When you’re an investor diving into Real Estate Investment Trusts (REITs), you’ll quickly realize that the usual metrics like earnings per share (EPS) don’t quite cut it. You need something that better captures the cash flow from operations, without the accounting noise. This is where Adjusted Funds From Operations (AFFO) comes into play—consider it your magnifying glass that zooms in on the important financial details you’re looking for.
So, what’s the deal with AFFO, and why should you care? Let’s break it down in the clearest way possible (because, let’s be honest, no one likes financial jargon unless it’s necessary).
What is AFFO?
At its core, Funds From Operations (FFO) is a measure of a REIT’s cash flow that adjusts net income by adding back non-cash expenses like depreciation and amortization (because real estate, unlike tech companies, doesn’t just vanish into thin air). But, while FFO is useful, it can still include a few things that might distort the picture—think of them as the financial equivalent of a selfie filter: they make things look better than they actually are.
Adjusted Funds From Operations (AFFO) takes FFO a step further by subtracting any capital expenditures (CapEx) or recurring maintenance costs that are necessary to keep the property running smoothly. Essentially, AFFO shows the true cash flow a REIT can generate from its properties, after accounting for the costs needed to maintain and improve those assets.
In short: AFFO = FFO – CapEx & Maintenance Costs.
Why Should You Care as an Investor?
Here’s where it gets exciting for you as an investor. When it comes to investing in REITs, you want to know whether a company is generating enough cash flow to pay reliable dividends and support future growth. That’s where AFFO shines. Here’s why:
1. The Real Picture of Cash Flow
Let’s face it: the point of investing in a REIT is often to earn reliable dividends. So, you need to know whether the company has enough cash to back those payouts. AFFO is a fantastic metric for this, because it gives a more realistic view of the REIT’s ability to generate sustainable cash flow.
By excluding capital expenditures (those pesky maintenance and improvement costs), AFFO gives you a better idea of the actual cash the company has left after maintaining its properties—cash that can be used to pay dividends, fund future growth, or pay down debt.
2. Avoiding the Maintenance Mirage
Real estate is not like a tech startup that can live off software updates. Buildings need maintenance—and plenty of it. While FFO takes depreciation into account, it doesn’t address the cost of maintaining or improving those properties. You could have a great FFO figure, but if you’re not accounting for all the money being poured into property upkeep, it’s like thinking you have more in your bank account than you do. AFFO adjusts for that.
3. Sustainable Dividends? You Bet.
Dividends are the bread and butter for many REIT investors, and AFFO is the key to understanding whether those dividends are sustainable. If you’re looking at a REIT that’s been paying hefty dividends based on FFO, it might be time to dig deeper. After all, it’s one thing to pay out dividends from a temporary cash influx, but it’s quite another to pay them out of a steady stream of actual cash flow.
With AFFO, you get a clearer picture of whether those dividend payments are being made from sustainable earnings or whether they’re being propped up by one-off gains or accounting tricks. If a REIT’s AFFO payout ratio is too high, it could signal trouble, because the company may be stretching its available cash flow to keep up with dividend promises.
4. Better Comparisons Across REITs
Not all REITs are created equal. Some focus on residential properties, others on commercial real estate, and still others may be into industrial or healthcare. But no matter the niche, AFFO allows you to compare these REITs on a more apples-to-apples basis. Since AFFO strips out the noise from different capital expenditures, it helps you evaluate whether one REIT’s cash flow generation is better (or worse) than another’s.
So if you’re comparing a retail REIT with a residential REIT, AFFO helps smooth over the differences in their accounting practices and maintenance costs. This gives you a clearer view of which REIT is more efficient and has better long-term prospects for generating cash flow.
How is AFFO Calculated?
Alright, here’s the fun part. It’s not a difficult formula, but it is important to know exactly what goes into it. To calculate AFFO, you typically start with FFO and then make a few adjustments.
- Start with FFO (Funds From Operations). This is usually calculated by taking net income, adding back depreciation and amortization, and adjusting for any gains or losses on property sales.
- Subtract Capital Expenditures (CapEx): These are the costs associated with improving, upgrading, or maintaining the properties that the REIT owns.
- Account for Maintenance Costs: These are costs that need to be subtracted to reflect the ongoing investment in the properties. Sometimes companies will break this out as “maintenance CapEx” in their reports.
Now you have AFFO, which should be a more reliable representation of the REIT’s true cash flow.
For example:
- FFO = $10 million
- Less: CapEx = $3 million
- Less: Maintenance costs = $1 million
The AFFO in this case would be:
$10 million – $3 million – $1 million = $6 million
This is the amount of cash the REIT has left over to pay dividends, reinvest in properties, or distribute as it sees fit.
A Real-World Example: Why It Matters
Let’s say you’re eyeing two REITs, Company A and Company B. Company A is in the commercial real estate game, and Company B focuses on residential properties.
Both companies report a similar FFO, but when you dig into their AFFO, you find that Company A has significantly higher maintenance costs, which lowers its adjusted cash flow compared to Company B. So while Company A might look like it’s producing more cash on paper, the truth is that its operations are more capital-intensive, which could put a squeeze on its ability to grow or maintain dividends.
In this case, AFFO helps you see through the surface-level numbers and gives you a more accurate view of which company is actually generating the cash flow needed to grow or maintain a healthy, sustainable business.
The Takeaway: Cash Flow and Dividends, Baby
So, here’s the bottom line: AFFO is your go-to metric for evaluating REITs. It strips away the accounting distractions and gives you a clearer, more reliable picture of the company’s true cash flow, factoring in the costs of maintaining and improving its properties. And as an investor, you need to know whether a REIT can keep the dividends rolling while maintaining its properties and staying profitable.
If you’re looking for a REIT that can sustain growth and keep delivering on those sweet dividends, AFFO is your financial magnifying glass. Use it to look past the surface and get a better sense of the company’s true ability to generate cash from its core operations.