FFO and AFFO for REITs

Standard accounting net income is a poor measure of how much cash a REIT is actually generating, for a specific and fixable reason: accounting depreciation assumes buildings steadily lose value over time, the way a piece of machinery or a fleet of trucks would, and forces a REIT to subtract a large non-cash depreciation charge from earnings every year. Real buildings, well-maintained in a normal market, typically don't actually lose value that way — many appreciate over time — so depreciation makes a REIT's reported net income look understated relative to the actual cash the properties are throwing off. REITs and their investors responded by adopting their own earnings measure built to correct for exactly this.

FFO: adding depreciation back

Funds from operations (FFO), defined by the REIT industry's own trade association, starts from net income and adds back real estate depreciation and amortization, while also excluding gains or losses from selling properties (since those are one-off, not part of ongoing operating performance). The result is a much closer approximation of the REIT's recurring, ongoing cash-generating ability than net income, and it's the headline number REIT investors actually watch, quote, and value REITs against — REIT share prices are far more commonly discussed as a multiple of FFO per share than as a multiple of earnings per share.

AFFO: going one step further

FFO still has a gap: it adds back all depreciation, but buildings do need genuine, recurring capital spending — a new roof, new HVAC systems, tenant improvements to re-lease space — and that spending is real cash going out the door even though it isn't captured well by either net income or FFO. Adjusted funds from operations (AFFO) takes FFO and subtracts a recurring capital expenditure estimate along with a few other smaller adjustments (like straight-lining rent), landing on a number many analysts consider the closest available proxy for the REIT's true distributable cash flow — the actual cash available to pay out as dividends after keeping the properties in working order.

For example, a REIT reports net income of $50 million after subtracting $70 million of depreciation. Adding that depreciation back (and excluding a $5 million one-off property sale gain) gives FFO of roughly $115 million. Subtracting an estimated $20 million of recurring capital expenditure needed to maintain the portfolio brings AFFO down to about $95 million — a figure much closer to what the REIT can sustainably distribute to shareholders than either the $50 million net income or the $115 million FFO would suggest on their own.