Funds From Operations is the primary earnings measure used by equity REITs because GAAP net income systematically understates their true operating performance. The issue is real estate depreciation: under GAAP, a REIT charges depreciation on its properties as if they were wasting assets, even though well-maintained commercial real estate typically holds or appreciates in value over time. FFO adjusts for this distortion by adding back real estate depreciation and amortization and excluding gains or losses from property sales, producing an earnings figure that better reflects the sustainable cash-generating capacity of the portfolio.
The FFO definition published by the National Association of Real Estate Investment Trusts is the industry standard. Starting from GAAP net income, Nareit FFO adds back real estate depreciation and amortization, adjusts for impairments on depreciable real estate, and excludes gains and losses on sales of depreciable real estate. The result is a number that is comparable across REITs and across time, and it is the figure on which most REIT analyst consensus estimates are built. FFO per share — net FFO divided by diluted weighted-average shares outstanding — is the earnings-per-share equivalent for a REIT and the metric that drives most of the sell-side research published on the sector.
Adjusted FFO (AFFO) takes FFO several steps further by deducting items that reduce the cash actually available for distribution to shareholders. The most important deductions are recurring capital expenditures — the real, ongoing maintenance spending required to keep the properties competitive — and leasing commissions and tenant improvement allowances amortized over the lease term. AFFO also normalizes straight-line rent (reversing the GAAP smoothing that makes reported rent higher than cash rent in early years and lower in later years) and sometimes adjusts for stock-based compensation. The resulting AFFO number is a much closer proxy for distributable cash than either GAAP net income or FFO.
For a REIT investor, the payout ratio of dividends divided by AFFO is the single most important coverage metric. A payout ratio below 80% indicates a dividend the REIT can sustain through normal business cycles; a ratio above 100% indicates the dividend is being funded from sources other than ongoing operations, which is rarely sustainable. AFFO multiples — the stock price divided by AFFO per share — are the primary valuation anchor for public REITs, functioning the way P/E ratios do for operating companies. Understanding the FFO-to-AFFO bridge is essential for anyone underwriting public REIT securities or comparing public market valuations to private real estate transactions.
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