What is Adjusted Funds from Operations (AFFO)?

When it comes to evaluating Real Estate Investment Trusts (REITs), the concept of Adjusted Funds from Operations (AFFO) is often mentioned as a significant indicator of a REIT’s financial health. While Funds from Operations (FFO) provides a good starting point, AFFO takes the analysis a step further by accounting for the ongoing expenses required to maintain and grow real estate assets.

Adjusted Funds from Operations (AFFO) is a REIT-specific performance metric that adjusts Funds from Operations (FFO) to reflect the costs associated with maintaining and improving the REIT’s properties. AFFO starts with FFO, which adds back non-cash expenses like depreciation to net income, and further deducts capital expenditures, maintenance costs, and other non-recurring items. This approach provides a more realistic view of the REIT’s cash flow, offering investors insight into its true ability to pay dividends.

Why is AFFO Important for REIT Investors?

For REIT investors, AFFO is a crucial measure because it’s an indicator of the recurring cash flow available to distribute to shareholders. Since REITs are legally required to distribute at least 90% of taxable income as dividends, understanding AFFO helps investors assess dividend sustainability. The AFFO metric adjusts for costs that are not part of regular operations but are necessary to maintain the properties, providing a clearer view of the income available for distribution.

AFFO is especially important because:

• Dividend Reliability: AFFO reflects the REIT’s ability to maintain or grow dividend payments over time.
• Long-Term Viability: By including property maintenance and capital expenditures, AFFO highlights the REIT’s capacity to sustain assets in the long term.
• Comparative Measure: AFFO allows investors to compare REITs more effectively, as it standardizes cash flow adjustments across REITs with different types of assets and management practices.

How Financial Models Help in Analyzing AFFO

Financial models are very valuable for analyzing AFFO by projecting future cash flows, maintenance expenses, and potential capital expenditures. These models help investors estimate how AFFO might change under various scenarios, such as property acquisitions, lease renewals, or market downturns. By modeling AFFO, investors can gain insights into the REIT’s ability to handle operational changes, pay dividends, and make strategic investments.

Formula for Calculating AFFO

The calculation of AFFO begins with FFO and adjusts for necessary maintenance and non-cash items, as follows:

AFFO = FFO - Capital Expenditures - Routine Maintenance - Straight Line Rent Adjustments

Where:

• FFO is Funds from Operations, which has been discussed in our last blog.
• Capital Expenditures and Routine Maintenance are the non-recurring costs required to maintain the value of properties.
• Straight-Line Rent Adjustments adjust rental income recognized evenly over the lease term, even if payments vary.

AFFO is a non-GAAP measure, meaning it’s not subject to standardized accounting rules. This lack of standardization can lead to inconsistencies in how different REITs report AFFO, therefore financial statement users should understand how the company defines the measure.

Metrics Calculated Using AFFO

Several valuable metrics can be derived from AFFO, each providing different insights into a REIT’s performance:

• AFFO per Share: Calculated by dividing AFFO by the number of outstanding shares, this metric provides a measure of cash flow per share, essential for evaluating dividend coverage.
• Payout Ratio (AFFO): This ratio divides the dividend per share by AFFO per share, indicating how much of the available cash flow is distributed to investors. A lower ratio suggests dividend stability, while a higher one might indicate potential risk.
• AFFO Yield: By dividing AFFO per share by the REIT’s stock price, investors can calculate the AFFO yield, which indicates the return from AFFO as a percentage of the stock’s price.

Conclusion

Adjusted Funds from Operations (AFFO) is an essential tool for understanding the financial health and dividend sustainability of a REIT. Unlike simple metrics such as net income, AFFO provides a more comprehensive picture by considering both cash-generating capabilities and necessary property expenditures. For investors, AFFO-based metrics offer insight into whether a REIT can sustain and potentially grow dividends, making it a cornerstone of informed REIT analysis.