Why It Matters
Here's the short version: GAAP net income doesn't work well for REITs because real property depreciation produces large paper losses even as the underlying buildings hold or gain value. FFO corrects for depreciation; AFFO goes further by also subtracting the real cash a REIT spends each year to maintain its properties. What's left is a conservative estimate of recurring cash flow — which is why most REIT analysts treat AFFO, not earnings per share, as the closest thing to "what this company actually earns."
At a Glance
- AFFO stands for Adjusted Funds from Operations
- Formula: AFFO = FFO - Recurring CapEx - Straight-Line Rent Adjustments
- FFO adds back depreciation to net income; AFFO also subtracts maintenance capital spending
- Payout ratio = Dividends per share divided by AFFO per share; above 100% is a warning sign
- AFFO yield = AFFO per share divided by share price
- Not standardized: each REIT defines recurring capex differently
- Most useful for comparing dividend sustainability across public REITs
AFFO = FFO - Recurring CapEx - Straight-Line Rent Adjustments
How It Works
Depreciation creates a unique distortion for REITs. Under GAAP, real estate depreciates over fixed schedules — 27.5 years for residential, 39 for commercial. These large non-cash charges reduce net income dramatically even as properties appreciate. A REIT showing a GAAP loss may be generating healthy recurring cash flow and paying a fully covered dividend.
FFO was the first fix. NAREIT standardized FFO in the 1990s to correct for this. FFO starts with net income, adds back real property depreciation, and removes gains or losses from property sales — one-time events, not recurring operations. FFO is now the dominant earnings metric in REIT analysis.
AFFO subtracts the real cash outflows FFO still ignores. A REIT must spend real cash each year to keep properties rentable: maintenance capital expenditures, tenant improvement allowances, and leasing commissions. AFFO deducts these recurring outflows. It also removes straight-line rent adjustments — GAAP spreads rent revenue evenly over a lease term even when cash payments are lumpy, and AFFO strips that non-cash smoothing out.
The AFFO payout ratio is the dividend health gauge. Divide dividends per share by AFFO per share. Below 80% signals comfortable headroom; 80%–100% is sustainable; above 100% means the dividend is funded by new equity or debt rather than recurring cash. AFFO yield (AFFO per share divided by share price) works like an earnings yield; comparing it to the cap rate on direct property in the same market reveals whether public or private real estate offers better value.
The core limitation is a lack of standardization. Each REIT defines recurring capital expenditure differently, so a REIT under payout pressure can reclassify borderline maintenance spending to inflate its AFFO. Cross-check against the investing activities section of the cash flow statement to verify what the company actually spent.
Real-World Example
Jennifer was comparing two industrial REITs for her self-directed IRA. Both traded at $45 and paid a $2.40 annual dividend. REIT A reported FFO of $3.00 per share; REIT B reported $2.80 — so on FFO alone, REIT A looked stronger.
But REIT A spent $0.80 per share on annual maintenance capex and tenant improvements; REIT B spent $0.45. REIT A's AFFO was $2.20; REIT B's was $2.35. REIT A's payout ratio was 109% — funded by debt, not recurring cash. REIT B came in at 102%, tight but improving. Jennifer chose REIT B. The FFO headline favored REIT A; the AFFO detail revealed it carried the riskier dividend.
Pros & Cons
- More accurate than FFO for dividend analysis. Subtracting recurring maintenance outflows gives a truer read on sustainable payout capacity than FFO does.
- Enables like-for-like sector comparisons. AFFO per share lets you compare REITs with similar property types without depreciation noise distorting the picture.
- Directly powers payout ratio analysis. Dividing dividends by AFFO per share produces a straightforward dividend sustainability check.
- Not standardized across REITs. Each company defines recurring capex on its own terms, so cross-company comparisons require careful footnote review.
- Requires more digging than headline metrics. AFFO is a non-GAAP figure found in earnings releases and supplemental filings, not on the face of financial statements.
- Less relevant outside public REITs. For direct ownership or private partnerships, net operating income and cash-on-cash return are the more appropriate measures.
Watch Out
Watch for reclassified capex. If a REIT's reported maintenance capex is substantially below peers with similar portfolios, the gap may reflect aggressive classification rather than genuine efficiency.
Watch for payout ratios above 100% when rates are rising. A REIT funding its dividend through new debt issuance becomes far more expensive to operate as refinancing costs climb.
Watch for AFFO figures that omit straight-line rent adjustments. Some supplementals present an "adjusted FFO" that resembles AFFO but leaves non-cash rent revenue in the figure. Confirm exactly which adjustments are included before comparing across companies.
The Takeaway
AFFO is the most practical metric for evaluating whether a REIT's dividend is genuinely covered by recurring operations. FFO corrects for depreciation; AFFO completes the picture by accounting for the maintenance cash the business must spend year after year. A payout ratio below 100% on an AFFO basis, sustained across multiple periods, is the core signal that a REIT dividend is durable — not the headline yield.