The saying “one size fits all” is not tossed around in the world of investing very often…  and that’s for good reason.

Risk appetites, investment horizons and financial goals mean portfolios can — and usually do — look different from person to person. Going a step further, each asset in those portfolios carry their own quirks that require tailored analysis.

#-ad_banner-#​With the wide range of products trading on public exchanges these days, it’s important to know that a worthwhile metric in one industry may not reliably apply to the next.

One shining example of this is EPS, or earnings per share.  Many investors use EPS quarter after quarter to rate their holdings, but if you used that metric to value one industry in particular, you’d be way off base.

Real estate investment trusts have been a cornerstone of my trading portfolio for years now.  While you may already be familiar with REITs and their inner workings, would you know how to properly value and compare them?

Correct REIT appraisal centers on a key metric known as funds from operations, or FFO. EPS, in comparison, is based largely on net income that has had depreciation removed from it.  Since real estate often keeps its value or appreciates, we need to add that number back in to get a more accurate view.

The basic formula for FFO is as follows:

Funds From Operations = Net Income + Depreciation + Amortization – Gains on Asset Sales + Losses on Asset Sales

This helps us find the true cash flow from operations for REITs.  Strong FFO supports existing processes, bolsters new acquisitions and ensures investors will be paid future dividends.

To give FFO some real world context, let’s look at a case study with one of the hottest REIT sectors right now: self-storage facilities.

What exactly is causing self-storage REITs to reach all-time new highs?  

1.    Mortgage rates are still relatively low.  
2.    Home and rental prices are increasing, while income growth hasn’t kept pace.
3.    Flourishing job markets (such as those in Texas) are boosting relocation.

All of these result in transitions where people might find themselves in need of extra storage space.  Whether waiting to close on a new home, downgrading due to higher rents or packing away items during a move, there are plenty of reasons to seek out the services of self-storage centers.

The three major players in this space are Public Storage (NYSE: PSA), Sovran Self Storage, Inc. (NYSE: SSS), and Extra Space Storage, Inc. (NYSE: EXR).

Fortunately, all three trusts reported earnings at the end of July, giving us a fresh set of FFO numbers to analyze.  On a per share basis, PSA comes ahead with an FFO of $1.97.  SSS takes the second spot with an FFO per share of $1.00, having disappointed analysts by $0.05.  EXR rounds out the bottom at $0.64 per share.

It’s important to note the size differences, however.  PSA dwarfs the competition with a market cap of over $30 billion.  SSS and EXR are just fractions of that size, carrying capitalizations of $2.5 billion and $6.1 billion, respectively. So how are we to compare the three effectively?

Just as you can divide price by earnings to arrive at a P/E ratio for stocks, you can divide price by FFO to put each REIT on the same playing field.  With that in mind, I’ve annualized the most recent quarter’s FFO numbers to compute the forward P/FFO ratios of PSA, SSS and EXR.

In the above context, we see that PSA is actually overvalued compared to the other two REITs, with SSS trading at the biggest discount.  We could actually make a case for going long SSS and shorting PSA in a pairs trade until valuations are more in line.

Risks to consider: While FFO should be your main starting point when analyzing REITs, it remains just one piece of the puzzle.  Occupancy rates, dividend growth, M&A activity, etc. should all be factored in to make the most informed decision possible.

Action to take–> Understanding the key metrics that drive your investments is essential to running a good portfolio.  In the case of REITs, tracking the latest FFO numbers will keep your fingers on the pulse of performance.  As far as self-storage REITs go, P/FFO ratios are high given the strong price growth in the past few years.  However, a conservative entry on SSS could yield some respectable gains if a pull-back were to occur in the near future.

Interested in REITs? My colleague Nathan Slaughter has recently discovered a high-yield income investment that allows regular investors to invest in real-estate like America’s wealthy. These “Eisenhower Trusts,” as we call this special group of REITs, allow anyone to invest in real estate and earn yields of 12% or higher — and it takes no more than $500 to get started. To learn more about this special asset class, I urge you to check out his latest report here.