What it means
Property companies report large depreciation charges even when their buildings are holding or gaining value, so net income understates the cash coming in. Funds from operations corrects for that by adding depreciation back and removing gains or losses on property sales, since those are one-off events rather than trading results.
It has been the sector's headline measure for decades. The weakness of funds from operations is that it ignores the money a landlord must keep spending simply to hold the portfolio steady: replacing roofs and lifts, fitting out space for a new tenant, and paying agents' commissions to sign leases.
AFFO deducts those recurring costs, which is why it is a better guide to what can actually be distributed to shareholders. A second adjustment addresses straight-line rent.
Accounting rules spread the total rent of a lease evenly over its life, so a lease with a rent free first year records income before any cash arrives, and AFFO removes that non-cash element to keep the measure tied to real money. The number matters most when judging whether a dividend is safe.
Dividing the dividend by AFFO per share gives a payout ratio, and a real estate investment trust distributing well over 90% of AFFO has little room to absorb a vacancy, a rate rise or a major refurbishment. Definitions vary between companies, particularly over which capital spending counts as recurring maintenance and which counts as growth investment.
Because AFFO is not defined by accounting standards, the sensible approach is to read the reconciliation each company publishes and, if comparing two of them, to recalculate both on the same basis. Analysts also use AFFO per share as a valuation anchor, quoting share prices as a multiple of AFFO in the same way other sectors use price to earnings.
It is a more demanding measure than funds from operations, and a company that looks cheap on one can look ordinary on the other.
In practice
Real-world examples.
Example
An office trust reports funds from operations up 4% but AFFO down 7%, because tenant fit-out costs rose sharply as it re-let space in an older building. The board holds the dividend flat rather than raising it, a decision the AFFO figure explains and the headline figure does not.
Example
An analyst comparing two industrial trusts finds nearly identical funds from operations per share. Recalculating both on a consistent maintenance capital expenditure definition shows one has AFFO roughly 12% higher, which explains the persistent gap in their share prices.
Example
A pension fund's investment committee screens property holdings for AFFO payout ratios above 95%. Two positions fail the screen, and a review finds both had funded recent dividends partly from asset sales rather than from rental cash.
Think of it
“AFFO is a more accurate cash flow measure-FFO minus regular capital spending needs.
Formula
Calculation
Funds from operations = net income + property depreciation and amortisation - gains on property sales
AFFO = funds from operations - recurring maintenance capital expenditure - straight-line rent adjustment - leasing commissions and tenant improvement costs
A retail property trust reports net income of $42,000,000, property depreciation of $58,000,000 and a $6,000,000 gain on selling a shopping centre. Funds from operations = $42,000,000 + $58,000,000 - $6,000,000 = $94,000,000.
From that, deduct recurring maintenance capital expenditure of $14,000,000, a straight-line rent adjustment of $3,000,000 and leasing commissions and tenant improvements of $5,000,000. AFFO = $94,000,000 - $14,000,000 - $3,000,000 - $5,000,000 = $72,000,000.
With 60,000,000 shares in issue, AFFO per share is $72,000,000 / 60,000,000 = $1.20. A dividend of $1.00 per share therefore represents a payout ratio of $1.00 / $1.20 = 83%, leaving about $0.20 per share of retained cash for reinvestment or reserves.Case study
Seen in the real world.
This is an illustrative and entirely fictional case. Ashgrove Retail Trust, an invented listed landlord of neighbourhood shopping centres, had grown its dividend for nine consecutive years and pointed to funds from operations of $2.05 per share against a dividend of $1.80 as evidence that the payout was comfortable. On that basis the cover looked adequate.
A new analyst rebuilt the numbers on an AFFO basis and found that recurring roof, car park and lift spending, plus rising tenant incentives on renewals, absorbed $0.45 per share. AFFO was therefore $1.60 per share, well below the $1.80 dividend, meaning the trust had been funding part of its distribution from disposals and new borrowing.
In this fictional account Ashgrove cut its dividend to $1.35 and set an explicit policy of paying no more than 85% of AFFO. The shares fell on the announcement but recovered within a year, and the trust's next refinancing was priced more keenly because lenders could see the distribution was covered by rental cash.
Watch out
Common mistakes.
- Treating funds from operations as the cash available for dividends, when it ignores the maintenance and leasing spending a landlord cannot avoid.
- Comparing AFFO between two property companies without checking how each one splits maintenance from growth capital expenditure.
- Reading a rising AFFO as proof of a healthy portfolio without asking whether maintenance has simply been deferred into a later year.
Questions
People also ask.
Why is depreciation added back for property companies?
Because well maintained buildings frequently hold or increase in value, so the accounting depreciation charge does not represent a real loss of economic value.
Is AFFO the same as free cash flow?
It is close in spirit, but AFFO deducts only recurring property spending and leaves out acquisitions and development, which free cash flow would normally include.
What payout ratio is considered safe?
There is no fixed rule, though many investors look for a distribution comfortably below 90% of AFFO so the company can absorb vacancies without cutting the dividend.
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