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Adjusted Funds from Operations (AFFO)

Guide to Understanding Adjusted Funds from Operations (AFFO)

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Adjusted Funds from Operations (AFFO)

How to Calculate AFFO (Step-by-Step)

AFFO, otherwise known as cash available for distribution (CAD), is tracked by real estate investors to evaluate the financial state of a REIT, specifically in the context of the REIT’s capacity to issue dividends to shareholders.

Real estate investment trusts (REITs) are entities that own a portfolio of income-generating real estate properties and have become a common option for investors looking to receive a strong yield without significant exposure to capital loss or volatility.

The starting point of the AFFO calculation is funds from operations (FFO), one of the most important metrics in the real estate industry.

FFO was developed by Nareit in an effort to reconcile net income, the GAAP-based measure of profitability (i.e. the “bottom line” of the income statement). In short, FFO represents the cash generated from the operations of a REIT and is viewed by most real estate investors as a more informative metric than net income, which tends to be more appropriate for corporations instead of REITs.

When prepared under GAAP accounting rules, the income statement of a REIT can be misleading to investors for numerous reasons, namely the non-cash expenses such as depreciation and amortization (D&A). The gains and losses from asset sales must also be recorded per GAAP accounting standards, regardless of the fact that there was no actual movement of cash.

To calculate FFO, non-cash charges such as depreciation and amortization are added to net income. From there, any gains from the sale of assets are subtracted from net income (or any losses incurred from the sale of assets are added back).

  • Non-Cash Expenses: Non-cash expenses such as depreciation and amortization should be treated as an add-back to understand the actual cash flow profile of a REIT.
  • (Gains) / Losses from Asset Sales: Similar to non-cash items, the gains or losses from the sale of assets are more related to accounting rules and can be misleading in the portrayal of a REIT’s cash flows.

The primary adjustment made to the FFO is related to the recurring capital expenditures (Capex) belonging to the REIT, along with any adjustments intended to normalize the rent or leasing costs, among various other factors.

With that said, FFO is the preferred metric for investors to understand the recurring operations of a REIT compared to net income. But there is one major drawback to the FFO metric that AFFO directly addresses, which is the routine capital expenditures of the REIT, i.e. maintenance Capex.

While FFO and AFFO are both non-GAAP metrics, they are widely viewed to be the more accurate when assessing the health of REITs compared to GAAP metrics.

Adjusted Funds from Operations (AFFO) Definition

Adjusted Funds From Operations Definition (Source: Nareit Glossary)

AFFO Formula

The formula to calculate funds from operations (FFO) takes net income and adds back the depreciation and amortization, subtracting any one-time gains from the sale of assets.

FFO = Net Income + Depreciation + Amortization – Gains on Sales of Property, net

The next step is to further normalize the FFO metric for factors such as non-cash rent and subtract capital expenditures (Capex).

AFFO = FFO + Non-Recurring Items – Capital Expenditures

However, it is important that only maintenance capex is deducted, as opposed to the entirety of a REIT’s capex, i.e. maintenance and growth capex.

AFFO Calculator – Excel Model Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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Step 1. REIT Funds from Operations (FFO) Calculation

Suppose a REIT generated $25 million in net income over 2021, along with $2 million in depreciation, which will be treated as a non-cash add-back.

In the same period, the REIT also had a net gain of $500k from the sale of one of its properties. Since the gain from the sale is a one-time non-operating item, it represents a deduction.

The inputs for calculating the REIT’s funds from operations are as follows.

  • Net Income = $25 million
  • Depreciation = $2 million
  • (Gain) / Loss, net = –$500k

Given those assumptions, we can calculate the funds from operations (FFO) of the REIT as $26.5 million

  • FFO = $25 million + $2 million – $500k = $26.5 million

Step 2. REIT Adjusted Funds from Operations (AFFO) Calculation

With our calculation of FFO complete, we’ll assume that the maintenance capex of our hypothetical REIT was $4 million, which will be our only adjustment in our simplified AFFO calculation.

  • Maintenance Capex = $4 million

By subtracting the REIT’s FFO from the maintenance capex incurred across the corresponding period, we arrive at an AFFO of $22.5 million.

  • AFFO = $26.5 million – $4 million = $22.5 million

AFFO Calculator

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