We previously wrote about a very important pair of REIT metrics, funds from operations (FFO) and adjusted funds from operations (AFFO). REITs report AFFO as a measure of cash available for dividends to unitholders.
The definitions of these two measures are:
- FFO = Net Income + Depreciation + Amortization + Gains/Losses on Property Sales
- AFFO = FFO – Recurring Capital Expenditures, adjusted for Straight Line Rents
= Net Income + Depreciation + Amortization + Gains/Losses on Property Sales – Recurring Capital Expenditures, adjusted for Straight Line Rents
To review, FFO is a measure of cash flow per unit developed by the National Association of REITs (NAREIT) to fix certain drawbacks with GAAP earnings per share (EPS) by adding back non-cash charges. AFFO is a refinement that measures REIT operating cash flow after taking capital expenditures (CapEx) into account.
Straight line rent is a way to figure rental income based on total cost of lease payments divided by total lease terms. It can vary from actual rent collections due to factors such as escalating lease payments, which creates a deferred liability.
Both FFO and AFFO are expressions of the REIT’s equity value.
What Is Free Cash Flow?
Free cash flow (FCF) is a metric dealing with a REIT’s cash flow, similar but not identical to AFFO. Let’s delve deeper and tease the two apart.
FCF is the amount of cash flowing through the REIT from operations and paying for capital expenditures. It is the cash left over to pay dividends to unitholders, pay down debt to creditors, and other uses.
You calculate it thusly:
- FCF = (1 – Tax Rate) * Earnings Before Interest and Taxes + Depreciation + Amortization – Capital Expenditures Change in Working Capital
The EBIT term is operating earnings before paying interest and taxes. The EBIT term is expressed as its after-tax value by applying the REIT’s tax rate. However, REITs don’t pay taxes – they pass that honor through to unitholders. Therefore, the tax-rate term drops out.
Depreciation and amortization are non-cash expenses that reduce net income but do not affect cash flows, which is why they are added back.
Capital expenditures are funds spent by the REIT for acquiring or improving fixed assets, such as buildings, equipment and land. These costs are not expensed (i.e., fully deducted in the year incurred), but rather written down over the useful life of the asset (in other words, depreciated). CapEx is found as an investing cash flow in the REIT’s Cash Flow Statement – it is not an operating cash flow.
Working capital (WC) is the difference between the REIT’s current assets and current liabilities. Positive WC indicates the REIT can fully pay for its short-term liabilities (i.e., payable within 12 months). A change in working capital ( ∆WC) can be positive (as would occur if the REIT acquired a property), or negative (such as from the sale of a building). The ∆WC term accounts for an increase or decrease in cash or assets that can be readily converted to cash.
Equity Value vs Enterprise Value
As mentioned, AFFO is a measure of equity value, whereas FCF expresses enterprise value. To clarify
- Equity value: Equity value is used to determine what is available is to unitholders (i.e., available for dividends). It is calculated as
Equity Value = Market Capitalization = Number of Units x Price per Unit
- Enterprise value: A more inclusive measure of value that is available to all stakeholders (including creditors and minority interests), not just unitholders. It is calculated as:
Enterprise Value = Equity Value + Debt + Preferred Units + Non-controlling Interest – Cash and Cash Equivalents
For example, suppose the REIT’s market capitalization is $500 million – this is its equity value. If the REIT has debt of $400 million and cash & equivalents of $60 million, then its enterprise value is $840 million (i.e., $500M + $400M – $60M).
The significance of valuing a company using enterprise vs equity value goes to how you set up a discounted cash flow (DCF) model. In this kind of model, the value of the company is calculated as the sum of all future free cash flows discounted by the appropriate factor. In general, the market cap should equal the REIT’s DCF value, thereby informing unit prices.
When calculating the DCF value using enterprise value, the REIT’s free cash flows available to stakeholders are discounted by the weighted average cost of capital (i.e. the relative costs of debt and equity). Conversely, using equity value means you project free cash flows available tounit holders and discounting by the cost of equity.
FCF vs AFFO
FCF is a measure of the REIT’s enterprise value. Let’s point out some of the differences between FCF and AFFO.
The bottom line is that FCF, as an expression of enterprise value, accounts for net debt, which absorbs cash that would otherwise be available as dividends. FCF represents money that is available for dividends, debt service, unit buyback and investments. FCF (or more importantly, changes to FCF over time) helps you determine how much cash is available for all uses. It is a pre-interest term reflecting core business cash flows. Because it based on EBIT, it is vulnerable to manipulation under accrual accounting. For example, CapEx can vary substantially from year to year, so it makes sense to measure FCF over multiple years.
In contrast, AFFO is associated with equity value and expresses the funds available for unitholder dividends. AFFO reduces FFO by capital expenditures, because even though these expenditures are expensed over time, they are usually paid for up front, thereby reducing money available for dividends. AFFO is a post-interest term that includes non-core cash flows. It demonstrates a REIT’s cash flow performance in light of CapEx requirements.