Affo

Adjusted Funds From Operations (AFFO): Definition, Formula, Example, and FAQs

Adjusted Funds From Operations (AFFO) is a key financial metric used predominantly by Real Estate Investment Trusts (REITs) to represent the actual cash flow available for distribution to shareholders. It is a refinement of Funds From Operations (FFO) that attempts to provide a more accurate picture of a REIT's recurring economic earnings by accounting for certain non-cash items and significant recurring capital expenditures. AFFO falls under the broader category of financial metrics within the Real Estate Investment Trusts (REITs) industry.

History and Origin

The concept of Funds From Operations (FFO) was introduced by the National Association of Real Estate Investment Trusts (NAREIT) in 1991 to offer a more relevant measure of performance for REITs than traditional net income. This was because standard accounting practices, particularly depreciation expenses associated with real estate, did not accurately reflect a REIT's cash-generating ability or its capacity to pay dividends.¹⁴,¹³ While FFO provided a better benchmark, it still didn't fully capture the ongoing costs necessary to maintain and re-lease properties. As a result, analysts and investors began developing their own adjustments to FFO, leading to the emergence of various versions of Adjusted Funds From Operations (AFFO). NAREIT acknowledges AFFO as a widely used, albeit non-standardized, computation made by analysts to measure a real estate company's recurring FFO after deducting capital improvement funding.¹²

Key Takeaways

• AFFO is a non-Generally Accepted Accounting Principles (GAAP) measure that aims to reflect the true distributable cash flow of a REIT.
• It adjusts FFO by deducting recurring capital expenditures and non-cash rent adjustments.
• Investors often use AFFO to assess a REIT's ability to sustain and grow its dividend payments.
• Unlike FFO, there is no single, standardized definition of AFFO, meaning its calculation can vary among companies and analysts.
• AFFO provides a more conservative estimate of a REIT's operational cash flow compared to FFO.

Formula and Calculation

The calculation of Adjusted Funds From Operations (AFFO) typically begins with FFO and makes several crucial adjustments. While a universal formula does not exist, a common approach is:

Where:

• FFO (Funds From Operations): Calculated as Net Income plus depreciation and amortization of real estate, and excluding gains or losses from property sales.,¹¹
• Recurring Capital Expenditures (CapEx): These are routine, necessary investments to maintain the property's income-generating capacity and physical condition, such as replacing roofs, HVAC systems, or common area renovations. They differ from one-time growth-related expenditures.¹⁰,⁹
• Straight-line Rent Adjustments: Under accrual accounting, landlords often record rental income on a straight-line basis over the life of a lease, even if cash payments escalate over time. AFFO reverses this non-cash adjustment to reflect actual cash received or paid.⁸,⁷
• Non-Cash Stock Compensation: The value of stock or options granted to employees as compensation, which is a non-cash expense on the income statement.
• Other Non-Cash Adjustments: This may include other non-cash items that affect reported earnings but not actual cash flow, such as amortization of deferred financing costs or certain tenant allowances.⁶

Interpreting the AFFO

Interpreting AFFO involves understanding its purpose as a proxy for distributable cash flow. A higher AFFO generally indicates that a REIT has more cash available to pay dividends to its shareholders, which is a primary reason many investors own REITs. When evaluating a REIT, investors often look at the AFFO per share, as this directly relates to the potential dividend payout per share. A consistent and growing AFFO per share can signal a healthy and well-managed property portfolio. Conversely, a declining AFFO might suggest issues with property performance, increasing maintenance costs, or challenges in leasing activity. This metric is crucial for valuation in the REIT sector, as it offers a more "cash-like" perspective than traditional earnings.

Hypothetical Example

Consider a hypothetical REIT, "Diversified Properties Inc."
In the last quarter, Diversified Properties Inc. reported the following:

• FFO: $50 million
• Recurring Capital Expenditures: $8 million (for common area improvements and roof replacements across several properties)
• Straight-line Rent Adjustment (negative impact): $2 million (reflecting non-cash revenue recognized ahead of cash receipt)
• Non-Cash Stock Compensation: $1 million

To calculate the AFFO for Diversified Properties Inc.:

In this scenario, while the REIT had $50 million in FFO, after accounting for necessary recurring investments and non-cash accounting adjustments, the actual cash available to shareholders, or AFFO, was $39 million. This provides a more conservative and realistic view of the REIT's distributable earnings.

Practical Applications

AFFO is a critical metric in real estate investing, particularly for investors focusing on income-generating properties like those held by REITs. Its practical applications include:

• Dividend Sustainability Assessment: Investors frequently use AFFO to gauge whether a REIT's dividends are sustainable and likely to grow. A high dividend payout ratio relative to AFFO can signal that a REIT might be over-distributing and potentially unsustainable in the long term.
• Comparative Analysis: While not standardized, many analysts and REITs consistently apply their own AFFO methodologies, allowing for year-over-year comparison of a single REIT's performance and sometimes for comparison among similar REITs, though direct peer comparisons require careful review of each company's specific adjustments.
• Valuation: AFFO is often used in valuation models, such as dividend discount models or AFFO multiples (e.g., Price/AFFO), as it represents the cash flow truly available to shareholders.
• Asset Management Decisions: REIT management teams may use AFFO to inform capital allocation decisions, understanding how recurring property expenditures impact their distributable cash flow. For instance, the National Association of Real Estate Investment Trusts (NAREIT) provides definitions and resources for understanding these metrics in the context of REIT operations.⁵

Limitations and Criticisms

Despite its utility, Adjusted Funds From Operations (AFFO) has several limitations and faces criticism, primarily due to its lack of standardization. Unlike FFO, for which NAREIT provides guidelines, there is no universally accepted definition or calculation methodology for AFFO.⁴ This means that different REITs, analysts, or financial publications may calculate AFFO in varying ways, making direct comparisons between companies challenging.

Key criticisms include:

• Subjectivity in Adjustments: The "recurring capital expenditures" component of AFFO is often subjective. What one company considers a necessary recurring expense to maintain a revenue stream, another might classify differently, potentially inflating or deflating the reported AFFO. This lack of clear guidance can lead to inconsistency.
• Inconsistency Across Reports: Because companies are not mandated to report AFFO by regulatory bodies like the SEC, the presentation and underlying assumptions can vary widely. Investors must carefully review the footnotes and reconciliation statements of a REIT's financial statements to understand how AFFO is derived.
• Potential for Manipulation: The flexibility in calculating AFFO can open the door to management presenting a more favorable picture of cash flow than might be warranted, by minimizing the impact of necessary recurring investments or other adjustments.
• Exclusion of Growth CapEx: AFFO is intended to reflect distributable cash, so it typically excludes growth-oriented capital expenditures. However, distinguishing between maintenance CapEx and growth CapEx can be complex and is often subject to judgment.

AFFO vs. FFO

Adjusted Funds From Operations (AFFO) and Funds From Operations (FFO) are both non-GAAP financial metrics crucial for analyzing Real Estate Investment Trusts (REITs), but they serve slightly different purposes. FFO, as defined by NAREIT, starts with net income and adds back depreciation and amortization of real estate, along with gains or losses from property sales. The primary goal of FFO is to provide a more accurate measure of a REIT's operating performance by removing the non-cash impact of depreciation on real estate assets, which do not necessarily decline in value over time in the same way traditional fixed assets do.,³

AFFO takes FFO a step further by attempting to reflect the true cash flow available for distribution to shareholders. The key difference lies in the adjustments AFFO makes for recurring capital expenditures, straight-line rent adjustments, and sometimes non-cash stock compensation. While FFO aims to show the operational profitability from core real estate activities, AFFO seeks to represent the actual cash distributable to investors after accounting for the ongoing costs required to maintain the properties and their revenue streams.² Consequently, AFFO is generally a more conservative measure of a REIT's financial health and its capacity to pay dividends, whereas FFO is a broader indicator of operating performance.

FAQs

What is the primary purpose of AFFO?
The primary purpose of AFFO is to provide investors with a clearer, more realistic understanding of the actual cash flow a Real Estate Investment Trust (REIT) generates and has available to distribute as dividends to its shareholders. It refines FFO by factoring in necessary recurring expenses.

Is AFFO a GAAP measure?
No, Adjusted Funds From Operations (AFFO) is a non-Generally Accepted Accounting Principles (GAAP) measure. This means there is no standardized accounting rulebook for its calculation, leading to variations in how different companies or analysts compute it.

Why is AFFO important for REIT investors?
AFFO is important for investing in REITs because it offers a more conservative and arguably more accurate assessment of a REIT's capacity to pay and grow its dividends. Since many investors buy REITs for income, understanding the true distributable cash flow is crucial for evaluating investment sustainability and potential returns.

How does AFFO differ from operating cash flow?
While both relate to cash, AFFO and operating cash flow (found on the cash flow statement) are distinct. Operating cash flow includes changes in working capital and often reflects the total cash generated from a company's primary business activities. AFFO is a more specific metric for REITs that starts with FFO and then makes further adjustments for items like recurring capital expenditures and non-cash rent, aiming to directly represent distributable cash. The cash flow statement provides a comprehensive view of cash movements from operating, investing, and financing activities.

What are "straight-line rent adjustments" in AFFO?
Straight-line rent adjustments refer to the accounting practice where landlords recognize rental income evenly over the life of a lease, even if the actual cash payments from tenants are staggered or escalate over time. AFFO adjusts for this non-cash accounting effect to reflect the actual cash received or paid by the REIT for rent.¹