REIT Earnings: FFO and AFFO
Standard GAAP net income understates a real-estate company's cash-generating power because depreciation charges hammer earnings for buildings that are actually holding or gaining value, so REIT investors use FFO and AFFO instead.
Prerequisites: Accrual vs Cash Accounting
Depreciation exists to spread the cost of a wasting asset — a delivery truck, a factory machine — over its useful life, because those things really do wear out and become worthless. A well-located office building often does the opposite: it can be worth more in twenty years than it is today, especially if the land under it appreciates. GAAP still forces the REIT to depreciate the building anyway, which can make a real-estate company that is generating plenty of cash look barely profitable, or even unprofitable, on its bottom-line net income.
That mismatch is why the real-estate industry invented its own earnings metrics.
FFO adds depreciation back to net income because real-estate depreciation is a paper charge that often doesn't reflect actual economic loss in value. AFFO goes further, subtracting the real cash a landlord actually has to spend to keep buildings rentable. AFFO is the closer approximation to true distributable cash.
Building the two numbers
Funds From Operations (FFO) starts from GAAP net income and adds back real-estate depreciation and amortization, then removes gains (or adds back losses) from property sales, since those are one-off and not part of ongoing operations.
In words: take reported earnings, add back the non-cash depreciation charge that GAAP requires but doesn't reflect real value loss, and strip out lumpy one-time sale gains so the number reflects recurring operations.
Adjusted Funds From Operations (AFFO) takes FFO further, subtracting the recurring capital expenditures a landlord genuinely has to spend — new roofs, leasing commissions, tenant improvements — and adjusting for the difference between cash rent collected and straight-line rent recognized under GAAP.
In words: FFO overstates cash available to shareholders because it ignores the real, recurring dollars a landlord must reinvest just to keep tenants; AFFO nets those out to approximate what's actually left to pay dividends.
Worked example
A REIT reports GAAP net income of $40 million, which includes a $70 million depreciation charge and a one-time $15 million gain from selling a property.
FFO = $40m + $70m − $15m = $95 million. On an FFO basis the REIT looks far healthier than the $40 million net income implies.
Now suppose the REIT also spent $18 million this year on recurring capital items — leasing commissions and tenant improvements needed to keep occupancy up — and has $5 million of straight-line rent recognized in income that hasn't been collected in cash yet.
AFFO = $95m − $18m − $5m = $72 million. If the REIT pays out $68 million in dividends, its AFFO payout ratio is about 94% ($68m / $72m) — tight, but covered. Judged against the $40 million GAAP net income, that same dividend would look wildly unsustainable at a 170% payout ratio, which is the wrong conclusion.
What this means in practice
REIT price-to-FFO or price-to-AFFO multiples replace price-to-earnings as the standard valuation yardstick in the sector, and dividend coverage is judged against AFFO, not net income. Analysts also watch how a REIT defines its own "recurring" capex, since management has discretion there and can flatter AFFO by classifying more spending as one-time.
FFO and AFFO are not GAAP-defined, so companies calculate them slightly differently from one another. Always check the reconciliation table in the filing rather than comparing two REITs' self-reported AFFO figures at face value.
Further reading
- NAREIT, FFO White Paper