Adjusted Funds From Operations (AFFO)
Metric used to measure the financial performance of a Real Estate Investment Trust (REIT) by giving an accurate account of its residual cash flows
What Are Adjusted Funds From Operations (AFFO)?
Adjusted funds from operations (AFFO) is a metric used to measure the financial performance of a Real Estate Investment Trust (REIT) by giving an accurate account of its residual cash flows.
It is important in any investment, especially in REIT investments, as REITs must distribute at least 90% of their 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 specific details.
For example, AFFO adjusts FFO to subtract recurring capital expenditures (capex) and considers the effects of straight-line rents, providing a more accurate reflection of a REIT's true cash flow situation.
FFO continues to be widely accepted, and both FFO and AFFO serve different purposes and are used in different contexts.
Key Takeaways
- AFFO (Adjusted Funds From Operations) is a crucial metric for assessing REITs' financial performance and cash flows.
- REITs must distribute 90% of taxable income as dividends, making accurate AFFO calculations valuable for investors.
- AFFO adjusts FFO by subtracting capital expenditures and accounting for straight-line rents.
- To calculate AFFO, add back depreciation and amortization and subtract gains on asset sales, recurring capital expenditures, and straight-line rents.
- AFFO is a better indicator of dividend capacity than FFO and is a standardized industry metric.
How To Calculate Adjusted Funds From Operations
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 Underlying 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.
Gains on the sale of underlying assets are subtracted from net income because they are considered an unreliable indicator of a REIT’s typical cash flows. Asset sales are inconsistent and do not have a long-term impact on earnings.
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
Recurring capital expenditures for a REIT may include various expenses related to general upkeep, such as repairs and maintenance occurring over the life of a lease. Furthermore, straight-line rents are considered in the FFO calculation.
Straight-line rents are calculated by evenly spreading the rent over the lease term, resulting in a constant rental income throughout the lease, regardless of any scheduled rent increases. The straight-line method of calculating rent averages all the rents across the life of the lease so that it remains constant.
AFFO adjusts for this because straight-line rents inaccurately allocate higher rents at the beginning of the lease, creating a skewed representation of rental income over time.
Practical 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.
FFO Vs. AFFO
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 investors because REITs must pay 90% of their taxable net income to shareholders through 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.
Let us take a look at the below table to understand the difference between the two methods:
| Aspect | AFFO | FFO |
|---|---|---|
| Calculation | Includes depreciation, amortization, and gains on sale of assets. | Adjusts FFO for recurring capital expenditures and straight-line rents. |
| Purpose | Measures REIT operating performance but includes non-cash items and gains. | Refines FFO, focusing on cash available for dividends by accounting for essential expenses. |
| Inclusions/Exclusions | Includes gains on the sale of assets. Excludes recurring capital expenditures and straight-line rents. | Excludes gains on the sale of assets. Includes recurring capex and adjusts for straight-line rents. |
| Investor Relevance | Offers a view of cash generation but not necessarily cash available for dividends. | Provides a better measure of cash for dividends after necessary expenses. |
| Dividend Calculation | It is not ideal for estimating dividend capacity due to gains inclusion. | More accurate for evaluating dividend-paying capability. |
| Volatility Impact | It can be more volatile due to unpredictable gains. | It tends to be less volatile, focusing on recurring expenses. |
| Standardization | Standardized metric in the industry. | Less standardized, with variations in calculation and disclosure. |
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