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Adjusted funds from operations

What Is Adjusted Funds from Operations?

Adjusted funds from operations (AFFO) is a financial metric used primarily to evaluate the performance of Real Estate Investment Trusts (REITs). It provides a clearer picture of a REIT's recurring cash flow available for distribution to shareholders by making further adjustments to Funds from Operations (FFO). While FFO is an industry-standard non-GAAP measure for REITs, AFFO aims to offer an even more precise estimation of a REIT's true operating earnings capacity within the broader category of real estate finance.

History and Origin

The concept of Funds from Operations (FFO) was introduced by Nareit (National Association of Real Estate Investment Trusts) in 1991 to address the limitations of Generally Accepted Accounting Principles (GAAP)21, 22. GAAP accounting requires public companies to depreciate real estate assets, which, for REITs, can obscure their actual operating performance since property values often appreciate rather than depreciate over time20. FFO was developed as a supplemental measure to remove this non-cash charge and other non-recurring items from Net Income19.

However, FFO still had its shortcomings, particularly in accounting for necessary recurring capital outlays. Over time, analysts and investors recognized the need for a metric that further refined FFO to reflect a more accurate measure of a REIT's sustainable cash flow available for distribution. This led to the unofficial development and widespread adoption of Adjusted Funds from Operations (AFFO), also sometimes referred to as Funds Available for Distribution (FAD) or Cash Available for Distribution (CAD). While Nareit provides a standardized definition for FFO, AFFO does not have one universally accepted definition, leading to variations in its calculation among different REITs and analysts18.

Key Takeaways

  • Adjusted funds from operations (AFFO) is a non-GAAP financial measure used to assess the core operating performance and dividend-paying capacity of Real Estate Investment Trusts (REITs).
  • It refines Funds from Operations (FFO) by subtracting recurring capital expenditures and other non-cash adjustments that may inflate FFO.
  • AFFO provides a more conservative and arguably more accurate estimate of a REIT's sustainable cash flow for distributions.
  • The absence of a standardized definition for AFFO means its calculation can vary between companies, requiring careful comparison.
  • Despite being a non-GAAP metric, Adjusted Funds from Operations is widely used by analysts and investors to evaluate REITs due to its relevance to long-term profitability and dividend sustainability.

Formula and Calculation

The calculation of Adjusted Funds from Operations typically starts with Funds from Operations (FFO) and then subtracts or adds back specific items to arrive at a more precise measure of distributable cash flow. While there is no single, universally mandated formula, the general approach is:

AFFO=FFO−Recurring Capital Expenditures−Straight-line Rent Adjustments±Other Non-cash Adjustments\text{AFFO} = \text{FFO} - \text{Recurring Capital Expenditures} - \text{Straight-line Rent Adjustments} \pm \text{Other Non-cash Adjustments}

Where:

  • FFO: Calculated as Net Income plus Depreciation and Amortization of real estate, and excluding gains or losses from property sales17.
  • Recurring Capital Expenditures: These are essential, ongoing capital outlays required to maintain the property's income-producing capacity, such as roof replacements, HVAC system upgrades, or significant tenant improvements. These are distinct from growth-oriented Capital Expenditures aimed at expanding the portfolio.
  • Straight-line Rent Adjustments: GAAP requires rental income to be recognized on a straight-line basis over the life of a lease, even if cash payments escalate over time. This adjustment removes the non-cash portion of this revenue recognition.
  • Other Non-cash Adjustments: This can include items such as the amortization of above- and below-market leases, stock-based compensation, or deferred financing costs.

This formula helps normalize a REIT's earnings to provide a more accurate reflection of the cash flow available for shareholders16.

Interpreting the Adjusted Funds from Operations

Interpreting Adjusted Funds from Operations involves understanding what the metric represents and how it contributes to a comprehensive analysis of a REIT. A higher AFFO generally indicates a greater capacity for a REIT to generate sustainable dividends and fund its operations from its core real estate activities. Because AFFO accounts for recurring capital expenditures, it offers a more conservative and often more realistic view of a REIT's operational profitability compared to FFO.

Investors typically use AFFO per share to gauge how much cash a REIT is generating per share that could theoretically be distributed. A consistently growing AFFO per share is a positive sign, suggesting that the REIT's underlying properties are performing well and that it is effectively managing its maintenance costs. Conversely, a declining AFFO may signal operational challenges or an unsustainable dividend payout ratio. Analyzing AFFO alongside a REIT's dividend payout ratio is crucial, as it helps determine if the declared dividends are adequately covered by the company's operational cash flow.

Hypothetical Example

Consider a hypothetical REIT, "Diversified Properties Trust (DPT)," reporting its financial results.

Assume DPT has the following figures for the last quarter:

  • Net Income: $10,000,000
  • Real Estate Depreciation and Amortization: $3,000,000
  • Gain on Sale of Property: $1,500,000
  • Recurring Capital Expenditures: $1,200,000
  • Straight-line Rent Adjustments (negative, meaning cash rent was lower than recognized revenue): -$300,000
  • Non-cash Stock-based Compensation: $100,000

First, calculate FFO:

FFO=Net Income+Depreciation and Amortization−Gain on Sale of Property\text{FFO} = \text{Net Income} + \text{Depreciation and Amortization} - \text{Gain on Sale of Property} FFO=$10,000,000+$3,000,000−$1,500,000=$11,500,000\text{FFO} = \$10,000,000 + \$3,000,000 - \$1,500,000 = \$11,500,000

Next, calculate Adjusted Funds from Operations (AFFO):

AFFO=FFO−Recurring Capital Expenditures−Straight-line Rent Adjustments+Non-cash Stock-based Compensation\text{AFFO} = \text{FFO} - \text{Recurring Capital Expenditures} - \text{Straight-line Rent Adjustments} + \text{Non-cash Stock-based Compensation} AFFO=$11,500,000−$1,200,000−(−$300,000)+$100,000\text{AFFO} = \$11,500,000 - \$1,200,000 - (-\$300,000) + \$100,000 AFFO=$11,500,000−$1,200,000+$300,000+$100,000=$10,700,000\text{AFFO} = \$11,500,000 - \$1,200,000 + \$300,000 + \$100,000 = \$10,700,000

In this example, DPT's Adjusted Funds from Operations of $10,700,000 provides a more conservative measure of its cash flow available for distribution to shareholders than its FFO of $11,500,000, having accounted for necessary ongoing property maintenance and non-cash rental adjustments. This figure is crucial for assessing DPT's ability to maintain its dividends and invest in its existing portfolio.

Practical Applications

Adjusted Funds from Operations (AFFO) is a vital tool for investors and analysts in the real estate sector, particularly when evaluating REITs. Its practical applications include:

  • Dividend Sustainability Analysis: Investors often rely on REITs for consistent income through dividends. AFFO is considered a stronger indicator of a REIT's ability to cover its dividend payments from its ongoing operations than FFO, as it accounts for necessary maintenance Capital Expenditures.
  • Performance Comparison: While AFFO lacks a universal standard, analysts frequently adjust REITs' reported FFO to create a comparable AFFO measure across companies, aiding in more accurate peer-to-peer performance comparisons. This can inform valuation models and investment decisions.
  • Internal Management Tool: REIT management teams often use Adjusted Funds from Operations internally to assess operational efficiency, identify areas for cost control, and make informed decisions regarding property maintenance and capital allocation.
  • Due Diligence: For potential investors, reviewing a REIT's AFFO trends over several periods can reveal insights into the long-term health and stability of its portfolio and operations. Public companies regularly file their Financial Statements with the U.S. Securities and Exchange Commission, and investors can find detailed disclosures, including non-GAAP measures like FFO and sometimes AFFO, by searching the SEC EDGAR database15.

Limitations and Criticisms

Despite its usefulness, Adjusted Funds from Operations has several limitations and faces criticism:

  • Lack of Standardization: The most significant drawback of AFFO is the absence of a universally accepted definition. Unlike Funds from Operations, which Nareit provides a standard for14, each REIT or analyst may calculate AFFO differently. This variability can make direct comparisons between companies challenging and requires careful scrutiny of the specific adjustments made13.
  • Management Discretion: Because there's no official standard, management has discretion in what they include or exclude in their AFFO calculation, which can potentially be used to present a more favorable picture of the company's financial health. Investors must examine the reconciliation from GAAP Net Income to AFFO within a REIT's disclosures.
  • Not a GAAP Measure: As a Non-GAAP Financial Measure, AFFO is not prepared under the rigorous framework of Generally Accepted Accounting Principles. While often perceived as more insightful for REITs than traditional GAAP metrics, non-GAAP measures come with the inherent risk of inconsistency and potential for manipulation11, 12. The U.S. Securities and Exchange Commission (SEC) provides guidance on the use of non-GAAP measures, emphasizing the need for clear reconciliation to the most comparable GAAP measure and prohibiting misleading presentations9, 10.
  • Focus on Distribution Capacity: While AFFO is a good indicator of dividend-paying capacity, it might not fully capture a company's true economic earnings or long-term growth potential if it understates the real cost of maintaining and upgrading properties8. Some discussions within investor communities also highlight the debates around which adjustments are truly recurring versus non-recurring, affecting the accuracy of AFFO as a measure of sustainable cash flow [3, for more on these discussions see the Bogleheads forum discussion on FFO vs. AFFO].

Adjusted Funds from Operations vs. Funds from Operations

Adjusted Funds from Operations (AFFO) and Funds from Operations (FFO) are both critical non-GAAP metrics used in analyzing Real Estate Investment Trusts (REITs), but they serve slightly different purposes and involve distinct adjustments.

FFO, as defined by Nareit's definition of FFO, begins with a REIT's Net Income and typically adds back real estate-related Depreciation and Amortization, and excludes gains or losses from the sale of properties7. Its primary aim is to remove the impact of non-cash depreciation, which can distort the profitability of real estate assets under GAAP. FFO is widely recognized as the industry standard for REIT performance.

AFFO takes FFO a step further to provide a more conservative and arguably more accurate measure of the cash generated by a REIT that is truly available for distribution to shareholders. The key difference lies in the additional adjustments AFFO makes, most notably subtracting recurring Capital Expenditures (CapEx) necessary to maintain the properties' income-producing ability6. It also often adjusts for non-cash items like straight-line rent adjustments, which account for the difference between cash rents received and rental income recognized under GAAP. While FFO is an indicator of operating performance, AFFO aims to reflect a REIT's capacity to pay dividends sustainably. Unlike FFO, there is no single official standard for AFFO, meaning its calculation can vary from one company to another4, 5. When comparing the two, FFO is broadly accepted, while AFFO offers a deeper dive into true distributable cash flow.

FAQs

Q: Why is Adjusted Funds from Operations (AFFO) important for REITs?
A: AFFO is important because it offers a more realistic view of a REIT's ability to generate cash from its core operations that can be paid out as dividends. Unlike standard accounting measures, it accounts for the ongoing costs of maintaining properties, providing a clearer picture of sustainable earnings.

Q: Is AFFO a GAAP measure?
A: No, Adjusted Funds from Operations is a Non-GAAP Financial Measure. This means it is not prepared according to the standardized rules of Generally Accepted Accounting Principles. Companies present it as a supplemental metric to provide additional insights not fully captured by GAAP.

Q: How is AFFO different from the Cash Flow Statement?
A: While both relate to Cash Flow, the Cash Flow Statement is a formal GAAP financial statement that tracks all cash inflows and outflows from operating, investing, and financing activities. AFFO is a non-GAAP metric specifically designed for REITs, starting from Net Income and adjusting for certain non-cash items and recurring capital expenditures to estimate distributable cash flow for shareholders, primarily within operating activities3.

Q: Why do REITs use non-GAAP metrics like AFFO?
A: REITs use non-GAAP metrics like AFFO because traditional GAAP accounting, particularly Depreciation of real estate assets, can misrepresent the economic performance of real estate companies1, 2. AFFO provides investors with a more relevant measure of a REIT's operating profitability and its capacity to generate consistent income, which is a primary reason investors own REITs.

Q: Can I compare AFFO across different REITs?
A: You can compare AFFO across different REITs, but with caution. Since there is no single standardized definition for Adjusted Funds from Operations, each company may calculate it slightly differently. It is crucial to review the reconciliation provided in each REIT's Financial Statements and accompanying notes to understand the specific adjustments they make. This allows for a more informed comparison. For further detail, refer to Wall Street Prep's AFFO explanation.