Analyzing REITs: FFO, AFFO, and Dividend Sustainability

• FFO, or Funds From Operations, adjusts GAAP earnings for depreciation and gains or losses on property sales to reflect a REIT's operating cash generation.
• AFFO refines FFO by removing recurring capital expenditures and other non-cash items, and it's a better proxy for distributable cash flow when assessing dividend sustainability.
• Net Asset Value, calculated on a per-share basis, helps value REITs by comparing market price to underlying property value; common discounts or premiums signal market expectations.
• Assess dividend sustainability by comparing dividends to AFFO per share, conservative payout ratios, balance sheet health, and growth drivers such as rent escalators and development pipelines.
• Watch for common pitfalls: relying solely on GAAP earnings, ignoring maintenance capex, overlooking tenant concentration and lease structure, and misreading NAV estimates.

Introduction

Real Estate Investment Trusts, or REITs, are companies that own, operate, or finance income-producing real estate. They pay out most of their taxable income as dividends, so conventional earnings metrics and valuation methods need adjustment to reflect real estate economics. This article explains the critical metrics investors use when analyzing REITs, and why those metrics matter.

Why should you care about FFO, AFFO, and NAV when evaluating REITs? Because these measures give you a clearer view of cash available for dividends and the intrinsic value of the property portfolio. You'll learn how to calculate and interpret FFO and AFFO, how to use NAV for valuation, and how to assess whether a REIT's dividend is sustainable and likely to grow.

Why GAAP Earnings Fall Short for REITs

GAAP net income isn’t a reliable indicator of a REIT's recurring performance. That’s because depreciation, a non-cash expense, is large for real estate under GAAP, and it reduces net income even though property values often appreciate over long periods. Also, one-off gains or losses from property sales can distort the picture.

FFO was developed by the National Association of Real Estate Investment Trusts to address these issues. It strips out depreciation and adjusts for gains or losses on property sales, giving a cleaner view of operating cash flow. If you want to know how much cash a REIT generates from its core business, FFO is the starting point.

FFO: Definition, Calculation, and Use

Funds From Operations, or FFO, starts with net income and makes two primary adjustments: add back real estate depreciation and amortization, and subtract gains or add back losses from property sales. The basic formula is simple and widely reported by REITs themselves.

Basic FFO formula

FFO = Net Income + Depreciation & Amortization on real estate assets - Gains (or + Losses) from property sales. Note that interest, general and administrative expenses, and normal operating costs remain in the metric.

Example: Suppose $O (Realty Income) reports net income of $200 million, depreciation of $250 million, and a $10 million gain on a property sale. FFO = 200 + 250 - 10 = $440 million. FFO per share is FFO divided by diluted shares outstanding, which helps compare with the dividend per share.

How investors use FFO

Investors use FFO to compare operating performance across REITs because it removes accounting noise. You’ll often see price-to-FFO ratios, similar to P/E but more relevant for REITs. However, FFO still doesn't capture recurring capital spending needed to maintain properties, which is where AFFO comes in.

AFFO: Refining FFO into Distributable Cash Flow

Adjusted Funds From Operations, called AFFO or FAD in some reports, attempts to represent cash available to pay dividends after accounting for recurring maintenance capital expenditures and other non-cash items. Because REITs must maintain property quality, AFFO is a closer proxy for what can sustainably be distributed to shareholders.

Common AFFO adjustments

1. Start with FFO.
2. Subtract recurring maintenance capex, sometimes called leasing-related capex.
3. Adjust for straight-line rent and amortization of lease incentives, since these are non-cash accounting items that affect FFO but not current cash.
4. Adjust for recurring non-cash compensation if material.

Example calculation: Continuing with $O, assume FFO is $440 million, recurring maintenance capex is $80 million, and straight-line rent adjustments reduce cash by $10 million. AFFO = 440 - 80 - 10 = $350 million. If $O has 500 million diluted shares, AFFO per share = $0.70. If the REIT pays $0.60 per share in annual dividends, the AFFO payout ratio is 86% (0.60/0.70).

Interpreting AFFO payout ratios requires context. An 80% payout ratio may be sustainable for a triple-net lease REIT with low capex needs, but it would be risky for a development-heavy REIT that needs more capital to grow.

NAV-Based Valuation for REITs

Net Asset Value, or NAV, tells you what a REIT’s real estate portfolio might be worth on a per-share basis. NAV is calculated by estimating the market value of properties, subtracting liabilities, and dividing by diluted shares outstanding. Comparing NAV per share to market price helps identify discounts or premiums.

Calculating NAV step by step

1. Start with reported book value of real estate assets.
2. Apply market-based adjustments, such as cap rate changes, recent comparable sales, or third-party appraisals, to approximate fair market value.
3. Subtract debt, minority interests, and other liabilities.
4. Divide by diluted shares to get NAV per share.

Example: A REIT reports book value of properties at $10 billion. Based on recent cap rate compressions and sales, you estimate market value at $12 billion. With $4 billion in debt and 400 million diluted shares, NAV per share = (12 - 4) billion / 400 million = $20. If the REIT trades at $16 per share, the market is pricing a 20% discount to NAV.

Discounts may reflect expected declines in NOI, capital needs, management concerns, or market liquidity. Premiums typically signal confident growth prospects or scarce, high-quality assets like logistics or cell towers.

Assessing Dividend Sustainability and Growth Potential

Dividend sustainability in REITs hinges on the relationship between AFFO and the dividend, balance sheet strength, lease structures, portfolio quality, and growth opportunities. Look beyond headline yields to the drivers behind cash flow.

Key indicators to evaluate

• AFFO payout ratio, ideally conservative relative to business model; many healthy REITs run below 80% though some stable net-lease REITs may sit higher.
• Dividend coverage trend: is AFFO per share growing, flat, or declining? Coverage expanding over time supports payout increases.
• Balance sheet metrics: debt-to-EBITDA or net debt-to-EBITDA, interest coverage, weighted average debt maturity, and access to capital markets.
• Lease characteristics: rollover schedules, weighted average lease term, rent escalation clauses, and tenant credit quality. Long-term, inflation-linked leases like those common in industrial or cell tower REITs support predictable growth.
• Growth pipeline: development projects, acquisitions, and internal rent growth. Be realistic about funding; growth financed through excessive equity issuance can dilute AFFO per share.

Example: $PLD (Prologis) often shows steady AFFO growth driven by strong rent growth in logistics and long-term leases. If AFFO per share has grown 8% annually and payout ratio is 60%, dividend growth is likely sustainable. By contrast, a mall REIT with a shrinking occupancy rate and high AFFO payout may struggle to maintain its payout.

Real-World Examples and Numbers

Example 1, Triple-net lease REIT: $O (Realty Income) has historically reported stable FFO and AFFO with limited maintenance capex because tenants handle property costs. If $O reports FFO per share of $1.40 and subtracts $0.25 for maintenance capex and straight-line rents, AFFO per share of $1.15 against a dividend of $0.90 implies a 78% payout, which many investors find acceptable given tenant diversification and long lease terms.

Example 2, Industrial REIT: $PLD may report higher depreciation adjustments and capital needs for development. Suppose PLD reports FFO of $3.00 per share and deducts $0.60 of maintenance plus development stabilization costs to get AFFO of $2.40. With a dividend of $1.80, payout is 75%. Growth in same-store NOI and high leasing demand support potential dividend increases.

Example 3, Maturing mall REIT: $SPG could show declining FFO per share because of store closures, requiring higher upkeep. If FFO is $2.00 and AFFO after capex is $1.20, but the dividend equals $1.50, the payout exceeds AFFO, signalling reliance on asset sales or balance sheet maneuvers, which is risky over time.

Common Mistakes to Avoid

• Relying solely on GAAP earnings: GAAP can understate recurring cash flow because of depreciation. Use FFO and AFFO instead.
• Ignoring maintenance capex: Treating FFO as distributable cash without subtracting maintenance capex can overstate ability to pay dividends. Always check AFFO adjustments.
• Overlooking lease detail and tenant concentration: High exposure to a single tenant or short average lease terms increases risk. Review lease expirations and tenant credit quality.
• Misreading NAV: NAV is an estimate subject to valuation assumptions. Don't treat a NAV discount as free upside without understanding why the market is skeptical.
• Assuming high yield equals value: A high dividend yield often signals underlying stress. Verify coverage, balance sheet health, and earnings quality before concluding it's a bargain.

FAQ

Q: How often do REITs report FFO and AFFO?

A: Most publicly traded REITs report FFO every quarter and often provide AFFO or adjusted metrics in earnings releases or supplemental materials. If AFFO is not reported, you can usually derive it from the supplemental cash flow and capex disclosures.

Q: Is AFFO standardized across REITs?

A: No. AFFO lacks a single universal standard, so presentation varies. Compare line-item adjustments across peers and reconcile to cash flow statements to ensure apples-to-apples comparisons.

Q: Can a REIT grow dividends without growing AFFO?

A: Yes, temporarily. REITs can use debt, asset sales, or equity issuance to fund distributions, but this is not sustainable long-term. Persistent dividend growth usually requires rising AFFO per share or accretive acquisitions funded conservatively.

Q: How should I use NAV when screening REITs?

A: Use NAV to identify potential mispricings: trade at steep discounts may offer upside but investigate causes. Combine NAV with AFFO yield and balance sheet metrics to form a balanced view.

Bottom Line

FFO and AFFO are indispensable tools for analyzing REITs because they focus on recurring cash generation and distributable cash. FFO removes accounting depreciation and sale gains, while AFFO further accounts for maintenance capex and non-cash items to approximate cash available for dividends.

Combine AFFO-based payout analysis with NAV valuation, lease and tenant assessments, and balance sheet health to judge dividend sustainability and growth potential. Start with the REIT's supplemental disclosures, compare peers, and watch payout trends over multiple quarters to avoid common pitfalls.

Next steps: when you evaluate a REIT, pull the last four quarters of FFO and AFFO, calculate payout ratios, review the NAV sensitivity to cap rates, and map lease rollovers. Doing this regularly will make you smarter about dividend quality and total return potential in REIT investing.