FFO, AFFO, and why REITs ignore net income

Why net income breaks for a property company

Open a REIT's income statement and the first line that misleads you is depreciation. GAAP requires a building to be written down over a life measured in decades, on the theory that the asset is consuming itself the way a piece of equipment does. Buildings mostly do not behave that way. A well-located apartment tower or grocery-anchored center can hold its value or appreciate over the same period the accountants are writing it to zero, and the owner is spending real money on the roof and the elevators to keep it that way. So the largest single expense on the income statement is a non-cash charge levied against an asset that is not actually shrinking in value.

The effect is not small. A property company can collect stable contractual rent, comfortably service its debt, pay a dividend every quarter, and still report net income near zero. Some report negative net income in years when nothing went wrong at all.

The second break is gains on sale. Because depreciation has been steadily reducing the tax and book basis of a building, selling it years later almost always produces a large accounting gain, even if the sale price barely beats what was paid. Sell two assets in one quarter and net income spikes. Sell nothing the next quarter and it collapses. That makes earnings lumpy, non-comparable across companies with different disposition programs, and useless as a run rate.

This is the entire reason the sector invented its own earnings metric. When an interviewer asks why REITs report funds from operations, the answer they want starts with depreciation being a non-cash charge against assets that do not depreciate economically, and finishes with gains on sale making net income lumpy. If you only say "depreciation is non-cash," you have given half the answer.

Funds from operations, the sector's replacement for earnings

The industry-standard definition is narrower than people assume. Funds from operations is:

• net income computed under GAAP,
• plus depreciation and amortization on real estate,
• minus gains (plus losses) on sales of depreciable real property,
• with impairment write-downs of depreciable real estate also excluded,
• and with the same adjustments applied to unconsolidated joint venture interests at the company's ownership share.

Two of those clauses are where candidates get marked down.

First, FFO adds back real estate depreciation, not all depreciation. Depreciation on corporate assets stays in. Amortization of a corporate software system, furniture at the head office, vehicles in a maintenance fleet: those are genuine consumption of a wasting asset, and the standard definition leaves them as a charge. A candidate who says "you add back D&A" is describing EBITDA, not FFO, and a good interviewer will hear the difference.

Second, the joint venture clause matters because real estate is a joint venture business. Companies own half of a mall, a third of a development, a small strip of a fund. If you consolidate nothing and add back nothing, the venture's depreciation never gets reversed and your FFO understates the company. The convention is to look through to the company's proportionate share and apply the identical adjustments there.

Note what FFO does not do. It does not add back interest expense, so it is an after-leverage number, which is why FFO multiples respond to capital structure in a way that the property-level metrics discussed in cap rates and net operating income do not. It does not add back general and administrative expense, so it is a corporate-level metric rather than an asset-level one. And it does not subtract a dollar of capital expenditure. That last omission is the reason AFFO exists.

One more mechanical point that shows up in modeling tests: when you quote FFO per share you almost always want FFO available to common, which is after preferred dividends. Preferred stock is common in REIT capital structures, and forgetting to strip the preferred dividend inflates the number attributable to common holders.

Adjusted funds from operations, or what is actually available to pay a dividend

AFFO starts at FFO and moves toward cash. The standard build subtracts the recurring spending that keeps the portfolio producing the rent FFO just counted:

• Recurring maintenance capital expenditure. Roofs, parking lots, HVAC, unit turns. Not development or major redevelopment spending, which is growth capital and gets treated separately.
• Tenant improvements and leasing commissions. In office and retail especially, signing a tenant costs real cash. TI packages and broker commissions are the price of the lease that is generating the rent.
• The straight-line rent adjustment, removing the non-cash portion of reported rental revenue.
• Other non-cash items, which vary by policy: amortization of above-market and below-market lease intangibles picked up in acquisitions, amortization of deferred financing costs, and non-cash equity compensation, which some companies add back and others deliberately do not.

You will also see the same idea labeled cash available for distribution or funds available for distribution. Treat CAD, FAD, and AFFO as cousins rather than identical twins, and check the definition before you compare across companies.

The point of AFFO is dividend coverage. FFO tells you what the portfolio earned before the cost of keeping it leased and standing. AFFO is a much better proxy for the cash a board actually has available to pay out. When you are stress-testing whether a distribution is safe, or feeding a metric into the valuation approaches covered in how real estate companies are valued, AFFO is the number that behaves.

Straight-line rent, the follow-up they like to ask

Most commercial leases contain contractual escalations, say a fixed bump every year or an increase every five years. Accounting does not let you report the cash as it arrives. It requires you to total the contractual rent over the lease term and recognize it evenly across the term.

The consequence: early in a lease, reported rental revenue exceeds the cash the tenant is actually paying. Late in the lease, cash rent exceeds reported revenue, and the relationship reverses. The cumulative difference sits on the balance sheet as a straight-line rent receivable, which builds up over the front half of a lease and unwinds over the back half.

That receivable is worth watching. A company signing a lot of new long leases with steep escalators will show a fast-growing straight-line rent receivable, and a meaningful gap between reported revenue and cash collected. That is not fraud, it is the accounting working as designed. But it does mean reported FFO is running ahead of cash, and it is exactly the kind of quality-of-earnings observation that separates a candidate who memorized a formula from one who understands it. Subtracting the straight-line adjustment in AFFO is how you neutralize it.

Every company's "core FFO" is its own invention

FFO has a standard industry definition. Almost nothing else in this vocabulary does.

Companies routinely report "core FFO," "normalized FFO," "operating FFO," or "FFO as adjusted," each starting from standard FFO and then removing whatever management considers non-recurring: transaction costs on an acquisition, debt extinguishment charges, severance, litigation settlements, casualty losses, mark-to-market swings on hedges. Some of those adjustments are defensible. Some are a company that has reported "non-recurring" acquisition costs every year for a decade.

AFFO is worse, because there is no standard at all. One company subtracts non-cash compensation, another adds it back. One capitalizes a category of spending that a peer expenses. One counts second-generation tenant improvements as recurring, another calls them growth. The headline AFFO per share figures of two otherwise similar companies can be built on definitions that do not overlap.

The banker's answer is that you do not accept the reported numbers into a comp set. You take each company back to standard FFO, then rebuild the adjustments consistently across the whole set using the supplemental disclosure package, and you say so in a footnote on the page. Interviewers like hearing this because it is what the job is. The analyst work in a REIT comps run is less about pulling multiples than about making sure the denominators were computed the same way, which is a large part of what the coverage team does day to day, as described in what REGL bankers actually do.

The three metrics side by side

Payout ratios and per share mechanics

Because REITs must distribute the large majority of taxable income to keep their tax status, as covered in REIT structures and tax rules, the dividend is not discretionary in the way an industrial company's is. That makes coverage a live analytical question rather than a formality.

Compute the payout ratio on AFFO, not on FFO. An 80% FFO payout can be a 105% AFFO payout once you take out maintenance capex and leasing costs, and the second number is the one that tells you the truth. A company paying out more than its cash flow is funding the gap with asset sales, borrowings, or equity issuance. That is not generosity, it is a dividend being financed rather than earned, and it usually ends in a cut. When you see a payout above cash flow, the follow-up questions are how long the gap has been open, what is funding it, and whether the leases already signed will close it.

The per share denominator has a sector-specific wrinkle. Most REITs are organized as UPREITs, where the public company holds an interest in an operating partnership and other holders own OP units in that partnership. OP units are economically equivalent to shares and are typically exchangeable into them. If you divide total FFO by only the public share count, or divide FFO attributable to the REIT alone by a share count that includes units, you get a number that is wrong in either direction. FFO per share should be computed fully diluted, including OP units, with the numerator and denominator covering the same economic ownership.

The traps

Four mistakes account for most of the damage in interviews.

Adding back all depreciation. The standard definition adds back real estate depreciation and amortization, not corporate. Say it precisely.

Forgetting that FFO subtracts no capital expenditure. This is the single most common gap. If you present FFO as the money available for the dividend, you have skipped the cost of keeping the buildings leased and functional, which is exactly what AFFO exists to capture.

Treating FFO as cash flow. It is an adjusted earnings metric. It sits after interest and after G&A, it still contains straight-line rent and other non-cash revenue, and it is not cash from operations. Calling it "cash flow" in a superday is a quick way to invite the question you cannot answer.

Comparing two companies' core FFO as though the definitions match. They almost never do. The correct instinct, and the one worth saying out loud, is to rebuild to a common definition before drawing a conclusion.

Practice question

Why do REITs report FFO instead of net income, and what is the difference between FFO and AFFO?

Net income does not describe a property company well, for two reasons. Depreciation is a large non-cash charge against buildings that often hold or grow in value, so reported earnings understate the economics badly. And because depreciation keeps reducing basis, selling an asset produces a big accounting gain, which makes net income lumpy and hard to compare between companies with different disposition programs.

FFO fixes both. You take net income, add back real estate depreciation and amortization, take out gains on sales of depreciable property and add back losses, exclude impairments of depreciable real estate, and make the same adjustments for joint ventures at share. Two details matter: you only add back real estate depreciation, not corporate, and you usually want FFO available to common, so after preferred dividends.

AFFO goes further toward cash. From FFO you subtract recurring maintenance capex, tenant improvements and leasing commissions, and the straight-line rent adjustment, plus other non-cash items depending on company policy. FFO says what the portfolio earned. AFFO says what is actually available to pay the dividend, so payout ratios should be run on AFFO. The catch is that FFO has a standard definition and AFFO does not, so in a comp set you rebuild the adjustments consistently yourself.

What the interviewer is listening for: whether you can name both defects in net income rather than only the depreciation one, and whether you know FFO subtracts no capital expenditure. The precise wording on real estate versus total depreciation signals whether you learned the definition or half-remembered it. Volunteering that AFFO is company-defined and needs to be normalized before comparison is what an analyst who has actually built a REIT comp set would say.