To maintain important tax benefits, real estate investment trusts (REITs) must pay out, in dividends to shareholders, at least 90 percent of their taxable income. That income can derive from rents, interest income, and management fees. In addition, REITs earn capital gains and losses on the sale of properties. Investors are keenly interested in how a REIT is performing because it directly affects the dividends they receive. However, REIT performance measurement is complicated and requires a metric more sophisticated than earnings per share (EPS).
What’s Wrong with EPS
EPS divides net revenues (revenues minus all costs) by the number of shares. The problem with EPS is that certain costs are non-cash, specifically depreciation and amortization, which are accounting procedures to deduct the cost of long-lived assets over a specified number of years. Non-cash expenses distort the amount of money available for dividends as reported by EPS. REITs are very sensitive to depreciation expense because their major assets are depreciable physical properties, and these expenses don’t impact the cash a REIT makes.
Funds from Operations
To get a better handle on cash flows, the REIT world uses a different metric to measure performance, funds from operations (FFO). According to the NAREIT (National Association of Real Estate Investment Trusts), FFO is “equal to a REIT’s net income, excluding gains or losses from sales of property, and adding back real estate depreciation.” In other words, FFO is roughly equivalent to cash flow per share, because it adds back non-cash charges.
NAREIT warns that analysts and companies don’t all use the same definition of FFO, which complicates its interpretation. A further weakness of FFO is that it ignores certain factors that impact the amount available for shareholder dividends. The adjusted funds from operations (AFFO) was developed to give investors a better indicator of cash available for dividends.
Adjusted Funds from Operations
AFFO, which is also known as funds available for distribution, takes into account certain costs necessary to operate a portfolio of properties but that don’t show up in net income. AFFO adjusts FFO in two ways by subtracting:
- Capital expenditures: Certain recurring costs necessary for maintaining portfolio properties – and the revenue streams they generate – are not immediately expensed. These costs cover some items in rental units, such as carpets, blinds, etc., as well as leasing expenses and allowances made to tenants for improvements. These costs are capitalized – treated as assets rather than expenses – and are gradually expensed via the accounting procedure of amortization. Although the cost is expensed over a number of years, the cash to pay for them is spent up front and therefore reduces the money available for dividends. By subtracting these capitalized costs right away, REITs produce a better picture of funds available for distribution.
- Straight-lining: Strait-lining averages rent payments over the life of the tenant’s lease. It is an accounting term, not an actual cash flow. The AFFO calculation subtracts the straight-line rent in excess of contract rent, which is the rent cash flow actually received. This removes phantom cash not available for distribution.
AFFO does the best job of reporting the actual cash received by the REIT, and therefore the amount of cash that can be distributed as dividends. Note that FFO and AFFO, while commonly used for REITs, are not defined under the International Financial Reporting Standards.