How does depreciation affect the valuation of REITs compared to standard companies?

The correct answer emphasizes the distinct treatment of depreciation in the valuation of Real Estate Investment Trusts (REITs) versus standard companies. For REITs, depreciation is a non-cash expense. While it is recorded on the income statement, it does not impact the actual cash flows generated by the properties. As such, when valuing REITs, analysts often add back depreciation to net income to arrive at a measure of cash flow, known as Funds From Operations (FFO). This practice reflects the true operating performance and cash-generating ability of the REIT, helping to provide a clearer picture of its valuation.

In contrast, for standard companies, depreciation plays a critical role in capturing the wear and tear on physical assets, which can affect net income and, subsequently, the valuation metrics derived from net income. In these cases, depreciation reduces taxable income, adjusting the cash flow dynamics by influencing net earnings and perhaps leading to a lower valuation when analyzing cash flows or earnings growth.

The unique nature of REIT operations and the requirement of distributing most of their taxable income as dividends also affect how depreciation is perceived and treated in valuation models, further distinguishing their treatment from that of typical corporations.