The Underwriter's Guide to Real Cash Flow: Why FFO is Flawed and How We Calculate AFFO

A lot of junior analysts starting in real estate securities or corporate REIT analysis get confused about why traditional GAAP Net Income is useless for commercial property, and why FFO alone still paints an overly optimistic picture.

Here is the exact step-by-step waterfall we use to bridge GAAP Net Income to true distributable cash flow (AFFO):

1. Start with GAAP Net Income
2. Add Back Real Estate Depreciation & Amortization: Buildings don't depreciate in cash terms the way machinery does; adding D&A back gets you to NAREIT FFO.
3. Deduct Straight-Line Rent Adjustments: Accounting rules require landlords to average contractual rent hikes over a 15-year lease upfront. Subtracting non-cash straight-line rent ensures you only count actual cash checks received.
4. Deduct Recurring Tenant Improvements (TI) & Leasing Commissions (LC): This is where generic FFO fails. To keep an office or retail property occupied, the landlord has to spend real cash renovating tenant space and paying brokers upon lease turnover.
5. Deduct Capitalized Maintenance CapEx: Parking lot repaving, roof replacements, and HVAC overhauls are real cash outflows that GAAP capitalizes on the balance sheet rather than expensing on the income statement.

The Result: Adjusted Funds From Operations (AFFO).

When you evaluate dividend coverage on AFFO rather than FFO, you quickly realize why several 9%+ yielding REITs are actually in dividend-trap territory with payout ratios exceeding 115% of true cash flow, while blue chips run at conservative 65-75% AFFO payout ratios.

What are the standard TI/LC reserve assumptions your shops are underwriting per square foot across industrial and retail right now?