The SEC requires that all publicly traded companies file audited financial statements. This includes their recorded “net income,” a term that is clearly defined under generally accepted accounting principles (GAAP). And that works very nicely for most common-stock businesses.

But not so much for real estate investment trusts.

The same goes for earnings per share (EPS). In accounting, real estate depreciation – a loss of asset value over time due to regular wear and tear – is always treated as an expense. Yet, in the real world, real estate appreciates in value as long as it’s in a good location and well-managed. As such, real estate company earnings are generally influenced heavily by depreciation costs that are non-cash in nature and don’t reflect asset value changes. And neither net income nor EPS fully takes those into consideration. 

Publicly traded REITs still report net income since they legally have to. But they also add in completely different information in order to provide data that is actually useful to their investors.

All of which to say that analyzing REITs properly and profitably requires knowing a different outlook and vocabulary terms.

Depreciation and GAAP Net Income: Understanding Land-Based Business 

There are a number of ways to measure increases and decreases in a REIT’s value. But looking at streams of income and cash flows are the most common.

To understand these metrics, we first have to recognize that property prices grow due to:

• Inflation and increasing construction costs
• Rising rents and operating income
• Property upgrades
• The fact that there’s a finite amount of land to begin with

That’s why, when a REIT’s net income under GAAP reflects a large depreciation expense… it’s a meaningless measure of cash flow. You must add back real estate depreciation into the equation to make it matter.

There are other adjustments that should be made as well. For instance, subtracting any capital gain income recorded from the sale of properties. And then there’s the fact that GAAP net income is normally determined after “straight-lining” contractual rental income over the term of the lease.

Straight-lined rents make for an easy calculation. The total rent expected over the original lease agreement is divided by the number of months in the contract. Which sounds reasonable…

Until you consider how rents tend to increase year over year and/or based on outside factors. They’re not static, nor do they operate in a static environment. 

Depreciation factors in here too, since straight-lining assumes that a rental property loses value steadily over time. Which – when handled properly by REIT management – doesn’t happen as expected thanks to maintenance considerations and upgrades.

To address this shortcoming, the National Association of Real Estate Investment Trusts (Nareit) created the concept of “funds from operations,” or FFO. Nareit formerly introduced the idea in 1991, with a few revisions made over the following years. And the Securities and Exchange Commission (SEC) finally accepted it in 2003.

What Is FFO?

Computing FFO is pretty simple:

FFO = Net Income + Depreciation + Amortization – Gains on Sales of Property

(Editor’s Note: Amortization is the process of reducing a loan taken out on an asset through regular payments against both the principle and interest.)

FFO per share is now the yardstick for comparative REIT valuations, and with good reason considering the glaring issues involved when “regular stock” earnings calculations are applied to real estate. 

However, even FFO has its shortcomings. It still doesn’t account for certain non-cash and seldom-occurring items, which really should be removed to reach an accurate conclusion. In this regard, it serves as a proxy for recurring cash flow that can be used to support dividend payments.

There’s an even better calculation to use when looking for pure valuation assessments

What Is AFFO?

Enter in adjusted funds from operations, which subtracts recurring capital expenditures (capex) from FFO. Basically, AFFO is an acknowledgement that not all depreciation is non-cash in nature.

(Editor’s Note: Capex refers to the funds a company uses to acquire, upgrade, or maintain a physical asset.) 

If you’re a landlord, you can generally expect to be called upon to make 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 even a lease renewal for an existing tenant will likely require some additional tenant improvement expenses.

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? AFFO tries to factor that in.

AFFO: Real Estate’s Real Value

With that said, there’s more to AFFO than just recurring capex. For instance, straight-lined rents are a beauty.

We’ve already mentioned how, according to GAAP, rental income is straight-lined over the term of a lease. But let’s look at what that looks like…

Say you have annual rent increases of 2% a year for a contracted five-year rental period. By the fifth year, rents will be about 8.25% more than they were in the first. So, under GAAP, you even the rents out. This means you show rents of just over 4% more than you actually collected in the first year.

To offset this phantom income, you’re supposed to factor in an accrued rent receivable (i.e., contracted though yet unpaid rent) 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. 

That alone can be problematic, but here’s another issue: There’s no discounting rent to reflect the fact that a dollar in the fifth year will be worth less than a dollar in the first. Inflation is a very real factor in how much or how little a company earns and profits. Yet it’s completely ignored in this evaluation.

Naturally, that’s a problem when assessing companies that make most or all of their profits from real estate. Straight-lined rents, for one thing, mean that FFO-per-share growth will be lower than actual cash flows would suggest. 

In FFO’s defense, it came about before straight-lined rent was adopted for GAAP calculations. Therefore, it didn’t have the opportunity to calculate for it. Even so, this is a definite weakness that AFFO steps in to solve.

Since AFFO is designed to be a closer proxy for actual normalized cash flows, a common calculation of AFFO is:

AFFO = FFO – Straight-Lined Rents – Capex + Equity-Based Compensation
+ Lease Intangibles + Deferred Financing Cost.

Let’s explain some of those terms:

• Equity-based compensation means value-based benefits given to employees outside of monetary pay and bonuses. Typically, this is in the form of stock ownership, which are non-cash in nature… but can offer dividends, which are, of course, cash.
• Lease intangibles first came into the real estate vocabulary around 2004 in order to reflect the cost of procuring tenants. This is another understood aspect of real estate rentals that is considered non-cash – and one that used to simply be chalked up as part of the valuation process. Yet since lease intangibles are never reflected in any official evaluation by the Appraisal Institute, the industry’s gold standard of assessment, it usually makes sense to factor them into AFFO.
• Deferred financing costs encompass the various costs involved to issue debt such as loans and bonds: the fees and commissions paid to whatever law firms, auditors, investment banks, and/or regulators are involved. This can be another non-cash factor if the fees associated with bank or bond financing are paid upfront and then subject to non-cash expenses later. Then again, there’s also a clear cash component involved as bonds and banknotes mature and are replaced

Does all that make AFFO sound pretty thorough?

It is. However…

You do need to know that AFFO isn’t sanctioned by the SEC. REITs don’t have to report it if they don’t want to, so some of them don’t. It’s also not a regulated term within the industry itself, so some executives and analysts make their own adjustments as they see fit.

Even with those shortcomings though, AFFO is very helpful to determine a REIT’s high-level estimate of normalized cash flow per share.

So, Which Should You Use to Analyze a REIT? FFO or AFFO?  

Hands down, the nod goes to AFFO.

Straight-lined rents can be material, which inflates FFO. Also, the lack of transparency and consistency in analyst reports makes it difficult to reliably compare FFO between companies, especially when looking across REIT sectors. 

For example, net-lease REITs tend to have modest, if any, capex requirements, which is a big deal. Yet AFFO accounts for it; FFO does not. So if a company has a very strong FFO value but doesn’t report AFFO, it may be helpful to look into its capex value to see if that calculation is being ignored for a reason. 

Regardless, for my money, comparisons like this will tend to make the net-lease space relatively cheaper to others that haven’t disclosed AFFO.

What About Funds Available For Distribution? 

In Ralph Block’s book, Investing in REITs, he writes how “some REITs and investors who use funds (or cash) available for distribution… often distinguish it from AFFO” to account for “non-recurring capital expenditures.”

AFFO deducts the amortization of real estate-related capital expenditures from FFO. But funds available for distribution (FAD) or cash available for distribution (CAD) are often derived by deducting normal and recurring capex, as well as the nonrecurring kind. Some REITs and investors who calculate FAD or CAD may also deduct repayments of principal on mortgage loans.

Which just goes to prove what Block added in his book about the two terms: that “there is no widely accepted standard for making these adjustments when calculating” them.

What About Net Asset Value? 

Many institutional investors and analysts prefer net asset value (NAV). While we consider this approach important at iREIT®, it’s not our primary method for determining value because it’s more of a liquidation approach. 

Simply put, most dividend investors prefer analyzing cash flows (which AFFO does). With that said, we agree that NAV is useful in evaluating a REIT’s overall capabilities. So it’s worth understanding. 

It begins with determining a capitalization rate for a portfolio of properties. Next, it applies that cap rate to a 12-month forward-looking estimate of net operating income (NOI), which takes into consideration:

• Estimated value of property
• Developments in process
• Equity in consolidated joint ventures
• Approximate value of fee income streams, non-rental revenue businesses, and other investments

After adding in those factors, NAV subtracts debt and other obligations, then adjusts for government-subsidized financing. Finally, the dollar amount of outstanding preferred stock is deducted.

NAV = (Assets – Liabilities – Preferreds) ÷ Number of Shares Outstanding

(Editor’s Note: Per-share NAV also takes into account “in the money” options, operating partnership units, and convertible securities.)

Keep in mind that this approach is subjective. For instance, the investor or analyst can assign any cap rate to the NOI. And since REITs are rarely liquidated, investors should always be reluctant to pay more than 100% of NAV. 

We use the word “reluctant” here instead of something stronger and more definitive because there are exceptions to the rule. Few and far between, mind you, but exceptions nonetheless. 

If there are very strong catalysts involved for value creation – such as low cost of capital, or robust FFO and dividend growth forecasted – the REIT in question might be worth investing in anyway. With the key words being “if” and “might be.”

Green Street Advisors, an independent REIT research firm, has a well-deserved reputation in the use of NAV and is a leading advocate of this valuation metric. For more information about that organization, click here.