A video board display’s the numbers after the closing bell of the Dow Industrial Average at the New York Stock Exchange on November 8, 2017 in New York. Wall Street inched to another trifecta of record closes with the Dow finishing at its fifth straight all-time high. / AFP PHOTO / Bryan R. Smith (Photo credit should read BRYAN R. SMITH/AFP/Getty Images)
In my role as the Editor of the Forbes Real Estate Investor, I get many requests from REIT investors and one of the most frequently asked questions is what is FFO and AFFO?
In my recently published book, The Intelligent REIT Investor, my co-author (Stephanie Krewson-Kelly) cover this topic in detail, and you can find the book on Amazon HERE.
Keep in mind that REITs have always found reported earnings per share to be of little investor value, since real estate company earnings are generally weighed down by depreciation costs that are non-cash and also not reflective of asset value changes.
To address this shortcoming, a new term Funds from Operations (or FFO) was adopted by the National Association of Real Estate Investment Trusts (NAREIT) in 1991 and then formally accepted as a reportable financial term by the Securities and Exchange Commission in 2003. Computing FFO is simple. All you have to do is remove depreciation and real estate gains or losses from earnings:
Net Income + Depreciation Expense Gains on Asset Sales + Losses on Asset Sales
Upon its adoption, FFO multiples rather than earnings multiples, quickly became the yardstick for comparative REIT valuations. But there are definite shortcomings to FFO, since some non-cash and seldom occurring items are removed from earnings to arrive at FFO, FFO sort of sounds like a proxy for recurring cash flow that can be used to support dividend payments.
It is far from this.
So, many analysts and some companies began to report Adjusted Funds from Operations (or AFFO). The biggest change by far that AFFO makes to FFO is to subtract recurring capital expenditures.
Basically, this is an acknowledgement that not all depreciation is non-cash.
If you are a landlord, you can generally expect to be called upon to make real estate improvements to your real estate each time you sign up a new tenant. Those tenant improvements will generally suffice for the duration of the lease term, but signing up a tenant for a lease renewal will likely also require an added tenant improvements allowance.
So, the question is this: How much do real estate companies have to shell out every year to retain their portfolio quality and tenant occupancy levels?
Now, there is more to AFFO than just recurring capital expenditures.
Straight-lined rents are a beauty. In one of the more poorly conceived parts of GAAP, rental income is often required to be straight-lined over the term of a lease. So, say you have annual rent increases of 2% a year for five years. By the fifth year, the rents are about 8.25% more than in the first, so under GAAP you even the rents out which means that you show rents of just over 4% more than you actually collected in the first year.
The offsetting entry to this phantom income is an accrued rent receivable that will grow over the first half of the lease and then start to decline in the second half. Many companies book the receivable without any allowance for doubtful accounts and, of course, there is no discounting of the rents to reflect the fact that a dollar of rent in the fifth year will be worth less than a dollar of rents today.
One obvious result from rents that are straight-lined is that FFO per share growth will be lower than the actual cash flows would suggest. The omission of not deducting this clear non-cash inflation of revenues from FFO may have been because straight-line rent GAAP adoption occurred after the 1991 adoption of FFO by NAREIT.