What Does AFFO Mean in Real Estate?

AFFO Meaning

In the context of real estate, especially when discussing Real Estate Investment Trusts (REITs), AFFO stands for Adjusted Funds From Operations. It is a refined metric that aims to provide a more accurate picture of a REIT’s true, recurring cash flow potential than the more commonly cited Funds From Operations (FFO).

How AFFO Is Derived:

• Starting Point – FFO: First, analysts determine the FFO of a REIT. FFO is calculated by taking the REIT’s net income (as per Generally Accepted Accounting Principles, or GAAP) and adding back depreciation and amortization related to real estate, as well as removing any gains or losses on property sales. This adjustment helps counterbalance the non-cash expenses (like depreciation) that are inherent in real estate accounting but may not truly reflect the property’s cash-generating capabilities.
• Further Adjustments – AFFO: From the FFO figure, additional adjustments are made to capture the recurring nature of the REIT’s cash flow. These typically include:
  1. Capital Expenditures and Leasing Costs: Deducting ongoing, necessary capital expenditures (often called “CapEx”) that are required to maintain or improve the quality and value of the real estate assets. This also includes leasing commissions and tenant improvement costs needed to keep properties occupied at competitive market rates.
  2. Straight-Line Rents and Non-Recurring Items: Adjusting for non-cash revenue items such as straight-line rents, which spread out rent concessions or fixed increases over the lease term, as well as removing one-time revenue or expense spikes that don’t reflect the property’s ongoing earning capacity.

Why AFFO Matters:
Investors and analysts view AFFO as a more reliable guide for dividend-paying potential and sustainable distributions of a REIT. Since REITs must distribute at least 90% of their taxable income to maintain their tax-advantaged status, understanding how much true free cash flow a REIT generates helps gauge the safety and growth prospects of its dividend. AFFO aims to strip away transitory or non-cash factors to highlight what’s left for shareholders after the necessary costs of maintaining and enhancing the property portfolio.

In summary, AFFO serves as a crucial tool in evaluating the ongoing, real-world cash flow of REITs, helping investors understand how much cash a trust truly generates and can return to its shareholders.