P/FFO vs. P/AFFO: Understanding REIT Valuation Metrics

P/FFO vs P/AFFO are considered more sophisticated metrics to measure REIT performance. Though earnings per share (EPS)Earnings Per Share (EPS)Earnings per share (EPS) is a key metric used to determine the common shareholder's portion of the company’s profit. EPS measures each common share's profit is often used to measure the performance of a REIT, P/FFO (Price/Funds from Operations) and P/AFFO (Price/Adjusted Funds from Operations) are preferred since they embrace procedures that better estimate the performance of the real estate industry.

EPS takes the total revenues for the period minus all costs, divided by the total number of shares to get the earnings per share. It does not consider the fact that certain costs may be non-cash, such as amortizationAmortizationAmortization refers to the process of paying off a debt through scheduled, pre-determined installments that include principal and interest and depreciation. Non-cash expenses reduce the dividends paid to the shareholders, while most real estate properties appreciate as opposed to depreciating. The P/FFO and, consequently, the P/AFFO take into consideration such costs and overlook them to give the shareholders their deserved dividend amounts.

Differences: P/FFO vs P/AFFO

There are two conspicuously notable differences between the two methods of determining the performance of a real estate investment trust (REIT)Real Estate Investment Trust (REIT)A real estate investment trust (REIT) is an investment fund or security that invests in income-generating real estate properties. The fund is operated and owned by a company of shareholders who contribute money to invest in commercial properties, such as office and apartment buildings, warehouses, hospitals, shopping centers, student housing, hotels. First, the P/FFO comes with a common formula across the board used by different companies, while the P/AFFO lacks a standard formula. Different companies use different formulas and include various factors in the formula for calculating the P/AFFO. It makes the P/AFFO difficult to compare between different companies and REITs.

Secondly, the P/AFFO is an adjusted version of the P/FFO. The P/AFFO is adjusted by subtracting any capital expendituresCapital ExpendituresCapital expenditures refer to funds that are used by a company for the purchase, improvement, or maintenance of long-term assets to improve from the P/FFO. The P/FFO ignores capital expenditures and other routine maintenance costs like repainting and roof replacement. They are vital costs that keep the property in its best condition and make it attractive to investors and potential tenants. The P/AFFO also subtracts straight-line rent income, which decreases the cash available for distribution.

Similarities: P/FFO vs P/AFFO

P/FFO is the net income plus amortization and depreciation. The costs are added back because when calculating the net income, we deduct the total costs from the total revenue.

Depreciation and amortization are non-cash expenses that do not affect the cash flows of a company. Deducting non-cash expenses from the revenue results in a lower profit. Therefore, the dividends distributed to shareholders are reduced by the sum of the non-cash expenses.

Both the P/FFO and P/AFFO add back the non-cash costs to the net income to eliminate the effects of depreciation and amortization, which do not affect cash flow. Both methods work better than conventional procedures such as the EPS in measuring the real estate industry’s performance.

Both metrics are also common in the measurement of REITs but are not yet defined in financial reporting standards. Currently, the International Financial Reporting Standards (IFRS) does not officially recognize the two procedures as qualified measurements for the real estate industry.

P/FFO vs. P/AFFO: Which is More Appropriate to Use?

Between the two metrics, the most appropriate measurement for evaluating the real estate industry depends on the instance. When conducting a comparison of REITs across multiple companies, the most preferred metric is the P/FFO. This is because P/FFO is standardized, and multiple REITs will use the standard formula.

P/AFFO lacks a standardized formula. The adjusted funds from operations can, however, be termed as a better estimator of the REIT’s performance since it eliminates non-cash costs from the formula. The P/AFFO is precise since it subtracts the capital expenditures and other routine maintenance expenses.

Both methods offer the possibility of giving a common estimate in rare circumstances. If a REIT does not incur depreciation, amortization, and capital expenditures, both methods will arrive at similar figures in the measurement of REIT performance. For example, the P/FFO takes the net income and adds depreciation and amortization, which, in this case, is absent, making both formulas identical. The P/AFFO takes the P/FFO and subtracts the capital expenditures and other routine expenses, which, in this case, are absent.

Related Readings

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To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:

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