source: [i3investor]
REIT – Cash Flow and Free Cash Flow - L. C. Chong
Author: Tan KW | Publish date: Sat, 9 Nov 15:59
Posted by L. C. Chong on November 9, 2013
If you try to estimate the value of a real estate investment trust (REIT), you will quickly find that traditional metrics like the earnings-per-share (EPS) ratio, growth, and the price-to-earnings (P/E) multiple do not apply. (Investopedia)
In this article, I will show you recommended method in calculating cash flow and free cash flow for a REIT company.
Funds From Operations (Cash Flow)
For most businesses, net income numbers, include depreciation expenses, which are significant line items. Depreciation is an acceptable non-cash charge that allocates the cost of an investment made in a prior period. But real estate is different than most fixed-plant or equipment investments: property rarely loses value and often appreciates. Net income, a measure reduced by depreciation, is therefore an inferior gauge of performance. Therefore, REITs are instead judged by funds from operations (FFO), which excludes depreciation.
Unfortunately, in Malaysia, FFO is not commonly reported in annual report. So, we have calculate them by ourselves.
Funds from operations (FFO) is REIT cash flow (no depreciation/amortization). FFO means net income (computed in accordance with GAAP), excluding gains (or losses) from debt restructuring and sales of property, plus depreciation and amortization of assets uniquely significant to the real estate industry, and after adjustments for unconsolidated entities in which the REIT holds an interest. Adjustments for these entities are to be calculated to reflect FFO on the same basis.
How to calculate FFO?
Revenues – Operating expenses – Depreciation & amortization – Interest expense – General & Administrative expense = NET INCOME (GAAP)
Net Income –Profit from real estate sales + Depreciation & amortization = FFO
Example:
Take note that not all items in depreciation and amortization are legitimate for add-backs.
Adjusted Funds From Operations (Free Cash Flow)
FFO contains a weakness: it does not deduct for capital expenditures required to maintain the existing portfolio of properties. Shareholders’ real estate holdings must be maintained (for example, apartments must be painted), so FFO is not quite the true residual cash flow remaining after all expenses and expenditures.
In estimating the value of an REIT, professional analysts therefore use a measure called "adjusted funds from operations" (AFFO). Although FFO is commonly used, professionals tend to focus on AFFO for two reasons. One, it is a more precise measure of residual cash flow available to shareholders and therefore a better "base number" for estimating value (for example, applying a multiple or discounting a future stream of AFFO). Two, because it is true residual cash flow, it is a better predictor of the REIT’s future capacity to pay dividends. (Investopedia)
How to calculate AFFO?
FFO – Recurring capital expenditures (e.g. painting, carpets, etc.) – Amortization of tenant improvements – Amortization of leasing commissions – Adjustment for rent straight-lining = Adjusted FFO (AFFO)
In Malaysia REITs’ annual reports, most of the time, “recurring capital expenditures” refers to “Enhancement of investment properties” and “Acquisition of equipment”.
Sometimes. you will see “Acquisition of property, plant and equipment” in REITs’ annual reports, such as STAREIT 2012 annual report. You have to read the footnotes properly. Often, it refers to acquisition of a new investment properties, but this is not a recurring capital expenditures. Remember, the keyword is “recurring”.
As I mentioned just now, you hardly see “Amortization of tenant improvements”, “Amortization of leasing commissions” and “Adjustment for rent straight-lining” in REITs’ annual reports.
Applications of FFO and AFFO
I won’t go into details of applying FFO and AFFO as you learn it from this article:http://www.investopedia.com/articles/04/112204.asp. For DCF valuation, I use AFFO as “Owner Earnings”.
In this article, I will show you recommended method in calculating cash flow and free cash flow for a REIT company.
Funds From Operations (Cash Flow)
For most businesses, net income numbers, include depreciation expenses, which are significant line items. Depreciation is an acceptable non-cash charge that allocates the cost of an investment made in a prior period. But real estate is different than most fixed-plant or equipment investments: property rarely loses value and often appreciates. Net income, a measure reduced by depreciation, is therefore an inferior gauge of performance. Therefore, REITs are instead judged by funds from operations (FFO), which excludes depreciation.
Unfortunately, in Malaysia, FFO is not commonly reported in annual report. So, we have calculate them by ourselves.
Funds from operations (FFO) is REIT cash flow (no depreciation/amortization). FFO means net income (computed in accordance with GAAP), excluding gains (or losses) from debt restructuring and sales of property, plus depreciation and amortization of assets uniquely significant to the real estate industry, and after adjustments for unconsolidated entities in which the REIT holds an interest. Adjustments for these entities are to be calculated to reflect FFO on the same basis.
How to calculate FFO?
Revenues – Operating expenses – Depreciation & amortization – Interest expense – General & Administrative expense = NET INCOME (GAAP)
Net Income –Profit from real estate sales + Depreciation & amortization = FFO
Example:
Take note that not all items in depreciation and amortization are legitimate for add-backs.
- Legitimate add-backs
- real property depreciation
- amortization of capitalized leasing expenses
- amortization of tenant allowances and improvements
- Add-backs not allowed
- amortization of deferred financing costs
- depreciation of computer software
- depreciation of company office improvements
Adjusted Funds From Operations (Free Cash Flow)
FFO contains a weakness: it does not deduct for capital expenditures required to maintain the existing portfolio of properties. Shareholders’ real estate holdings must be maintained (for example, apartments must be painted), so FFO is not quite the true residual cash flow remaining after all expenses and expenditures.
In estimating the value of an REIT, professional analysts therefore use a measure called "adjusted funds from operations" (AFFO). Although FFO is commonly used, professionals tend to focus on AFFO for two reasons. One, it is a more precise measure of residual cash flow available to shareholders and therefore a better "base number" for estimating value (for example, applying a multiple or discounting a future stream of AFFO). Two, because it is true residual cash flow, it is a better predictor of the REIT’s future capacity to pay dividends. (Investopedia)
How to calculate AFFO?
FFO – Recurring capital expenditures (e.g. painting, carpets, etc.) – Amortization of tenant improvements – Amortization of leasing commissions – Adjustment for rent straight-lining = Adjusted FFO (AFFO)
In Malaysia REITs’ annual reports, most of the time, “recurring capital expenditures” refers to “Enhancement of investment properties” and “Acquisition of equipment”.
Sometimes. you will see “Acquisition of property, plant and equipment” in REITs’ annual reports, such as STAREIT 2012 annual report. You have to read the footnotes properly. Often, it refers to acquisition of a new investment properties, but this is not a recurring capital expenditures. Remember, the keyword is “recurring”.
As I mentioned just now, you hardly see “Amortization of tenant improvements”, “Amortization of leasing commissions” and “Adjustment for rent straight-lining” in REITs’ annual reports.
Applications of FFO and AFFO
I won’t go into details of applying FFO and AFFO as you learn it from this article:http://www.investopedia.com/articles/04/112204.asp. For DCF valuation, I use AFFO as “Owner Earnings”.
http://lcchong.wordpress.com/2013/11/09/reit-cash-flow-and-free-cash-flow/
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