Five year summary of PDCO stock price. From 2012 to 2018

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Noam Ganel is the Managing Director of Pen & Paper, a value-oriented stock research publication. Subscriptions are now available. He also serves as  Vice President in Capital Markets at Silvergate Bank and holds the Chartered Financial Analyst (CFA) credential.

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Funds from operations

FFO is the one number all REIT investors look for

December 14, 2018

Funds from operations are the net income without non-cash or non-operating expenses. To the net income we add (1) depreciation and amortization, (2) gains and losses from real estate sales, (3) gains or losses from change in control and (4) impairment write-downs of real estate. Because GAAP accounting requires an annual depreciation of real estate, while in reality real estate often appreciates in value, the intent behind FFO is to get us closer to the economic truth.

Yet funds from operations do not include capital expenditures. Omitting this expense results in an inflated, optimistic measure of earnings. So the real estate industry often includes a second measure called adjusted funds from operations (AFFO). It is now often reported by management. In AFFO reporting, managements discusses the amount of cash spent on the maintenance of existing properties and on the development of new properties and acquisitions.

The FFO and AFFO definition

To calculate the adjusted funds from operations, we use the funds from operations less capital expenditures and less any gains on sale. We then adjust for straight-lining of rent and any one-time loss or gain. We then add back amortization related to stock compensation and other deferred costs.

AFFO is a superior measure to the FFO because the maintenance of real estate, whether it is renovating the lobby or replacing the roof, is a real and frequent cost that affects cash flow. To see the wide difference between net earnings, funds from operations and adjusted funds from operations, I will use Plymount Industrial Reit most recent annual report.

For 2017 the company reported a net loss of $14 million. But if we add back depreciation of $14 million and remove the gain of $231 thousand from real estate sale, we get funds from operations of $260 thousand. To arrive at AFFO, we further deduct for the recurring capital expenditures, straight line rents and added back non-cash interest expense, acquisition costs and stock compensation. This results in AFFO of $818 thousand.

So we arrived at three numbers that tell a different story. Returning to PLYM, the 5-year average net loss was $25 million. The 5-year average loss from funds from operations was $17 million and the 5-year average loss from adjusted funds from operations was $9 million. In 2017, all three numbers improved, and the company showed profit in AFFO. And it is the REIT investor’s job to determine whether the reported earnings are a sign of a better, promising future.

FFO of all listed U.S. equity REITs. Source: S&P Global Market Intelligence

FFO and AFFO multiple

Like the popular price to earnings ratio, investors in REIT companies often estimate whether a stock is a bargain or expensive using multiplies such as price to FFO ratio or price to AFFO ratio. Observing these ratios over time provides a signal of how the stock market is valuing the company. And it also allows us to see the relative value across companies.

Judging by the price to FFO ratio, the stock market believes that Essex Property Trust is a superior to Mid-America Apartment Communities. For Essex, between 2013 and 2017, funds from operations were as low as $7.6 (in 2013) and as high as $11.191 (in 2017). And during this time, the average price to FFO ranged between 20 and 23 times.

For Mid-America the price to FFO was as low as $4.34 and as high as $6.15. The 5-year average price to FFO was 15 times. For over five years, the stock market felt ESS was worth 33% more than MAA. Let us move from the particular case of Essex versus Mid-America to the general cas and ask what are some of the reasons that one REIT stock is priced higher than a different REIT stock.

There are three common reasons. The first reason is growth expectation. If REIT’s A portfolio of real estate is currently earning below-market rents, a case could be made that future earnings will grow. Another reason for a growth premium is that the portfolio of real estate is in areas in high demand. Consider apartment rents in San Francisco or Vancouver.

The second reason is risk associated with the real estate. If REIT's A portfolio of real estate consists of apartments, while REIT's B portfolio of real estate consists of single, anchor-tenant shopping malls, then investors demand a discount for the additional risk they take (the risk is that if one tenant leaves, the shopping center is effectively shut down.)  

The third reason is risk associated with capital structure. If REIT A carries more debt than REIT B than investors will view REIT A to be riskier and will demand a discount to the net asset value. If REIT A has preferred stock holders who are paid a dividend prior to the common stock holders, then investors would demand a discount, too.    

The aggregate price to FFO multiple for equity REITs compared to p/e multiple on the S&P 500. Source: S&P Global Market Intelligence

The drawback

Funds from operations are not a perfect earnings measure. They do not include the value of land for example. So, if a REIT has a substantial number of projects under development, which currently are not generating any income but are expected to generate income in the future, then the price to funds from operations may appear artificially rich. Visit my analysis of Heritage Growth Properties to see an example.

Adjusted funds from operations are supposed to bring us closer to the true earnings of a REIT. But since for most real estate projects, the capital expenditure varies significantly each year, it is practically impossible to compare between a single year's AFFO of REIT A to AFFO of REIT B. And since many REIT companies do not report AFFO measures - and since there is no standard calculation of the metric - for now at least, AFFO remains a subjective number.