Net income can differ materially from a REIT's recurring property performance. Cost-model real estate depreciation reduces income, while gains on property sales can raise it. FFO and AFFO correct for this, and Level II expects you to explain why each adjustment matters, not just calculate a result.
Quick Answer
FFO and AFFO adjust REIT net income to better reflect recurring operating performance. FFO adds back real estate depreciation and removes gains on property sales. AFFO goes further by subtracting recurring maintenance capital expenditure and noncash rent adjustments. Neither measure equals cash available after all obligations, and AFFO is not calculated the same way across all REITs.
Key Takeaways
FFO starts from net income and removes two main distortions: real estate depreciation and gains or losses on property sales.
AFFO starts from FFO and subtracts items FFO still leaves in, mainly recurring maintenance spending and noncash rent effects.
FFO is not a cash flow measure. Interest expense generally remains reflected through net income. FFO does not capture principal repayments, working-capital movements, or recurring capital spending as a complete cash-flow measure would.
AFFO has no single required formula. Different REITs define noncash adjustments and maintenance expenditure differently, so cross-company comparison needs care.
The real estate depreciation add-back removes a noncash accounting allocation. It does not establish that buildings cannot lose economic value or need capital reinvestment.
What You Need to Know for CFA Level II
The LOS asks you to describe the use of FFO and AFFO, not to memorize one fixed formula from a regulatory body.
You should be able to reconcile FFO from net income and explain each adjustment's purpose.
You should be able to reconcile AFFO from FFO and explain why its adjustments vary by reporting convention.
You need to know why property-sale gains are removed, not added, when moving from net income to FFO.
You need to distinguish maintenance capital expenditure from expansion or acquisition capital expenditure when calculating AFFO.
This note explains FFO and AFFO adjustments. The same reading explicitly requires calculating and interpreting REIT share value with price-to-FFO and price-to-AFFO multiples, so you must also be able to use these measures in valuation.
Explain the Move from Net Income to FFO
Net income for a REIT includes two items that can distort the picture of recurring property performance.
Why FFO Adjusts Depreciation and Property-Sale Gains
Real estate depreciation allocates the cost of depreciable property over an accounting life under a cost model. The annual charge need not match changes in market value. Adding it back helps compare operating performance, while maintenance needs, obsolescence, and actual value declines still require analysis.
Property-sale gains are one-time events. A REIT that sells a building at a gain books that gain in net income for that period only. Including it in a measure meant to show recurring operating capacity misrepresents what the REIT will generate going forward.
FFO adjusts for the stated depreciation charge because it is a noncash allocation, rather than a current-period cash outlay. It subtracts gains on property sales (or adds back losses) because these are nonrecurring and unrelated to core leasing operations.
FFO Formula and Interpretation
Where:
FFO = simplified funds from operations
NI = net income available to the stated equity holders
= included real estate depreciation and amortization add-back
= net property-sale gains, negative for losses
The simplified formula assumes no other required adjustments. A full reporting definition can address impairment, changes in control, and interests in unconsolidated entities. Check the specified convention.
Interest expense generally remains deducted through net income; FFO is not an income measure before all financing costs.
Principal repayments and working-capital cash movements are not fully captured, so strong FFO can coexist with funding pressure.
Interpret AFFO and Comparability Limits
FFO still leaves out two items that affect how much cash a REIT can actually distribute to shareholders on a recurring basis.
Recurring Maintenance vs. Expansion Capital Expenditure
Recurring maintenance capital expenditure keeps existing properties in working condition. Capitalized recurring building-system replacements or tenant improvements may fall into this category under the stated convention.
Ordinary repairs already expensed in net income must not be deducted a second time.
This differs from expansion capital expenditure, which funds new acquisitions, developments, or major property upgrades intended to grow the portfolio rather than sustain it.
Under this note's simplified convention, deduct recurring maintenance capital expenditure and exclude expansion spending. Other AFFO definitions may include additional adjustments, so follow the exhibit rather than claiming a universal rule.
Noncash Rent Adjustments
Noncash rent adjustments arise mainly from straight-line rent accounting, where a lease with scheduled rent increases is reported as if rent were level across the term.
This creates a noncash income component in early lease years that does not match actual cash collected. AFFO removes this to align reported income with cash received.
AFFO Formula and Comparability Limitations
Where:
AFFO = adjusted FFO under the exhibit convention
FFO = funds from operations
= recurring maintenance capital expenditure
= net noncash income adjustments to remove, including the stated rent effects
AFFO is not standardized across REITs or data providers. One REIT may define mnt definition, or the comparison is not reliable.
aintenance capital expenditure narrowly, while another includes a broader set of recurring costs.
When comparing AFFO per share across companies, confirm that each used a consiste
AFFO gives a better read on distributable capacity than FFO, but it still does not account for debt maturities, refinancing risk, or leverage levels, which remain separate analytical steps.
Working Example
A REIT reports the following for the year, in millions:
Net income: 20
Real estate depreciation: 8
Gain on property sale: 3
Maintenance capital expenditure: 4
Noncash straight-line rent income: 1
Step 1: Calculate FFO.
Step 2: Calculate AFFO.
FFO of 25 million strips out the depreciation charge and the one-time sale gain, giving a cleaner view of recurring property income than the 20 million net income figure. AFFO of 20 million then removes cash actually spent on upkeep and noncash rental income not yet collected. In this example, AFFO happens to equal net income, but that is coincidental here. It reflects a different calculation path, not identical meaning. AFFO is the more conservative estimate of sustainable distributable capacity.
Common Exam Traps
Adding property-sale gains
Candidates sometimes add the sale gain instead of subtracting it, treating all unusual items as add-backs. In this example, adding instead of subtracting would produce FFO of 31 million instead of the correct 25 million. Sale gains are nonrecurring income already included in net income, so they must be removed, not added.
Treating all capital expenditure as maintenance
If a REIT also spent on acquiring a new property, including that spending as recurring maintenance would understate AFFO under the stated convention. Only recurring upkeep spending belongs in the AFFO subtraction. Expansion spending is excluded from this calculation entirely.
Calling AFFO a universally standardized figure
Candidates sometimes assume AFFO is defined identically across companies, similar to GAAP net income. AFFO definitions vary by reporting convention, so comparing AFFO per share across REITs requires confirming the adjustments used.
Equating FFO with cash available after all obligations
FFO generally includes interest expense through net income, but it is not a complete measure of debt-service capacity. Scheduled principal repayments and working-capital movements still require separate review. A REIT with high FFO can still face a cash shortfall if leverage and refinancing needs are high.
Practice Question
A REIT reports FFO of 30 million for the year. Recurring maintenance capital expenditure is 5 million. The REIT also recognizes 2 million of noncash straight-line rent income during the year, under its stated AFFO convention. What is the REIT's AFFO?
27 million
25 million
23 million
Correct Answer: C
Calculations/Workings
All amounts are in millions, so AFFO is 23 million.
Why Other Options Are Wrong
Option A: Adding the noncash rent adjustment instead of subtracting it produces 27 million: 30 − 5 + 2 = 27. Noncash rent income must be removed from FFO, not added, because it does not represent cash actually collected.
Option B: Omitting the noncash rent adjustment produces 25 million: 30 − 5 = 25. This only accounts for maintenance capital expenditure and ignores the second required AFFO adjustment.
Continue Your CFA Level II Prep With KeyPoint
Use structured lessons, practice questions, mock exams, and progress tracking to focus on the time you have left
FAQs About REIT Valuation Using FFO and AFFO
Why is FFO different from net income?
Net income includes real estate depreciation and property-sale gains, both of which distort the picture of ongoing operating performance. FFO removes these so analysts see recurring income from leasing activity.
Why can AFFO differ across REIT reports?
AFFO has no single required calculation. Companies define recurring maintenance capital expenditure and noncash adjustments differently, so the specific items subtracted vary by reporting convention.
Can maintenance spending be deducted twice?
Yes, if an analyst subtracts a routine repair in AFFO even though it was already expensed in net income. Separate recurring capital expenditure from operating expenses and trace the reconciliation. The AFFO adjustment should remove an omitted cash requirement, not repeat a cost already included.