When it comes to real estate investment trusts (REITs), standard metrics like earnings per share (EPS) and price-to-earnings ratios (P/E) may not give you the most accurate information you need about performance and value. Instead, experts often refer to funds from operations (FFO) and adjusted funds from operations (AFFO) as key metrics. Therefore, understanding FFO and AFFO is essential to accurately assessing a REIT's financial health, growth prospects, and overall investability.
FFO and AFFO are tailored to the needs of REITs. Unlike traditional corporations, REITs generate revenue primarily through property rentals and are required to distribute most of their revenue as dividends. FFO incorporates depreciation and other non-cash expenses into net income, providing a clearer picture of a REIT's operating performance. AFFO takes this a step further, factoring in capital expenditures and other adjustments to provide a more complete picture of a REIT's sustainable dividend-paying ability.
Key Takeaways
Traditional metrics like earnings per share (EPS) or price-to-earnings ratios (P/E) are not a reliable way to estimate the value of a real estate investment trust (REIT). A more appropriate metric is funds from operations (FFO), which adjusts for depreciation, preferred dividends, and distributions. FFO is best used in conjunction with other metrics like growth rate, dividend history, and debt-to-equity ratios.
REIT Income Statement
Let's start with a brief overview of the income statement for XYZ Residential (XYZ), a hypothetical housing REIT.
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From 2019 to 2020, XYZ's net income, or “bottom line,” increased by almost 30%. However, the net income figure includes an important item: depreciation and amortization.
For most businesses, depreciation is an allowable non-cash expense that allocates the cost of investments made earlier. However, real estate differs from most investments in fixed plant and equipment because assets rarely go down in value, but rather go up in value.
Net income less depreciation and amortization is a poor indicator of performance, so it makes sense to judge REITs on their FFO excluding depreciation and amortization.
Funds from operating activities (FFO)
Companies must reconcile FFO, which is reported in the footnotes, with net income. A common calculation is to add depreciation expense to net income and subtract gains on sales of depreciable assets.
We deduct these gains, assuming they are one-time and do not contribute to the REIT's ability to sustain its dividend payments over the long term. A reconciliation of net income and FFO for 2019 and 2020 (excluding minor items for clarity) can be expressed as follows:
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After adding depreciation and deducting real estate gains, FFO will be approximately $838,390 in 2019 and $757,600 in 2020.
FFO is required to report, but it has a weakness: it doesn't subtract the capital expenditures required to maintain the existing real estate portfolio. Because shareholders' real estate holdings need to be maintained by, say, repainting an apartment, FFO is a bit different from the actual residual cash flow after expenses and costs.
Therefore, professional analysts use AFFO to estimate the value of a REIT. Although FFO is commonly used, experts tend to focus on AFFO for two reasons.
This is a more accurate measure of the residual cash flow available to shareholders and is therefore a better “base number” for estimating value. This is true residual cash flow, which is a better predictor of a REIT's future dividend paying ability.
There is no uniform definition for AFFO, but most calculations subtract capital expenditures. For XYZ, approximately $182,000 is subtracted from FFO to arrive at AFFO for 2020. This figure is typically found on a REIT's cash flow statement. It is used to estimate the cash needed to maintain existing properties, but a closer look at specific properties can provide more accurate information.
Traditional metrics such as EPS and P/E ratios are unreliable for estimating a REIT's value.
Increase FFO and/or AFFO
Using FFO and AFFO, you can more accurately estimate the value of a REIT and find growth projections for either or both. To do so, you should closely monitor the potential prospects for the REIT and its sector. The details of assessing the growth prospects of a REIT are beyond the scope of this article, but here are some data points to consider:
Potential for rent increases Potential to improve and maintain occupancy Plans to upgrade or upscale properties. One popular and successful strategy is to acquire lower-priced properties and upgrade them to attract higher quality tenants. Higher quality tenants lead to higher occupancy rates, fewer evictions, and higher rents. External growth prospects. Many REITs drive FFO growth through acquisitions. However, this is easier said than done, because REITs must distribute most of their profits and don't usually have that much cash. However, many REITs have successfully streamlined their portfolios and sold underperforming properties to fund the acquisition of undervalued properties.
Applying a multiple to FFO/AFFO
A REIT's total return comes from two sources: dividends paid and price appreciation. Expected price appreciation can be broken down into two components: an increase in FFO/AFFO and an expansion in the price-to-FFO or price-to-AFFO ratio.
Let's look at XYZ's multiple. Here we are looking at price divided by FFO. This is market cap (market capitalization) divided by FFO. In this example, XYZ's market cap (number of shares x price per share) is approximately $8 million.
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Interpretation of data
How do you interpret these multiples other than in comparison to industry peers? Like the P/E ratio, interpreting price-to-FFO and price-to-AFFO multiples is not an exact science; multiples vary depending on market conditions and the specific REIT subsector. However, as with any stock category, you want to avoid buying stocks with multiples that are too high.
Besides dividends paid, price appreciation can come from two sources: increased FFO/AFFO or increased valuation multiples (price-to-FFO ratio or price-to-AFFO ratio). Both factors should be considered when looking at REITs with good FFO growth prospects.
For example, if FFO grows by 10% and the multiple remains at 10.55x, the price will rise by 10%. However, if the multiple increases by about 5% to 11x, the price appreciation will be about 15% (10% FFO growth + 5% multiple expansion).
It is useful to calculate the inverse 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 value a REIT, compare the AFFO yield with:
Our estimates of REIT growth in market capitalization rates FFO/AFFO
The capitalization rate tells investors what the market is currently paying for a property. For example, 8% means that investors are generally paying about 12.5 times the net operating income for each property (1 divided by 8%).
Let's assume that the market capitalization rate is around 7% and that XYZ's expected FFO/AFFO growth rate is high at 5%. Given that the calculated AFFO yield is 7.2%, our price is reasonable compared to the market capitalization rate and therefore would be considered a good investment (a little higher would be better).
Moreover, the expected growth should ultimately translate into a higher stock price and higher dividends. Indeed, if all other investors agreed with our valuation, XYZ's stock price would be much higher because a higher multiple would be required to incorporate these growth expectations.
Where does the funds from operations (FFO) metric come from?
Is FFO the same as cash flow from operations (CFO)?
No. CFO is the amount a company generates from normal business activities and is reported on the cash flow statement. FFO refers to a REIT's profitability, which is calculated by adding depreciation, amortization, and losses on asset sales to revenue, but subtracting gains on asset sales and interest income.
Can you use the FFO and AFFO ratios to compare different REITs?
Yes, ratios such as price-to-FFO and price-to-AFFO multiples can be used to compare the relative value of different REITs. These REIT ratios are similar to P/E ratios used for other companies. A low multiple indicates that the REIT is undervalued, while a high multiple may be overvalued, but the valuation should also take into account context and other financial metrics.
What is the formula for FFO and AFFO?
The formula for calculating FFO is:
FFO = Net Income + Amortization + Depreciation – Capital Gains from Sale of Real Estate
Although there is no standard formula, AFFO is usually calculated as follows:
AFFO = FFO + Rent Accretion – Capital Expenditures – Routine Maintenance
Conclusion
Valuing a REIT becomes clearer when looking at its FFO rather than its net income. Potential investors should also calculate its AFFO, which subtracts the expected expenses needed to maintain the real estate portfolio. AFFO is a good tool for gauging a REIT's dividend paying ability and growth prospects.