Adjusted Funds From Operations (AFFO)

AFFO is a metric used to gauge the strength of a REIT by measuring its residual cash flows

Adjusted funds from operations (AFFO) is a metric used to measure the strength of a real estate investment trust (REIT) by giving an accurate account of its residual cash flows.

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It is important in any investment, especially in REIT investments, as this fund must payout at least 90% of its taxable income to investors in the form of dividends. Hence, having an accurate account of this measure is valuable.

AFFO is usually derived from the REIT's funds from operations (FFO) but is adjusted to account for critical details that the FFO does not. For example, AFFO adjusts FFO to subtract recurring capital expenditures (capex) and adjust straight-line rents' effects. While FFO continues to be widely accepted, it is considered an inferior measure to AFFO.

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How to Calculate AFFO

The AFFO is calculated using the FFO, which is the measure used to show the cash flow of REITs. The formula for FFO is shown below.

FFO = Net Income - Gains on Sale of Assets + Depreciation + Amortization

Depreciation and amortization are added back to funds from operations because they are both considered non-cash expenses and therefore do not affect the firm's level of money.

The reason that gains on the sale of assets are subtracted from net income is that it is considered an unreliable indicator of a REITs typical cash flows, as the sale of assets is not consistent and does not have a long-term impact on earnings.

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The AFFO makes minor adjustments to the FFO to solve some of the disadvantages of using the FFO to measure a REIT's residual cash flow. The equation for AFFO is shown below:

AFFO = FFO - Recurring Capex - Straight-lined Rents

The recurring capital expenditures of a REIT might include a range of expenditures often related to general upkeep, including repairs and maintenance that occur over the life of a lease. In addition, straight-lined rents are adjusted in the FFO.

Straight-line rents are a measure of rent calculated by averaging the rent of a house over the course of a lease. Many leases include rent increases at a fixed interval. The straight-line method of calculating rent averages all the rents across the life of the lease so that it remains constant.

AFFO adjusts this because it inaccurately gives higher rents at the beginning of the lease and lower rents towards the end.

wall-street-oasis_finance_adjusted-funds-from-operations-affo_straight-line-rents

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Example of AFFO

Understanding the AFFO might be easier with an example. 

Imagine a REIT that has brought in $2.5 million in net income and has sold three houses in the past year with a net gain of $600k. Furthermore, the REIT recorded $60k of amortization and $30k of depreciation. With this information, we can calculate the FFO.

FFO = $2.5 million - $600k + $30k + $60k = $1.99 million

It doesn't end there, though. Picking up where we left off, imagine that recurring capital expenditures amounted to $400k, and adjusting the straight-lined rents amounted to an additional $60k.

AFFO = $1.99 million - $400k + $60k = $1.65 million

It may be beneficial to find AFFO/share, calculated by dividing AFFO by the number of outstanding shares. Imagine, in this case, that's 165,000 shares.

AFFO/Share = $1.65 million / 165k shares = $10 per share

Comparing it to the price per share will give us great insights into the REIT's valuation.

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AFFO vs FFO

FFO is a metric first introduced by the National Association of Real Estate Investment Trusts (NAREIT) to measure the residual income that a REIT earns in a year. This measure is essential to an investor because REITs must pay 90% of their taxable net income to shareholders in the form of dividends. According to NAREIT, this is the most commonly accepted figure for evaluating a REIT's performance.

This measure, however, differs slightly from AFFO. The AFFO is derived from the FFO, but includes some essential adjustments. As a result, many investors regard the AFFO as a superior measure to the FFO as it tweaks some of the flaws of the FFO.

While there is not necessarily only one way to calculate the AFFO, it typically includes adjusting the straight-line rents to account for higher rents at the end of a lease. Another common difference is that recurring capital expenditures are subtracted from the FFO, as this cannot be expensed to shareholders in the form of dividends. This usually includes general upkeep, such as repairs made to the houses.

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