Typically, investors look at a company’s dividend payout ratio to determine the sustainability of the dividend being paid. This ratio is usually calculated based on net income. As a real estate company, there is a supplemental measure to net income that can be used to measure a real estate company’s ability to generate cash flow to pay dividends. That measure is "adjusted funds from operations available to common stockholders," or AFFO. Most research analysts in our industry track AFFO to provide an additional assessment of dividend-paying ability. The AFFO calculation adds back non-cash depreciation, and deducts property sales gains from net income, while adjusting for other unique revenue and expense items that are not pertinent to measuring ongoing operating performance. To further illustrate:
- If net income is the only measure used to assess operating performance and dividend-paying ability for a real estate company, it appears that most of these companies pay out more in dividends than they earn. This is because a very large depreciation expense on a real estate company's income statement is deducted to arrive at net income.
- The net income calculation also includes gains or losses from the sale of properties, which can cause net income to vary quite a bit and doesn't necessarily reflect the reliability of the cash being generated by the company's assets.
- Companies typically are required to estimate the "life" of their buildings and equipment and depreciate them over their estimated useful lives. Based on these estimated lives, they are required to record depreciation charges each period.
- Real estate assets, on the other hand, are long-lived, income-producing assets and, in many cases, real estate may actually appreciate in value over time. In other words, real estate assets are not being used up in the same manner that other assets are used up and require replacement.
- This depreciation charge is usually the largest expense on the REIT income statement, particularly if the REIT owns a very large real estate portfolio, like Realty Income.
Use the income statement highlighted below for an explanation of how we calculate AFFO:
- You can see in the expense section of the income statement that the top highlighted line is Depreciation, the first and largest expense.
- Moving down to the next highlighted "adjusted funds from operations" line, you will see the AFFO number. That number is calculated by:
- Adding back depreciation
- Deducting gains from property sales
- Adjusting for other unique revenue and expense items that are not pertinent to measuring ongoing operating performance
- When you compare AFFO per share to dividends paid, the third highlighted items, you see that we generated more AFFO than we paid in dividends, so we do have more than enough cash flow to pay dividends.
Past performance is not a reliable indicator of future performance. The price of Realty Income shares may go down as well as up and you may not get back all or any of your original investment.
Dividends are not guaranteed. They are paid only when declared by our Board of Directors after reviewing our financial condition. View
Risks for more information.