When evaluating real estate investment trusts (REITs), two metrics frequently come into play: Funds From Operations (FFO) and Adjusted Funds From Operations (AFFO). These metrics are good representatives of the cash flow that the REIT generates. In this article, we’ll explore the differences between FFO and AFFO, how they are calculated, and why understanding them is vital for making informed investment decisions.

What is FFO, or EPRA Earnings?

Funds From Operations (FFO) is a key performance metric used by REITs to provide investors with a better understanding of their cash flow from operations.Traditional metrics like net income can be misleading for REITs due to the heavy influence of non-cash charges such as depreciation and amortization in U.S. GAAP accounting, or fair value adjustments in IFRS accounting. This is where FFO comes in.

For example, FFO adjusts net income by adding back depreciation and amortization related to real estate assets. This adjustment makes sense because the value of real estate properties often appreciates or stays stable over time, rather than depreciating like machinery or technology might. Additionally, FFO excludes gains or losses from property sales, as these are not reflective of ongoing operational performance.

To put it simply, FFO provides a clearer picture of a REIT’s operational cash flows and its ability to generate income from its core property portfolio. In Europe, you might also hear the term EPRA Earnings, which is a similar concept to FFO but is the standardized version used by the European Public Real Estate Association (EPRA).

What Are the Adjustments to FFO to Calculate AFFO?

While FFO offers valuable insight into a REIT’s performance, it doesn’t fully account for all recurring costs that can impact a REIT’s ability to distribute cash to investors. This is where Adjusted Funds From Operations (AFFO) becomes relevant.

AFFO aims to provide a more accurate picture of the cash available for distribution to shareholders by making additional adjustments to FFO. The goal of AFFO is to account for cash flows that FFO might overlook, particularly those affecting the long-term sustainability of distributions. Therefore, when we value a REIT using the DCF method, we will try to forecast the AFFO as the measure of cash flow generated by the REIT. Here are the key adjustments typically made:

1. Share-Based Compensation: Share-based compensation is a form of payment made by REITs to their employees or management, often in the form of stock options or restricted stock units. FFO does not deduct share-based compensation, but AFFO does. This adjustment is made because, over time, share-based compensation can lead to dilution, which affects the cash flow available to each shareholder.

2. Straight-Line Rent Adjustment: REITs often engage in long-term leases where the rent gradually increases over the lease period. Straight-line rent is an accounting method that averages rental income over the lease term, leading to discrepancies between reported rent and actual cash received. AFFO adjusts for these discrepancies by subtracting the portion of revenue that has not yet been collected in cash, giving investors a more realistic sense of the cash inflows.

3. Recurring Capital Expenditures: Recurring capital expenditures are the ongoing costs required to maintain and upgrade properties. These are not one-time investments but recurring expenses needed to keep properties competitive and rentable. Examples might include roof repairs, HVAC replacements, or other ongoing maintenance costs. AFFO deducts these expenditures to reflect the true cash flow available for distribution to investors.

4. Leasing Costs and Tenant Improvements: Leasing costs include both internal and external commissions paid to secure tenants, while tenant improvements involve costs incurred to customize rental spaces for new tenants or lease renewals. These costs are deducted from FFO to arrive at AFFO, providing a clearer picture of the recurring cash outflows required to maintain tenant occupancy and keep properties rentable.

Core FFO vs. AFFO

Some REITs also report Core FFO, which aims to present the cash flow generated from core operations, excluding non-recurring and non-core items. Core FFO is often used by companies to provide a more normalized view of their operational performance, focusing on ongoing, stable revenue streams. However, it’s important to note that Core FFO is not equivalent to AFFO, as it does not make adjustments for items like recurring capital expenditures that are necessary to maintain the properties. While Core FFO gives insight into core operational cash flow, AFFO provides a more complete picture of the cash available for distribution to shareholders.

Magnitude of Difference Between FFO and AFFO

The difference between FFO and AFFO can vary depending on several factors, including the type of properties owned, lease structures, and the extent of recurring maintenance required. Typically, AFFO is lower than FFO because it accounts for those recurring expenses that are necessary to sustain the properties over the long term.

For many REITs, AFFO is usually around 5-15% lower than FFO. This difference can be more pronounced for REITs with a high level of recurring capital expenditures or those providing generous share-based compensation.

AFFO Disclosure

While FFO is widely reported and standardized by NAREIT (National Association of Real Estate Investment Trusts), AFFO is less consistent across companies due to variations in accounting practices. Some REITs may use different definitions or avoid reporting AFFO altogether, making it more challenging for investors to compare. In the research paper “On the potential outcomes of standardizing non-GAAP financial measures: Evidence from the REIT industry” by Gee and Park (2024), they find that “from 2007-2020, despite FFO’s existence, 78 percent of US REITs disclose unstandardized “adjusted FFO” (AFFO), which is more predictive of future operating performance and dividends, more value relevant, and more comparable across REITs than standardized FFO”. However, they also note that the adjustments made to calculate AFFO vary significantly between firms.

When AFFO is not disclosed, investors need to be cautious when evaluating a REIT’s distribution sustainability. FFO alone might overstate a company’s ability to pay dividends because it doesn’t account for all cash expenses.

In Canada, REITs are required to publish AFFO as part of their financial disclosures. The intended use of AFFO, as outlined by REALPAC (Real Property Association of Canada), is to provide a recurring economic earnings measure that reflects the cash flow available for sustainable distributions to shareholders. REALPAC has provided guidance on how AFFO should be calculated to ensure consistency across REITs. According to REALPAC, the calculation of AFFO starts with FFO and then deducts recurring capital expenditures, leasing costs, tenant improvements, and adjustments for straight-line rent, among other items. Specifically, the adjustments to FFO to arrive at AFFO include:

• Recurring Capital Expenditures (CAPEX): These are the expenditures required to maintain and sustain the property portfolio, such as repairs and replacements of existing assets.
• Leasing Costs: This includes both internal and external leasing commissions paid to secure tenants. Leasing costs are deducted to accurately reflect the expenses associated with maintaining tenant occupancy.
• Tenant Improvements: Costs incurred to adapt rental space for a new tenant, or for lease renewals, are also deducted from FFO to calculate AFFO.
• Straight-Line Rent Adjustments: AFFO adjusts for straight-line rent accounting, which averages the rent revenue over the lease term, by deducting the portion of revenue that has not yet been received in cash.

This standardized approach helps provide a clear and comparable measure of the cash flow available for distribution to shareholders, offering a more accurate representation of a REIT’s ability to sustain its dividend payments. 

For example, following is RioCan’s AFFO disclosure, as part of the Third Quarter 2024 report to unitholders: 

Using FFO vs. AFFO Multiples for Comparison

Valuation multiples are commonly used by investors to compare REITs within the same sector. The FFO multiple and AFFO multiple are both useful, but they serve slightly different purposes. If only FFO is available, using an FFO multiple can still give a reasonable estimate of valuation, particularly if the company has relatively stable and predictable expenses.

However, relying solely on the FFO multiple instead of the AFFO multiple can lead to minor inaccuracies, as FFO might not fully reflect all cash expenditures. In practice, the magnitude of error when using FFO instead of AFFO is often relatively small, especially when comparing REITs in the same industry and location, which tend to have similar levels of capital expenditures and rent arrangements. Nevertheless, AFFO is generally considered a more conservative measure of a REIT’s cash flow potential. It is crucial to avoid comparing FFO multiples with AFFO multiples, as they represent different measures.

An Example to Clarify FFO and AFFO

Using Realty Income’s 2023 financial statement, let’s illustrate the calculation of Funds From Operations (FFO) and Adjusted Funds From Operations (AFFO).

FFO Example

In Realty Income’s 2023 financial statement, net income available to common stockholders was $872.3 million. FFO is calculated by adjusting this net income, mostly for real estate-related depreciation and gains or losses on the sale of properties. In 2023, adjustments included:

• Depreciation and amortization: $1,895.2 million
• Gain on sales of real estate: $(25.7) million

After adjustments, FFO available to common stockholders amounted to $2,822.1 million. This amount is an important measure of cash flow as it adds back non-cash depreciation and excludes gains or losses that are not part of ongoing operations.

AFFO Example

AFFO, which stands for Adjusted Funds From Operations, starts with FFO and makes additional adjustments for items like straight-line rent, leasing commissions, and recurring capital expenditures. For Realty Income in 2023, adjustments to FFO to arrive at AFFO included:

• Straight-line rent and expenses, net: $(141.1) million
• Leasing costs and commissions: $(9.9) million
• Recurring capital expenditures: $(0.3) million
• Amortization of share-based compensation: $26.2 million

After adjustments, AFFO available to common stockholders was $2,774.9 million.

Magnitude of Difference

The difference between FFO and AFFO for Realty Income in 2023 was approximately $47.2 million, highlighting the impact of recurring capital and operational adjustments on reported cash flow. FFO per diluted share was $4.07, while AFFO per diluted share was slightly lower at $4.00, indicating a minor difference. In contrast, the difference between LTM FFO and AFFO for RioCan is 14.5%, which is more significant.

Realty Income states that AFFO is an essential measure for understanding the cash flow available for distributions to shareholders, highlighting its importance in providing a realistic and sustainable view of operational performance.

Summary

• FFO (Funds From Operations) provides insight into a REIT’s operational cash flows by adjusting net income for real estate depreciation and amortization.
• AFFO (Adjusted Funds From Operations) makes additional adjustments to FFO, accounting for cash flows like straight-line rent, share-based compensation, and recurring capital expenditures, to offer a more accurate view of cash available for distribution.
• Difference Between FFO and AFFO: AFFO is usually lower than FFO due to adjustments for ongoing expenses, and the difference can range from 5-15%, depending on the REIT.
• Not All REITs Disclose AFFO, which makes FFO a more common metric, though it may not fully reflect all recurring costs. Also, in U.S.-based companies, not all AFFO disclosures use the same calculation.
• Valuation Multiples: FFO multiples can be used to compare REITs in the same industries since the magnitude of difference between FFO and AFFO is expected to be roughly similar. It’s better to use AFFO Multiples if possible, but they are not always available.

Disclaimer: The information provided in this post is for informational purposes only and reflects my personal opinions. It should not be considered as professional financial, legal, or investment advice. Please consult with a professional before making any investment decisions. I am not responsible for any actions taken based on this information. The full disclaimer can be found here.