Adjusted Funds From Operations (AFFO)

Adjusted Funds From Operations (AFFO), also known as Cash Available for Distribution (CAD), is a crucial financial metric used by investors to evaluate Real Estate Investment Trusts (REITs). Think of it as the refined, truer measure of a REIT’s cash-generating power. While its cousin, Funds From Operations (FFO), was a great first step away from misleading traditional accounting numbers, AFFO takes it further by accounting for the real-world costs of maintaining properties. Specifically, AFFO starts with FFO and then subtracts the recurring Capital Expenditures (CapEx)—like replacing roofs or updating HVAC systems—that are necessary to keep the buildings in good shape and the rent checks flowing. Because it provides a more realistic view of the cash available to be paid out, AFFO is considered by many to be the best indicator of a REIT's ability to sustain and grow its dividends. It's a non-GAAP measure, meaning companies have some leeway in how they calculate it, so a little detective work is always required.

For decades, investors have grappled with how to properly value companies that own physical assets. For REITs, traditional Net Income is notoriously misleading. Why? Because standard accounting rules require companies to deduct depreciation every year, assuming buildings lose value over time. As any property owner knows, well-maintained real estate often appreciates, making reported profits look artificially low. To fix this, the REIT industry created Funds From Operations (FFO), which cleverly adds back depreciation to Net Income, giving a better sense of cash flow. But FFO has its own blind spot: it ignores the very real cash costs required to maintain a property's value. A building doesn't stay pristine on its own! It needs new carpets, fresh paint, and updated systems. These aren't one-off expansion projects; they are recurring, necessary expenses. This is where AFFO shines. It's the “real-world” version of FFO. By subtracting these maintenance costs, AFFO tells you how much cash the business is truly generating after keeping its properties competitive. For an investor focused on the long term, this is the number that matters most because it's the source of sustainable dividends.

While companies might have slight variations, the core concept of the AFFO calculation is straightforward:

• AFFO = FFO - Recurring Capital Expenditures (also called Maintenance CapEx) +/- Other Adjustments (like straight-line rent)

Let’s break that down:

• Start with FFO: This is your baseline, calculated as Net Income + Depreciation and Amortization - Gains on Sale of Property.
• Subtract Recurring CapEx: This is the most important adjustment. It’s the money spent just to maintain the properties, not to expand or acquire new ones. Think of it as the “cost of staying in business.”
• Adjust for Straight-Lined Rents: This one is a bit more technical. Sometimes, long-term lease contracts have rent increases built-in. For accounting, companies “straight-line” or average out this rent over the lease term. This can make accounting revenue different from the cash actually collected in a given year. AFFO adjusts the number back to reflect the actual cash rent received, giving a truer picture.

This is critical: There is no single, universally standardized formula for AFFO. The “A” for “Adjusted” gives management discretion. One company might define “Recurring CapEx” differently than another. This isn't necessarily nefarious, but it means you can't always compare the AFFO of two different REITs without doing your homework. Your Job as an Investor: Always dig into a REIT's quarterly or annual reports. In the supplementary financial data, the company will provide a reconciliation table showing exactly how it gets from Net Income to FFO and then to AFFO. Scrutinize those adjustments to understand what they are and if they seem reasonable.

AFFO isn't just an academic number; it's a powerful tool for making practical investment decisions.

The most immediate use of AFFO is to check the health of a REIT's dividend. The AFFO Payout Ratio tells you what percentage of cash flow is being returned to shareholders.

• AFFO Payout Ratio = Total Dividends Paid / AFFO

Here's how to interpret it:

• Below 90%: Healthy. The dividend is well-covered by cash flow, leaving a cushion for future dividend increases, reinvestment in the business, or weathering a downturn.
• 90% - 100%: A potential yellow flag. The dividend is covered, but there's little room for error or growth.
• Over 100%: A major red flag! The company is paying out more in dividends than it earns in cash. This is unsustainable and may be funded by debt or issuing new shares, a dangerous game for investors.

Just as industrial companies are often valued using the Price/Earnings (P/E) ratio, REITs are best valued using the Price/AFFO (P/AFFO) multiple.

• P/AFFO = Current Share Price / AFFO per Share

A lower P/AFFO multiple can suggest a REIT is cheaper than its peers or its own historical average. For a value investor, comparing a REIT's P/AFFO to its competitors in the same sector (e.g., comparing apartment REITs to other apartment REITs) is a fundamental step in finding potential bargains. However, a low multiple isn't a buy signal on its own—it's a signal to start digging deeper to understand why it's cheap. Is it a hidden gem or a business in trouble? AFFO gives you the right place to start asking.