Explain the role of FFO (funds from operations) and AFFO (adjusted FFO) in valuing REITs

Net income understates a REIT's recurring earnings because it deducts depreciation on property that may be holding or gaining value. Funds from operations corrects this: FFO = net income + real estate depreciation and amortisation + losses on property sales − gains on property sales, with impairment write-downs added back. Adjusted funds from operations moves closer to the cash available for dividends: AFFO = FFO − non-cash rent (the straight-line rent adjustment) − recurring capital spending on maintenance and leasing, such as tenant improvements and leasing commissions. AFFO is the better guide to sustainable dividends but depends on estimates, so FFO is more widely reported. The trap is leaving gains on sale in FFO or forgetting to deduct recurring capital spending for AFFO.