When talking to a well versed analyst of real estate investment trusts (REIT) you will learn a few essentials of the industry. The primary essential when it comes to REIT earnings is adjusted funds from operations (AFFO). You want to know the AFFO so that you can determine the quality of earnings.
As outlined by the Investopedia, AFFO is:
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Adjusted funds from operations (AFFO) is a financial measure used to estimate the value of a real estate investment trust (REIT).
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AFFO is based on funds from operations (FFO), but is considered preferable, because it takes costs into consideration, thus more accurately estimating the REIT's present values and ability to pay dividends.
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Though no one official measure exists, a AFFO formula is along the lines of AFFO = FFO + rent increases - capital expenditures - routine maintenance amounts.
We would have preferred to use the National Association of Real Estate Investment Trust’s (NAREIT) definition of AFFO however they are clear in saying the following of FFO and AFFO:
“It is important to emphasize, however, that the underlying premise of the definition of FFO is not to sanction deviations from GAAP in the name of calculating Funds From Operations. In fact, the definition specifically refers to GAAP net income as the starting point in the calculation of FFO. Moreover, FFO is not intended to be used as a measure of the cash generated by a REIT nor of its dividend-paying capacity (NAREIT. Financial Standards White Paper. December 2018. page 3.)."
This might explain why there is a definition of FFO but no formula on the NAREIT website, in spite of the fact that every seasoned analyst of REITs is adamant about using AFFO to determine the ability of a REIT to pay a dividend.
One element of a REIT that you’ll be asked not to look at in determining the quality of a REIT is their net income. For some reason, net income is considered not relevant to the discussion of how well a REIT is run.
Realty Income: A Simplistic View on AFFO and Net Income
Realty Income (O) is the standard by which all other REITs aspire to become. Realty Income pays a substantial dividend on a monthly basis. The consistency of the dividend payment has earned the company a wide following.
In spite of the much deserved attention to the long-term benefits of holding Realty Income, there is one point that needs an investor’s close attention, the tendency for the share price to decline by -34%. In the last 23 years, Realty Income has trended lower in 10 of those years (43%). The regularity of Realty Income to decline by such substantial amounts should allow investors to pick and choose exactly when they want to buy (we’re not advocating selling here).
Understanding that the price of Realty Income is likely going to provide significant buying opportunities, it is worth taking the time to examine which attributes tip investors off as to what the ranges of undervaluation are. In this case, we’re going to look at the AFFO, net income, and stock price to see which components give us clues about the range of possibilities for buying Realty Income. Already we know that declines of -20% to -40% are indications based on price. But what does AFFO and net income tell us?
Below we compare Realty Income’s AFFO to the stock price on a year-over-year basis from 2004 to 2019.
For the entire 15-year period, 12 out of the 15 years (80%) saw a coincidence between the AFFO and change in the stock price. In the interest of measuring the potential for downside risk, we like to draw our attention to the periods when there are declines in either the stock price or the AFFO. This allows an analyst to project both buying opportunities and potential times to lighten up on holdings (Note: we understand that the claim is always to buy and hold forever a security like Realty Income. However, our pursuit is to recommend buying at infrequent but highly opportune times.)
In only one year (2009) out of fifteen (6.67%) did the AFFO decline, which also corresponded to the negative changes in stock price for that same year. Alternatively, there were five years that the price of Realty Income experienced declines but out of those periods only once (20%) did AFFO correspond to declines in share price. Again, AFFO is not representative of, or an observable determinant in, the stock price. However, there is little information conveyed about downside risk in the rare occurrence of a decline in AFFO.
Below we compare the net income to the stock price on a year-over-year basis from 2004 to 2019.
Eleven out of the 15 years (73%) saw coincidence between net income and change in the stock price. When we look at net income versus the stock price, there were four years (80%) that corresponded to the negative change in the stock price. Of the fifteen year period that is covered, there were five years of decline in the stock price.
In total, there were eight instances of net income declining with only four years of the stock price corresponding to the declines in net income leaving a coincidence of 53% between net income and the stock price.
Data Debrief
Thoughts
Given the above data, there appears to be a clear difference between AFFO and net income. As an analyst or an investor, we would want the data set that is the most reliable and gives some semblance of potential for downside risk.
On the one hand, AFFO seems to be the most predictable as it rarely ever declines. However, on the other hand, the net income seems to be the most consistent with the change in the stock price declines.
As an analyst or an investor, we prefer the metric that generates the best return. The best return is generally arrived at by making reliable assessments and acting in a timely manner based on the quality of the assessment.
If we had to make a review of a REIT’s prospects based on 20% of available data we would not feel confident enough to make an investment. If we had to make a review of a REIT’s prospects based on 80% coincidence with stock price declines then we would have some level of confidence in timing and allocation.
It should seem obvious that net income is far superior to AFFO for the sake of predicting future prospects of price declines. Since AFFO isn’t supposed to be used as a measure of cash generation or dividend paying capacity, why is it that AFFO gets all the love? Maybe a review of net income is more useful than previously thought.