What it means
Property companies report large depreciation charges on buildings that are often rising rather than falling in value, so reported net income understates the cash they actually generate. FFO fixes part of this by adding back real estate depreciation and stripping out gains and losses on property sales.
AFFO goes a step further by deducting the cash costs that FFO ignores. Those deductions are the point of the measure.
Recurring capital expenditure such as roof replacements, lift refurbishment and tenant improvement allowances is real cash that leaves the business every year, as are leasing commissions paid to agents. Removing them turns an accounting-flavoured figure into something closer to distributable cash.
AFFO also reverses the straight-line rent adjustment. Accounting rules spread a lease with rising rents evenly across its term, so early-year revenue includes rent that has not been collected yet, and AFFO takes that non-cash portion back out.
The same logic applies to amortised above-market or below-market lease intangibles. The main use of AFFO is the dividend payout ratio.
A trust distributing 95% of AFFO has almost no cushion, while one distributing 70% can absorb a vacancy or fund a refurbishment without cutting the dividend or borrowing. Analysts also value trusts on a multiple of AFFO per share in much the way other sectors use price to earnings.
The nuance to watch is that AFFO is not defined by accounting standards, so each company decides what counts as recurring capital expenditure. Two trusts with identical portfolios can report different AFFO simply because one classifies more spending as growth capital expenditure and therefore excludes it.
Comparing the definitions in the notes is as important as comparing the numbers.
In practice
Real-world examples.
Example
An office trust reports FFO growth of 6% but AFFO growth of only 1%, because tenant improvement allowances rose sharply as it re-let space at lower occupancy. Analysts focus on the AFFO figure, and the share price falls despite the headline FFO number.
Example
A residential trust's board sets a policy of distributing no more than 80% of AFFO. When AFFO per share falls from $1.40 to $1.20, the board holds the dividend at $0.96 rather than raising it, because that keeps the payout ratio exactly at the 80% ceiling.
Example
A lender assessing a $60,000,000 facility for a warehouse trust runs its covenant test on AFFO rather than net income, on the basis that AFFO reflects the cash left after the properties have been kept in lettable condition.
Think of it
“AFFO is adjusted FFO-accounting for the capital spending needed to maintain properties.
Formula
Calculation
FFO = Net income + real estate depreciation and amortisation - gains on property sales
AFFO = FFO - recurring capital expenditure - straight-line rent adjustment - amortised leasing costs
Take a fictional retail trust reporting for a full year. Net income is $22,000,000, real estate depreciation is $34,000,000 and it recorded gains on property sales of $3,000,000.
FFO = $22,000,000 + $34,000,000 - $3,000,000 = $53,000,000
During the same year it spent $8,000,000 on recurring capital expenditure, recognised a $1,500,000 straight-line rent adjustment and paid $2,500,000 of leasing commissions.
AFFO = $53,000,000 - $8,000,000 - $1,500,000 - $2,500,000 = $41,000,000
With 50,000,000 shares in issue, AFFO per share is $41,000,000 / 50,000,000 = $0.82. If the trust pays dividends of $0.75 per share, the AFFO payout ratio is $0.75 / $0.82, or about 91%, which leaves very little room before the dividend has to be funded from borrowing.Case study
Seen in the real world.
Kestrel Yield Properties is an invented trust used here as an illustrative example only. It owned suburban retail parks and had reported steadily rising FFO for four years, which management used to justify four consecutive dividend increases.
An analyst rebuilt the numbers on an AFFO basis and found that recurring capital expenditure had grown from $4,000,000 to $8,000,000 as the older centres reached the age at which car parks and roofs need replacing, while leasing commissions had doubled as tenant turnover rose. On those figures AFFO per share had been flat at roughly $0.82 for three years even as FFO per share climbed, and the payout ratio had drifted from about 76% to about 91%.
In this fictional case the board responded by holding the dividend flat for two years and publishing a five-year capital expenditure schedule alongside its results. Nothing about the underlying properties changed, but investors could finally see the difference between money the trust earned and money it could distribute.
Watch out
Common mistakes.
- Using FFO and AFFO interchangeably, when FFO ignores the recurring capital spending and leasing costs that AFFO deliberately deducts.
- Comparing AFFO across trusts without reading how each one defines recurring capital expenditure, since that single classification choice can move the figure materially.
- Treating AFFO as a standards-based accounting number, when it is a management-defined measure that sits outside audited financial statements.
Questions
People also ask.
Is AFFO the same as free cash flow?
It is the property sector's closest equivalent, but it is calculated before debt repayment and before growth capital expenditure, so it is not identical.
Why do analysts prefer AFFO for dividend analysis?
Because dividends are paid in cash, and AFFO is the measure that has already deducted the cash a portfolio needs just to stay competitive and occupied.
What payout ratio is considered safe?
Many investors look for AFFO payout ratios below roughly 85%, though the acceptable level depends on lease lengths, tenant quality and how much capital expenditure is still to come.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%