Adjusted Funds From Operations

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21 Aug, 2024

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Adjusted Funds From Operations (AFFO) is a performance indicator that accurately determines the current value of a Real Estate Investment Trust (REIT). For this purpose, it accommodates straight-line rents, capital expenditure, routine maintenance expenses, etc., to the trust's Funds From Operations (FFO).

Although the simple Funds From Operations (FFO) formula is available, AFFO is more reliable for finding a REIT value. Unlike the latter, the FFO doesn't consider recurring expenses like maintenance costs and frequent capital expenditures incurred over the Real Estate Investment Trust's (REIT) lifetime. Thus, AFFO in REIT is a real-time measure of a trust's efficiency in paying off the dividends from its net profits.

Adjusted Funds From Operations (AFFO) Definition

Adjusted Funds From Operations (AFFO) is a modified version of Funds From Operations (FFO), a conventional cash flow metric utilized in the real estate investment trust (REIT) sector.
AFFO adjusts FFO by deducting recurring costs, such as capital expenditure and maintenance expenses, while typically adding back straight-line rent to provide a more accurate assessment of a REIT's residual cash flow.
The formula for calculating AFFO may vary but generally involves subtracting recurring capital expenditure and straight-line rent from FFO. Different REITs may employ slightly different variations of this formula based on their specific accounting practices and circumstances.

Adjusted Funds From Operations Explained

The adjusted funds from operations is a revised or better version of the funds from operations since it gives due importance to the various recurring costs and straight-line rent, which are essential for running a real estate investment trust. A REIT is a business entity that owns, manages, and funds properties to generate income. Hence, the various business operations include buying, developing, renting, and leasing shops, office premises, buildings, malls, resorts, hotels, warehouses, apartments, and other facilities.

As the Generally Accepted Accounting Principles (GAAP) suggests, depreciating the business assets over their estimated life doesn't work for the properties. Hence, the charging of depreciation in the books unrealistically diminishes the net profit of the trust. Moreover, it is challenging to measure the REIT equity value using indicators like price-to-earnings ratio and earnings per share due to the capital nature of the business. Therefore, the funds from operations and AFFO are considered suitable measures for the REIT valuation.

The valuation of AFFO is based on the value of the FFO. Thus, the first step is determining the value of the funds from operations. The next step involves adjusting or deducting recurring costs, such as capital expenditure and maintenance costs, from the FFO. Finally, deduct the straight-line rent (total lease value/total lease period in months).

Formula

AFFO calculation methods can vary, and there isn't a standardized approach. However, commonly used formulas include:

1. AFFO = FFO - Recurring Capital Expenditure - Straight-Line Rent

2. AFFO = FFO + Rent Increases - Capital Expenditure - Routine Maintenance Cost

Here, FFO represents Funds From Operations, calculated as net income adjusted for certain noncash items like depreciation, amortization, gains, and losses on property sales, as well as income items like interest income.

It is important to note that while these formulas provide a basis for calculating AFFO, adjustments may vary based on specific REIT circumstances and accounting practices.

Examples

Let us understand the concept with the help of some hypothetical and real-world scenarios.

Example #1

Suppose we have a REIT, and its financial statements provide the following information:

Net Income: $7,500,000
Gain on Sale of Properties: $110,000
Loss on Sale of Properties: $180,000
Depreciation: $65,000
Amortization: $55,000
Interest Income: $70,000
Net Increase in Rent: $69,000
Capital Expenditure: $150,000
Routine Maintenance Cost: $125,000

Now, let us determine the Adjusted Funds From Operations (AFFO) using the provided data.

Step 1: Calculation of Funds From Operations (FFO)

FFO is calculated as the net income adjusted for certain noncash items and gains/losses on property sales:

FFO = Net Income + (Depreciation + Amortization + Losses on Underlying Properties Sales) - Gains on Underlying Properties Sales - Interest Income

FFO = $7,500,000 + ($65,000 + $55,000 + $180,000) - $110,000 - $70,000 = $7,620,000

Step 2: Computation of AFFO using the FFO value:

AFFO is calculated by adjusting the FFO for changes in rent, capital expenditure, and routine maintenance costs:

AFFO = FFO + Rent Increases - Capital Expenditure - Routine Maintenance Cost

AFFO = $7,620,000 + $69,000 - $150,000 - $125,000 = $7,414,000

Therefore, based on the provided financial data and calculations, the AFFO for the REIT would be $7,414,000.

Example #2

Realty Income, a leading commercial REIT, announced an upward adjustment in its full-year outlook for adjusted funds from operations (AFFO) on November 6, 2023. This revision, reflecting an increase in expected rental revenue, underscores the REIT's ability to generate sustainable cash flows from its diverse portfolio of commercial properties.

The positive market response, with Realty Income's shares rising by 1% to $50.86 post-announcement, reflects investor confidence in the REIT's strong operational performance and potential for value creation. Additionally, Realty Income's strategic acquisition of Spirit Realty Capital in a $9.3 billion deal aligns with its growth objectives, further solidifying its position as a leading player in the real estate market.

Adjusted Funds From Operations vs Funds From Operations

Both Adjusted funds from operations and funds from operations are the non-GAAP indicators of a REIT's cash flow; they differ in the following ways:

Basis	Adjusted Funds From Operations	Funds From Operations
Meaning	The AFFO in REIT determines the real-time value of the residual cash flow generated by a real estate investment trust.	The FFO is the indicator of a real estate investment trust's operating performance or cash flow.
Formula	*AFFO = FFO - Recurring Capital Expenditure - Straight-Line Rent*	*FFO = Net Income + (Depreciation + Amortization + Losses on Underlying Properties Sales) - Gains on Underlying Properties Sales - Interest Income*
Purpose	It was developed to overcome the shortcomings of the FFO.	It established a benchmark for real estate performance evaluation.
Interpretation	It measures the REIT's real-time residual cash flow available to the shareholders. Thus, it is a crucial analyzer of the REIT's dividend-paying capacity.	It determines the value of cash flow from the operations of a REIT.
Accuracy	It is a highly efficient measure when compared to FFO since it determines the actual residual cash flows of a REIT.	It needs to pay attention to the costs incurred in running the business and, therefore, seems less accurate.
Cost Consideration	It treats the FFO value for adjusting recurring costs or expenses as essential to keep the business going.	It overlooks the recurring costs like capex, routine maintenance costs, and rent expenses.

Frequently Asked Questions (FAQs)

What is AFFO growth?

AFFO growth represents the increase achieved by adjusting Funds From Operations (FFO) through additions such as amortization, offering-related expenses, share-based compensation expenses, severance expenses, casualty losses, net noncash interest expense for derivatives, and acquisition costs while deducting recurring capital expenditure.

Who uses adjusted funds from operations?

Investors and shareholders rely on AFFO within Real Estate Investment Trusts (REITs) to gauge the long-term dividend payout potential. Furthermore, AFFO serves as a critical metric for market analysts, aiding in the identification of lucrative real estate investment opportunities.

Can AFFO be higher than FFO?

In most cases, AFFO is observed to be lower than Funds From Operations (FFO) due to its calculation method, which involves subtracting recurring capital expenditure and straight-line rent from the FFO amount. This difference underscores AFFO's role in providing a more precise measure of a real estate investment trust's cash flow, as it accounts for essential expenses that directly impact the trust's financial performance.