A P/FFO multiple compresses three assumptions, conversion to AFFO, cost of equity and growth, and borrowing a peer's multiple without adjusting for the first one overstates value.
Derive the multiple rather than borrow it: the justified P/FFO is the share of FFO that converts to AFFO divided by the cost of equity less long-run growth. On an illustrative REIT converting 75 per cent of FFO to AFFO, with an 8.5 per cent cost of equity and 3.0 per cent growth, the justified multiple is 13.64x FFO, a value of $32.73 a share against a $30.00 price at 12.50x.
Worked in full in REIT Analysis and Valuation by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
P/FFO is the multiple REIT analysts quote, the listed real estate equivalent of a price-earnings ratio. Used on its own, it compares companies whose FFO is worth very different amounts, because FFO is struck before the capital the buildings consume. A REIT that spends a quarter of its FFO keeping its buildings let deserves a lower multiple than one that spends a seventh. The calculation below builds the multiple from its parts, then shows what borrowing a peer's multiple gets wrong.
| Input | Value |
|---|---|
| Share price | $30.00 |
| FFO per share | $2.40 |
| AFFO per share (after recurring capex, leasing costs and non-cash items) | $1.80 |
| AFFO as a share of FFO | 75% |
| Cost of equity | 8.5% |
| Long-run growth in AFFO per share | 3.0% |
| Peer group P/FFO / peer AFFO conversion | 15.0x / 85% |
Justified P/AFFO = 1 ÷ (cost of equity − growth)
Justified P/FFO = (AFFO ÷ FFO) ÷ (cost of equity − growth)
Value per share = justified P/FFO × FFO per share = AFFO ÷ (k − g)
In Excel: =(AFFO/FFO)/(k-g) for the multiple; =k-AFFO/Price for the growth the price implies.
Justified P/AFFO: 1 divided by (8.5 less 3.0 per cent) is 18.18x. Justified P/FFO: 75 per cent of that, 13.64x. Value: 13.64 times $2.40 is $32.73, the same as $1.80 divided by 5.5 per cent. That is 9.1 per cent above the $30.00 price.
The model is a growing perpetuity on AFFO, the cash the shares earn after keeping the portfolio let. Capitalising all of AFFO is consistent only if the 3.0 per cent comes from the existing portfolio, through rent growth and indexation, and any AFFO retained is reinvested at no more than the cost of equity. The dividend of $1.44 is 80 per cent of AFFO; if the retained 20 per cent is what funds the growth, value the dividend instead, or the growth is counted twice.
Reverse the model to read the market. At $30.00 the stock trades at 12.50x FFO and 16.67x AFFO, an AFFO yield of 6.0 per cent and an FFO yield of 8.0 per cent. With an 8.5 per cent cost of equity, the price implies long-run growth of 8.5 less 6.0, 2.5 per cent. The investment case is a view on whether the REIT can grow AFFO per share by 3.0 per cent a year rather than 2.5. That is a sharper question than "is 12.5x cheap?", and it can be tested against rent reversion, lease escalators and the accretion available on new investment.
| Cost of equity | Growth 2% | Growth 3% | Growth 4% |
|---|---|---|---|
| 7.5% | 13.6x, $32.73 | 16.7x, $40.00 | 21.4x, $51.43 |
| 8.5% | 11.5x, $27.69 | 13.6x, $32.73 | 16.7x, $40.00 |
| 9.5% | 10.0x, $24.00 | 11.5x, $27.69 | 13.6x, $32.73 |
The multiple depends only on the spread between cost of equity and growth, which is why the diagonal repeats. It is also very sensitive to it: one point of spread moves the justified multiple from 13.6x to 16.7x or 11.5x. A P/FFO valuation is a growth and discount rate assumption in a compressed form; stating the two numbers makes the assumption visible.
The peer group trades at 15.0x FFO. Applied to this REIT's $2.40 of FFO, that gives $36.00, 20 per cent above the price, and looks like a buy. But the peers convert 85 per cent of FFO to AFFO; this REIT converts 75. On AFFO the peers trade at 15.0 divided by 0.85, 17.65x. Applied to this REIT's $1.80 of AFFO, that gives $31.76, an adjusted multiple of 13.24x FFO. The naive comparison overstates the value by $4.24 a share, 13.3 per cent, purely because FFO hides the difference in capital intensity.
| Method | Multiple on FFO | Value per share |
|---|---|---|
| Peer P/FFO applied to FFO | 15.0x | $36.00 |
| Peer P/AFFO applied to AFFO | 13.24x | $31.76 |
Conversion alone moves the justified multiple a long way: at 8.5 per cent and 3.0 per cent, a REIT converting 65 per cent of FFO deserves 11.8x, one converting 85 per cent deserves 15.5x. Rebuild AFFO on one definition across the peer group first, as in calculating AFFO from FFO, then compare.
A P/FFO multiple is AFFO conversion divided by the spread of cost of equity over growth: 0.75 ÷ 5.5 per cent, 13.64x, here. Use it to read the growth a price implies, 2.5 per cent at $30.00, and adjust any peer multiple for conversion before applying it. The free workbooks for REIT Analysis and Valuation set the multiple beside net asset value and the implied cap rate, and the REIT valuation template runs the same tests on your own figures.
There is no single good level; the justified multiple depends on how much of FFO converts to AFFO and on the spread between cost of equity and growth. At 75 per cent conversion, an 8.5 per cent cost of equity and 3.0 per cent growth it is 13.64x; at 85 per cent conversion it is 15.5x, and at 65 per cent 11.8x.
P/AFFO is the better basis because AFFO deducts the recurring capital the portfolio consumes. P/FFO is quoted more often, so convert between them with the AFFO to FFO ratio. A peer trading at 15.0x FFO with 85 per cent conversion is on 17.65x AFFO, which applied to a REIT converting 75 per cent is 13.24x FFO.
Subtract the AFFO yield from the cost of equity. The illustrative REIT has AFFO of $1.80 at a $30.00 price, a 6.0 per cent AFFO yield; with an 8.5 per cent cost of equity, the price implies long-run AFFO growth of 2.5 per cent a year.
This article is one calculation from REIT Analysis and Valuation. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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