How to Assess REITs Using Funds from Operations (FFO/AFFO)

For real estate investment trusts (REITs), standard metrics like earnings per share (EPS) or price-to-earnings (P/E) ratios may not deliver the most accurate picture you need of performance and value. Instead, professionals often turn to funds from operations (FFO) and adjusted funds from operations (AFFO) as key indicators. Understanding FFO and AFFO is thus crucial for accurately evaluating a REIT's financial health, growth prospects, and overall investment potential.

FFO and AFFO are tailored to the needs of REITs. Unlike traditional companies, they generate income primarily through property rentals and must distribute most of their earnings as dividends. FFO puts depreciation and other noncash charges back into the net income, giving a clearer view of the REIT's operating performance. AFFO takes this a step further by accounting for capital expenditures and other adjustments, providing a picture of the REIT's sustainable dividend-paying capacity.

REIT Income Statement

Let’s start with a summary income statement from XYZ Residential (XYZ), a fictional residential REIT.

From 2019 to 2020, XYZ’s net income, or “bottom line,” grew by almost 30%. However, the net income numbers include depreciation expenses, which are significant line items.

For most businesses, depreciation is an acceptable noncash charge that allocates the cost of an investment made previously. But real estate differs from most fixed-plant or equipment investments because property seldom loses value and often appreciates.

Net income, a measure reduced by depreciation, is an inferior gauge of performance. As a result, it makes sense to judge REITs by FFO, which excludes depreciation.

Funds from Operations (FFO)

Companies are required to reconcile FFO, which is reported in the footnotes, along with net income. The general calculation involves adding depreciation back to net income and subtracting the gains on the sales of depreciable property.

We subtract these gains, assuming they are one-time events and don't contribute to the REIT's long-term ability to sustain its dividend payments. The reconciliation of net income to FFO (with minor items removed for the sake of clarity) in 2019 and 2020 could be laid out as follows:

After adding depreciation and subtracting property gains, FFO is about $838,390 in 2019 and almost $757,600 in 2020.

FFO must be reported, but it has a weakness. It does not deduct the capital expenditures required to maintain the existing portfolio of properties. Shareholders’ real estate holdings must be maintained by repainting apartments, for example, so FFO is not quite the true residual cash flow remaining after expenses and expenditures.

Professional analysts, therefore, use AFFO to estimate the REIT’s value. Although FFO is commonly used, professionals tend to focus on AFFO for two reasons:

1. It measures more precisely the residual cash flow available to shareholders, and it’s thus a better “base number” for estimating value.
2. It is true residual cash flow and a better predictor of the REIT’s future capacity to pay dividends.

AFFO doesn’t have a uniform definition, but most calculations subtract capital expenditures. For XYZ, almost $182,000 is deducted from FFO to get the AFFO for 2020. This number can typically be found on the REIT’s cash flow statement. It’s used to estimate the cash required to maintain existing properties, although a close look at specific properties could generate more accurate information.

Growth in FFO and/or AFFO

We can estimate the REIT’s value more accurately with FFO and AFFO and look for expected growth in one or both. This requires carefully watching the underlying prospects of the REIT and its sector. The specifics of evaluating a REIT’s growth prospects are beyond the scope of this article, but here are some data to consider:

• The possibility of rent increases
• The possibility of improving and maintaining occupancy rates
• Plans to upgrade or upscale properties. One popular and successful tactic is to acquire low-end properties and upgrade them to attract higher-quality tenants; better tenants lead to higher occupancy rates, fewer evictions, and higher rents.
• External growth prospects. Many REITs boost FFO growth through acquisitions. Still, that’s easier said than done because an REIT must distribute most of its profits and typically doesn’t hold much cash. However, many REITs successfully prune their portfolios and sell underperforming properties to finance the acquisition of undervalued properties.

Applying a Multiple to FFO/AFFO

The REIT’s total return is derived from two sources: dividends paid and the appreciation in price. Expected price appreciation can be divided into two elements: growth in FFO/AFFO and expansion in the price-to-FFO or price-to-AFFO ratio.

Let’s look at the multiples for XYZ. Note that we are showing price divided by FFO, which is market capitalization (market cap) divided by FFO. In this example, XYZ’s market cap (number of shares times the price per share) is about $8 million.

Interpreting the Data

Besides comparing them with industry peers, how do we interpret these multiples? Like P/E ratios, interpreting price-to-FFO and price-to-AFFO multiples is not an exact science. Multiples vary with market conditions and the specific REIT subsectors. However, as with other equity categories, we want to avoid buying into a multiple that is too high.

Aside from the dividends paid, price appreciation is derived from two sources: growth in FFO/AFFO or an increase in the valuation multiple (price-to-FFO or price-to-AFFO ratio). We should consider both sources when considering a REIT with favorable FFO growth prospects.

For example, if FFO grows at 10% and the multiple of 10.55× is maintained, the price will grow 10%. However, if the multiple increases about 5% to 11×, price appreciation will be about 15% (10% FFO growth + 5% multiple expansion).

A useful exercise takes the reciprocal of XYZ’s price-to-AFFO multiple: 1/(price/AFFO) = AFFO/price, or $575.7/8,000 = 7.2%. This is called the “AFFO yield.” To evaluate the REIT’s price, we can then compare the AFFO yield to the following: 

1. The market’s going capitalization rate
2. Our estimate for the REIT’s growth in FFO/AFFO

The capitalization rate tells investors how much the market currently pays for real estate. For example, 8% implies that investors are generally paying about 12.5 times (1 divided by 8%) the net operating income of each real estate property.

Let’s assume that the market’s capitalization rate is about 7%, and our anticipated growth for XYZ’s FFO/AFFO is a heady 5%. Given a calculated AFFO yield of 7.2%, we are likely looking at a good investment because our price is reasonable compared with the market’s capitalization rate. (It’s even a little higher, which is better.)

In addition, the expected growth should eventually translate into a better price and higher dividends. In fact, if all other investors agreed with our evaluation, XYZ’s price would be much higher because it would need a higher multiple to incorporate these growth expectations.

The Bottom Line

REIT evaluation produces greater clarity when looking at FFO rather than net income. Prospective investors should also calculate AFFO, which deducts the likely expenditures necessary to maintain the real estate portfolio. AFFO provides an excellent tool to measure the REIT’s dividend-paying capacity and growth prospects.