FFO AFFO Cap Rate: Valuing REITs Correctly

Key Takeaways

• FFO adds depreciation back to net income and removes property sale gains, giving a cleaner picture of a REIT's recurring cash earnings.
• A property trading at a 5% cap rate in a 4.5% rate environment looks very different when rates rise to 4.5%, cap rates and interest rates move together.
• Investors often compare AFFO across REITs without reading definitions; each company calculates it differently, making direct comparisons unreliable.
• Cap rate links property-level income to portfolio value, making it the bridge between REIT earnings analysis and net asset value estimation.

What It Is

FFO is net income with depreciation and amortization added back and gains or losses on property sales removed. Nareit created the measure in 1991 to give equity REITs a common operating-performance standard. The SEC recognizes FFO as a legitimate non-GAAP metric when presented alongside GAAP net income.

AFFO starts from FFO and subtracts recurring capital expenditures needed to keep properties in rentable condition, along with straight-line rent adjustments and other non-cash items. Nareit does not publish a single official AFFO formula, so each REIT defines its own version. Check the definitions before comparing two companies.

Cap rate, short for capitalization rate, is a property-level yield metric. It equals net operating income divided by property value, expressed as a percentage.

The Intuition

The point of FFO and AFFO is to strip out accounting noise. Real estate carries large depreciation charges that assume buildings lose value over time. In reality, well-maintained properties in healthy markets often hold or gain value for decades. Deducting depreciation like a factory machine produces a net income number that understates the actual cash a REIT generates.

Cap rate answers a different question. When you buy a building, you want to know what yield you are paying for the cash flow today, independent of financing. Cap rate gives you that number in one line, which makes it useful for comparing deals, tracking market trends, and valuing properties using the income approach.

How It Works

The FFO formula is straightforward.

FFO = Net Income
    + Depreciation and Amortization
    + Losses on Property Sales
    - Gains on Property Sales

AFFO takes FFO and subtracts what the company must spend to keep the buildings competitive.

AFFO = FFO
     - Recurring Capital Expenditures
     - Straight-Line Rent Adjustments
     +/- Other non-cash items

Recurring capex covers things like roof replacements, HVAC overhauls, tenant improvement allowances, and leasing commissions. A REIT that never reinvests eventually sees rents and occupancy fall.

Cap rate applies at the property level.

Cap Rate = Net Operating Income / Property Value

Net operating income is rental revenue minus operating expenses, but before mortgage interest, depreciation, and income tax. You can invert the formula to estimate a property's value from market cap rates.

Property Value = NOI / Market Cap Rate

Cap rates typically run between 4 and 10 percent, depending on property class, location, and the interest rate environment. Prime office in a major metro might trade at a 5 percent cap rate. A Class B suburban strip mall might trade at 9 percent. Lower cap rate means investors accept a lower yield because they expect stronger growth or lower risk.

Worked Example

Consider a REIT reporting 500 million dollars of net income, 1.2 billion of depreciation, 100 million of gains on sold properties, and 200 million of recurring capex.

FFO  = 500 + 1200 - 100 = 1,600 million
AFFO = 1,600 - 200     = 1,400 million

With 400 million shares outstanding, FFO per share is 4.00 dollars and AFFO per share is 3.50 dollars. If the stock trades at 42 dollars, the P/FFO multiple is 10.5 and the P/AFFO multiple is 12. Analysts often anchor REIT valuation to P/AFFO because it reflects distributable cash.

Now look at a single property the REIT owns. The building generates 600,000 dollars of NOI and comparable assets in the area trade at a 6 percent cap rate.

Implied value = 600,000 / 0.06 = 10,000,000

If the REIT carries the building on its books for 8 million, the market would value it at 10 million. Aggregating that kind of analysis across the portfolio gives an estimate of net asset value (NAV), another staple of REIT analysis.

Common Mistakes

1. Comparing FFO across REITs without reading definitions. While Nareit's FFO is fairly standardized, each company's AFFO reflects its own adjustments. A retail REIT and an industrial REIT can present different AFFO bridges that are not directly comparable.

2. Using cap rate as a discount rate. Cap rate captures year-one yield on current NOI. It is not the same as an investor's required return. A 5 percent cap rate property with 3 percent NOI growth has an unlevered expected return closer to 8 percent.

3. Ignoring capex intensity. Two REITs with identical FFO can have very different AFFO if one owns buildings that require heavy ongoing investment (older office, retail with tenant improvements) versus light-capex assets (self-storage, cell towers).

4. Confusing gross and net cap rates. Cap rate is always net of operating expenses. Quoting a "cap rate" based on gross rent inflates the figure and misleads the comparison.

5. Extrapolating cap rate across cycles. Cap rates move with interest rates. A 4 percent cap rate that looked reasonable when the 10-year Treasury yielded 1.5 percent looks expensive when it yields 4.5 percent. Always consider the spread to Treasuries.

Frequently Asked Questions

Q: What is FFO in simple terms? FFO is a REIT's net income with depreciation added back and gains from property sales removed. It gives a better view of recurring cash earnings because real estate buildings often hold value even as accounting rules write them down.

Q: How do FFO and cap rate affect investment decisions? Analysts value REITs on price-to-FFO or price-to-AFFO multiples the way stock investors use P/E ratios. Cap rates determine what individual properties are worth, which rolls up into the REIT's net asset value, a second way to judge whether the stock is cheap or expensive.

Q: What is a real-world example of cap rate in use? A building generating $600,000 of net operating income in a market where similar properties trade at 6% cap rates is worth $10 million. If the REIT carries it at $8 million on the books, that gap signals hidden value in the portfolio.

Q: How can investors use these metrics correctly? Always use AFFO when comparing dividend sustainability across REITs, and check each company's definition before comparing. Use cap rates with the current interest rate context, the spread between the cap rate and the 10-year Treasury matters as much as the cap rate itself.

Q: How is AFFO different from FFO? AFFO starts with FFO then subtracts recurring maintenance capital expenditures and non-cash rent adjustments. It better reflects actual distributable cash. A REIT with heavy capex needs, like aging office buildings, will show a much larger FFO-to-AFFO gap than a light-capex self-storage REIT.

Sources

1. Nareit. "Funds From Operations (FFO)." https://www.reit.com/glossary/funds-operation-ffo
2. Nareit. "Adjusted Funds From Operations (AFFO)." https://www.reit.com/glossary/adjusted-funds-operations-affo
3. JPMorgan Chase. "Cap Rates, Explained." https://www.jpmorgan.com/insights/real-estate/commercial-term-lending/cap-rates-explained
4. Nareit. "2002 White Paper on Funds From Operations." https://www.reit.com/sites/default/files/media/Portals/0/Files/Nareit/htdocs/policy/accounting/2002_FFO_White_Paper.pdf

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.