points of it organic. The FFO, AFFO and payout figures behind this case are live formulas in the free Meridian Industrial Trust workbook; the AFFO bridge itself is worked in how to calculate AFFO from FFO, and the multiple view of the same price in valuing a REIT on P/FFO.
Rearrange the Gordon growth model, price = D0(1 + g)/(k - g), to g = (k x P - D0)/(P + D0). For a REIT at $34.50 paying $1.72 a share with a 9 per cent required return, g = (3.1050 - 1.72)/36.22 = 3.82 per cent a year. The answer depends entirely on the required return you assume.
The dividend, because that is the cash shareholders receive; retained AFFO funds growth instead. Putting AFFO of $2.1167 in place of a $1.72 dividend gives an implied growth of 2.70 per cent rather than 3.82, because it counts the retained 18.7 per cent as paid out. That figure can only be read as growth with no reinvestment.
One the rent roll can sustain forever, which is closer to inflation plus modest reinvestment than to current same-store growth. In the worked case the price implies 2.59 per cent organic growth against 5.4 per cent same-store growth today; if 5.4 per cent lasted forever, the formula would justify $77.61 a share, more than twice the price.
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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