How to Assess a REITS Using Funds from Operations (FFO/AFFO) (2024)

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.

Key Takeaways

  • Traditional metrics such as earnings per share (EPS) and price-to-earnings (P/E) ratio are not reliable ways to estimate the value of a real estate investment trust (REIT).
  • A better metric to use is funds from operations (FFO), which makes adjustments for depreciation, preferred dividends, and distributions.
  • It’s best to use FFO with other metrics such as growth rates, dividend history, and debt ratios.

REIT Income Statement

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

How to Assess a REITS Using Funds from Operations (FFO/AFFO) (1)

From 2019to 2020, XYZ’s net income, or “bottom line,” grew by almost 30%. However, the net income numbersinclude 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 becauseproperty 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 REITsby FFO, which excludes depreciation.

Funds from Operations (FFO)

Companies are required to reconcile FFO, which is reported in the footnotes, along withnet 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, assumingthey are one-time events and don't contribute to the REIT's long-term ability to sustain its dividend payments. Thereconciliation of net income to FFO (with minor items removed for the sake of clarity) in2019and 2020 could be laid out as follows:

How to Assess a REITS Using Funds from Operations (FFO/AFFO) (2)

After adding depreciation and subtracting property gains, FFO is about $838,390 in 2019and 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 abetter 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’scash flow statement. It’s used to estimate the cash required to maintain existing properties, although a close look at specific propertiescould generate more accurate information.

Traditional metrics such asEPSand P/Eratio are unreliable in estimating a REIT's value.

Growth in FFO and/or AFFO

We can estimate the REIT’s value more accurately with FFO andAFFO 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 possibilityof rent increases
  • The possibilityof improving and maintaining occupancy rates
  • Plansto upgrade or upscale properties. Onepopular and successful tactic is to acquire low-endproperties and upgrade them to attracthigher-quality tenants;better tenants lead to higher occupancy rates, fewer evictions, and higher rents.
  • External growth prospects. Many REITs boostFFO growth through acquisitions. Still, that’s easier said than done because an REIT must distribute most of its profits and typically doesn’t holdmuch cash. However, many REITssuccessfully prune their portfolios and sell underperforming properties to finance the acquisition of undervalued properties.

Applying a Multiple to FFO/AFFO

The REIT’stotal return is derived from two sources:dividends paid andthe appreciation in price. Expected price appreciationcan be divided into two elements:growth in FFO/AFFOand 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’smarket cap (number of shares times the price per share) is about $8 million.

How to Assess a REITS Using Funds from Operations (FFO/AFFO) (3)

Interpreting the Data

Besides comparing them with industry peers, how dowe interpret these multiples? LikeP/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 investorshow 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 becauseour 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 pricewould be much higher because it would need a higher multiple to incorporatethese growth expectations.

Where did the funds from operations (FFO) metric come from?

The National Association of Real Estate Investment Trusts (Nareit), the REIT industry group in the U.S., created the FFO metric to better evaluate REITs. FFO is among the non-generally accepted accounting principles measures.

Are FFO the same as cash flow from operations (CFO)?

No. CFO is how much money a company generates from its regular business activities and is reported on the cash flow statement. FFO, instead, refers to an REIT’s profitability by adding depreciation, amortization, and losses on sales of assets to earnings, then subtracting any gains on the sale of assets and interest income.

Can I use FFO and AFFO ratios to compare different REITs?

Yes, ratios like the price-to-FFO and price-to-AFFO multiples allow you to compare the relative value of different REITs. These REIT ratios are analogous to the P/E ratio used for other companies. A lower multiple could indicate that a REIT is undervalued, while a higher multiple could suggest overvaluation, although context and other financial indicators should also be considered in any assessment.

What are the formulas for FFO and AFFO?

The formula for FFO is:

FFO = net income + amortization + depreciation - capital gains from property sales

Though there is no one standard formula, calculations for AFFO typically look as follows:

AFFO = FFO + rent increases - capital expenditures - routine maintenance amounts

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.

How to Assess a REITS Using Funds from Operations (FFO/AFFO) (2024)


How to calculate funds from operations for a REIT? ›

You can also calculate the FFO by adding together the REIT's net income, depreciation, amortization, and losses on property sales. Then subtract that figure from any gains on property sales and any interest income.

How to calculate affo for REITs? ›

Though no one official measure exists, an AFFO formula is along the lines of AFFO = FFO + rent increases - capital expenditures - routine maintenance amounts.

What is the best way to evaluate a REIT? ›

Traditional metrics like earnings per share (EPS) and price-to-earnings (P/E) ratio aren't reliable ways to evaluate REITs. Funds from operations (FFO) and adjusted funds from operations (AFFO) are better metrics.

What is the difference between Affo and funds from operations? ›

Summary. Adjusted Funds From Operations (AFFO) is a measure of the financial performance of a REIT, and it is used as an alternative to Funds From Operations (FFO). It is calculated by making adjustments to the FFO value to deduct normalized recurring expenditures and to use straight-lining of rents.

What is the method of calculating funds from operations? ›

Funds from Operations (FFO) → The reconciliation process to compute funds from operations (FFO) begins with net income and adds back the depreciation of real estate assets, similar to the indirect cash flow method of arriving at cash from operations (CFO).

What is a good FFO ratio for REIT? ›

REITs tend to have higher-than-average payout ratios, and 70–80% of FFO is common. But if this percentage is too close to (or higher than) 100%, a dividend cut could be on the horizon.

What is the 90% rule for REITs? ›

How to Qualify as a REIT? To qualify as a REIT, a company must have the bulk of its assets and income connected to real estate investment and must distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends.

How are REIT distributions calculated? ›

Combine the total amount of dividends the REIT paid over one year. You can estimate annual dividends by multiplying quarterly distributions by 4 or monthly distributions by 12. Divide this number by the REITs current share price. Multiply this number by 100 to change it into a percentage.

What is the 75 75 90 rule for REITs? ›

Invest at least 75% of its total assets in real estate. Derive at least 75% of its gross income from rents from real property, interest on mortgages financing real property or from sales of real estate. Pay at least 90% of its taxable income in the form of shareholder dividends each year.

What is the price per FFO? ›

P/FFO measures the ratio of the share price to the mean cash flow from operations. A high ratio suggests that the stock is priced higher compared to the company's cash flow - a sign of high investor confidence. Nevertheless, a high ratio also suggests that a stock may be overpriced.

How do you evaluate real estate funds? ›

Here, we go over eight critical metrics that every real estate investor should be able to use to evaluate a property.
  1. Your Mortgage Payment. ...
  2. Down Payment Requirements. ...
  3. Rental Income to Qualify. ...
  4. Price to Income Ratio. ...
  5. Price to Rent Ratio. ...
  6. Gross Rental Yield. ...
  7. Capitalization Rate. ...
  8. Cash Flow.

What is the 5 50 rule for REITs? ›

A REIT will be closely held if more than 50 percent of the value of its outstanding stock is owned directly or indirectly by or for five or fewer individuals at any point during the last half of the taxable year, (this is commonly referred to as the 5/50 test).

What is an example of funds from operations? ›

For example, for a company selling jewellery, income from investments or a one-time sale of a fixed asset could be considered non-operating income. Removing such non-operational transactions gives you the funds from operations.

What is the use of funds from operations? ›

Funds from operations are the largest source of funds used for the repayment of loans, purchase of assets, and the payment of dividends, taxes, and others.

What is the affo payout ratio? ›

Definition of AFFO Payout Ratio (REIT)

AFFO payout ratio that is calculated as total dividends paid divided by adjusted funds from operations over the same period.

Why do REITs use Funds From Operations? ›

FFO measures cash generated by REITs from their core operations, excluding gains/losses on sales. It is used to assess the financial performance and value of real estate companies. FFO provides a more accurate depiction of a REIT's profitability than net income.

What are operating expenses for REITs? ›

Operating Expense means salaries, wages, cost of maintenance and operation, materials, supplies, insurance, and all other items normally included under recognized accounting practices, but does not include allowances for depreciation in the value of physical property.

What is the Funds From Operations ratio? ›

Funds from operations (FFO) to total debt is a leverage ratio that is used to assess the risk of a company, real estate investment trusts (REITs) in particular. The FFO to total debt ratio measures the ability of a company to pay off its debt using net operating income alone.

What is the formula for Funds From Operations to debt? ›

FFO-to-Debt = FFO / Total debt

A type of leverage ratio which measures a firm's FFO to its total debt. A higher ratio indicates more cash flow to service debt, and hence lower credit risk.


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