VALUATION: RELATIVE VALUE (PRICE MULTIPLE) APPROACH
6.2 Funds from Operations and Adjusted Funds from
REIT analysts and investors make extensive use of two measures of operating perfor- mance that are particularly relevant to real estate. The first, funds from operations (FFO) is generally calculated as net income (computed in accordance with generally accepted accounting principles) plus 1) gains and losses from sales of properties and 2) depreciation and amortization.
Why is depreciation added back to net income? Investors believe that real estate maintains its value to a greater extent than other business assets, often appreciating in value over the long- term, and that depreciation deductions under IFRS and US GAAP do not represent economic reality. A taxable REOC that uses a moderate degree of leverage and regularly chooses to reinvest most of its income in its business usually will be able to defer a large part of its annual tax liability; that is, its cash income taxes will be low as a result of the accelerated depreciation rates for tax purposes permitted in most countries.
Gains and losses from sales of previously depreciated operating properties are also added back to net income on the grounds that they do not represent sustainable, normal income.
Adjusted funds from operations (AFFO), also known as funds available for distribution (FAD) or cash available for distribution (CAD), is a refinement of FFO that is designed to be a more accurate measure of current economic income. AFFO is most often defined as FFO adjusted to remove any non- cash rent and to subtract maintenance- type capital expenditures and leasing costs (including leasing agents’
commissions and tenants’ improvement allowances). So- called straight- line rent is the average contractual rent over a lease term and this figure is recognized as revenue under IFRS and US GAAP. The difference between this figure and the cash rent paid during the period is the amount of the non- cash rent or straight- line rent adjust- ment. Because most long- term leases contain escalating rental rates, this difference in rental revenue recognition can be significant. Also, deductions from FFO for capital expenditures related to maintenance and for leasing the space in properties reflect costs that need to be incurred to maintain the value of properties. The purpose of the adjustments to net earnings made in computing FFO and AFFO is to obtain a more tangible, cash- focused measure of sustainable economic income that reduces reliance on non- cash accounting estimates and excludes non- economic, non- cash charges.
AFFO is superior to FFO as a measure of economic income because it takes into account the capital expenditures necessary to maintain the economic income of a property portfolio. It is open, however, to more variation and error in estimation than FFO. The precise annual provision required to maintain and lease the space in a property is difficult to predict, and the actual expense in any single year may be significantly more or less than the norm because of the timing of capital expenditure programs and the uneven expiration schedule of leases. Consequently, estimates of FFO are more frequently cited measures, although analysts and investors will tend to base their investment judgments to a significant degree on their AFFO estimates.
Although many REITs and REOCs compute and refer to AFFO in their disclosures, their methods of computation and their assumptions vary. Firms that compile statis- tics and estimates of publicly traded enterprises for publications, such as Bloomberg and Thomson Reuters, tend not to gather AFFO estimates because of the absence of a universally accepted methodology for computing AFFO and inconsistent corporate reporting of actual AFFO figures, which hinders corroboration of analysts’ estimates.
Exhibit 8 illustrates the most straightforward, convenient way of calculating FFO and AFFO for hypothetical Office Equity REIT Inc.
Exhibit 8 Calculation of FFO and AFFO Office Equity REIT Inc (in thousands, except per share data)
Panel A: Calculation of funds from operations
Net income $160,638
Add: Depreciation and amortization $76,100
Add: Gains and losses from sale of depreciable real estate $25,000
Funds from operations $261,738
FFO per share (55,689 shares outstanding) $4.70
Panel B: Calculation of adjusted funds from operations
Funds from operations $261,738
Less: Non- cash (straight- line) rent adjustment $21,103 Less: Recurring maintenance- type capital expenditures and leas-
ing commissions $55,765
Adjusted funds from operations $184,870
AFFO per share (55,689 shares outstanding) $3.32
EXAMPLE 6
Analyst Adjustments (I)
1 Which of the following is the best measure of a REIT’s current economic return to shareholders?
A FFO B AFFO C Net income
2 An analyst gathers the following information for a REIT:
Net operating income $115 million
Book value of properties $1,005 million Market value of debt outstanding $505 million
Market cap rate 7%
Shares outstanding 100 million
Book value per share $5.00
The REITs NAV per share is closest to:
A $10.05.
B $11.38.
C $16.42.
3 All else equal, estimated NAV per share will decrease with an increase in/
to the:
A capitalization rate.
B estimated growth rate.
C deferred tax liabilities.
Solution to 1:
B is correct. AFFO is calculated from FFO by deducting non- cash rent, capital expenditures for maintenance, and leasing costs.
A is incorrect because it does not account for non- cash rent, capital expen- ditures for maintenance, and leasing costs. C is incorrect because it does not account for interest expense, general and administrative expense, non- cash rent, capital expenditures for maintenance, and leasing costs, which are appropriate adjustments to net income in calculating current economic return.
Solution to 2:
B is correct. The NAVPS estimates real estate values by capitalizing NOI. Valuing
$115 million of NOI with a capitalization rate of 7 percent yields a value for the properties of $1,642,857,000. After deducting $505 million of debt at market value, NAV is $1,137,857,000; NAVPS equals NAV divided by 100 million shares outstanding, or $11.38.
A is incorrect because it is the book value of the assets (not the net assets) per share: $1,005 million divided by 100 million shares = $10.05 per share. It does not take into account the market value of the assets and does not deduct debt. C is incorrect because it is the market value of the real estate; that is, NOI capitalized at 7 percent, divided by 100 million shares: $1,642,857,000/100,000,000 = $16.42.
This calculation excludes other assets and liabilities of the entity.
Solution to 3:
A is correct. The capitalization rate is used to calculate the estimated value of operating real estate because it is the NOI as a percentage of the value of operating real estate: NOI/Capitalization rate = Estimated value. As the capi- talization rate increases, the estimated value of operating real estate and thus the NAV will decrease.
B is incorrect because an increase in the estimated growth rate would increase the estimated NOI, and the estimated value of operating income. C is incorrect because deferred liabilities are not counted as “hard” liabilities and subtracted from the NAV.
EXAMPLE 7
Analyst Adjustments (II)
1 An increase in the capitalization rate will most likely decrease a REIT’s:
A cost of debt.
B estimated NOI.
C estimated NAV.
2 An analyst gathers the following information for a REIT:
Non- cash (straight- line) rent £207,430
Depreciation £611,900
Recurring maintenance- type capital expenditures and
leasing commissions £550,750
Adjusted funds from operations £3,320,000
AFFO per share £3.32
The REIT’s funds from operations (FFO) per share is closest to:
A £3.93.
B £4.08.
C £4.48.
3 Which of the following estimates is least likely to be compiled by firms that publish REIT analysts’ estimates?
A FFO B AFFO C Revenues
Solution to 1:
C is correct. The capitalization rate is used to estimate the market value of real estate, which is then used to calculate NAV.
A is incorrect because a higher capitalization rate does not decrease the REIT’s cost of debt. B is incorrect because the estimated NOI is based on income growth, not the capitalization rate.
Solution to 2:
B is correct. FFO = AFFO + Non- cash (straight- line) rent + Recurring maintenance- type capital expenditures and leasing commissions = 3,320,000 + 550,750 + 207,430 = £4,078,180. The number of shares outstanding = 3,320,000/3.32 = 1,000,000. FFO/share = 4,078,180/1,000,000 ≈ £4.08.
A is incorrect because it adds depreciation to AFFO (3,320,000 + 611,900 =
£3,931,900. 3,931,900/1,000,000 ≈ £3.93 per share.) C is incorrect because it also adds depreciation to AFFO + Non- cash (straight- line) rent + Recurring maintenance- type capital expenditures and leasing commissions.
Solution to 3:
B is correct. Firms that compile statistics and estimates of REITs tend not to gather AFFO estimates because of the absence of a universally accepted meth- odology for computing AFFO and inconsistent corporate reporting of actual AFFO figures.