What are Adjusted Funds From Operations (AFFO)?
Adjusted Funds From Operations (AFFO) is a measure of the financial performance of a REIT, and it is used as an alternative to Funds From Operations (FFO). It is calculated by making adjustments to the FFO value to deduct normalized recurring expenditures and to use straight-lining of rents.
Adjusted Funds From Operations (AFFO) is a measure of the financial performance of a REIT, and it is used as an alternative to Funds From Operations (FFO). AFFO is a superior measure compared to FFO because the former considers the maintenance costs of the real estate property over its life. The value of AFFO is obtained by making adjustments to the FFO figure to deduct recurring expenditures required to keep the real estate property running and generating revenues.
Another adjustment made to the FFO figure is the straight-lining of rents, which distributes rent expenses over the life of the property. Investors use AFFO as a better indicator of the REIT’s ability to pay dividends from its net earnings.
Adjusted Funds From Operations (AFFO) is a measure of the financial performance of a REIT, and it is used as an alternative to Funds From Operations (FFO).
It is calculated by making adjustments to the FFO value to deduct normalized recurring expenditures and to use straight-lining of rents.
introduction of Adjusted Funds From Operations—AFFO
Regardless of how industry professionals choose to compute adjusted funds from operations (AFFO), it is considered to be a more accurate measure of residual cash flow for shareholders than simple FFO. Though FFO is commonly used, it does not deduct for capital expenditures required to maintain the existing portfolio of properties, so it doesn’t quite measure the true residual cash flow.
Professional analysts prefer AFFO because it takes into consideration additional costs incurred by the REIT—and additional income sources too, like rent increases. Thus, It provides for a more accurate base number when estimating present values and a better predictor of the REIT’s future ability to pay dividends. This is a non-GAAP measure.
How to Calculate Adjusted Funds From Operations
When calculating the AFFO, the first step is to calculate the funds from operations, which measure the cash flows from a REIT’s leasing activities. The FFO was originally introduced by the National Association of Real Estate Investment Trusts (NAREIT) as a measure of cash flows generated by REITs.
FFO is obtained by deducting any gains on the sale of properties from the net income and adding back the depreciation and amortization costs. The value of the gains on the sale of properties is excluded from the FFO computation because the transactions are one-time events that do not affect the REIT’s future earning’s potential. The FFO’s formula is indicated below:
FFO = Net Income – Gains on Sales of Underlying Assets + Depreciation + Amortization
Once the value of FFO is obtained, any capitalized and amortized recurring expenditures are then deducted. The expenditures include costs that are incurred to maintain the properties owned by the REIT.
Some of these costs include painting projects, roof replacements, recarpeting, tenant improvements, etc. Another adjustment made to the FFO is the straight-lining of rent, which distributes the rent and lease expenses evenly across the life of the lease.
The formula for AFFO is given below:
AFFO = FFO – Recurring Capital Expenditures – Straight-lined Rents
How are Adjusted Funds From Operations Used?
Irrespective of the method of computation of Adjusted Funds From Operations selected, it stands out to be a more reliable method of measuring residual cash flow for stakeholders than funds from operations. It is so because it considers increases in rent and excessive costs borne by the REIT, thereby offering a clearer base number while making predictions for present values.
Also, it gives a better idea of the dividends that REITs can manage paying in future. It is considered to be a non-GAAP measure.
Example of Adjusted Funds From Operations
During the last reporting period, ABC Limited reported a net income of $2.5 million. It also incurred $100,000 and $150,000 in the form of depreciation and amortization costs, respectively, during the period. The company also made a profit of $500,000 from the sale of two properties in its portfolio. It also incurred an $80,000 loss on the sale of another property during the same period.
In the same period, ABC Limited also reported straight-lined rents of $130,000 and recurring capital expenditures of $200,000, which were incurred when making roof repairs, HVAC replacements, carpeting, and other structural improvements to the properties it owns.
Using the information above, we can calculate the AFFO as follows:
Step 1: Calculate the value of the FFO.
FFO = $2,500,000 + $100,000 + $150,000 – ($500,000 – $80,000)
FFO = $2,750,000 – $420,000
FFO = $2,330,000
Step 2: Deduct recurring capital expenditures and straight-lined rents from the value of FFO.
AFFO= FFO – Capital Expenditures – Straight-line Rent Adjustments
AFFO = $2,330,000 – $200,000 – $130,000
AFFO = $2,000,000