101 Concepts for the Level I Exam
Essential Concept 85: Relative Value Approach – REITs
Funds from operation (FFO) is accounting net earnings excluding:
- Depreciation charges on real estate
- Deferred tax charges (deferred portion of tax expenses)
- Gains/losses from sale of property and debt restructuring
Adjusted funds from operation (AFFO) is a refinement to FFO and is designed to be a more accurate measure of current economic income.
AFFO = FFO -straight line adjustment – recurring maintenance type capital expenditures and leasing commissions
In relative value approach, we use the P/FFO, P/AFFO, EV/EBITDA multiples to value REITs. The main drivers behind these multiples are:
- Expectations for growth in FFO
- Risk associated with underlying real estate
- Risk associated with capital structure and access to capital
P/FFO and P/AFFO Multiples: advantages and drawbacks
- These multiples are widely accepted.
- Portfolio managers can put REIT valuations into context with other investment alternatives. This makes it easier to compare REITs with other investments.
- FFO estimates are readily available.
- Multiples can be used in conjunction with growth rates and leverage levels for relative value analysis.
- Does not capture the intrinsic value of all real estate assets. For example empty buildings do not contribute to FFO but have value.
- P/FFO does not adjust for recurring capital expenditures. Although P/AFFO considers this, there are wide variations in estimates and assumptions.
- One-time gains/losses create issues with this model.