Canadian REITs: AFFO Payout Ratios and the Refinancing Arithmetic

Real estate investment trusts are bought for distributions and analysed, too often, on yield alone. The yield is an output. The inputs are three numbers that appear in every Canadian REIT's quarterly disclosure and are rarely read together: adjusted funds from operations, the payout ratio against it, and the debt maturity schedule.

FFO, AFFO and why the gap matters

Funds from operations starts with net income and adds back real estate depreciation, because a building's accounting depreciation rarely reflects its economic decline. FFO is a reasonable proxy for operating cash generation.

Adjusted funds from operations goes further and subtracts the money that has to be spent to keep the portfolio competitive:

• Maintenance capital expenditure — roofs, elevators, HVAC, parking.
• Leasing costs — commissions and tenant inducements.
• Straight-line rent adjustments, which recognise contractual rent escalations as revenue before the cash arrives.

AFFO is therefore the closer approximation of distributable cash. The FFO-to-AFFO gap is itself diagnostic: a persistently wide gap indicates a capital-hungry portfolio, common in older office and enclosed retail, while a narrow gap is typical of newer multi-family and industrial assets.

Every REIT defines AFFO slightly differently, and the definition is disclosed. Comparing two REITs' payout ratios without checking whether both deduct leasing costs on the same basis is a category error.

Reading the payout ratio honestly

A payout ratio of 80% of AFFO leaves 20% of distributable cash retained. That retained amount is the buffer against three simultaneous claims: development spending, unexpected capital repairs, and higher interest on refinanced debt.

Illustrative worked example. A REIT generates C$300M of AFFO, distributes C$240M (80% payout), and retains C$60M. It has C$500M of mortgage debt maturing next year at a 3.4% weighted-average coupon, refinancing at 5.4%. The incremental annual interest cost is C$10M — 17% of the retained buffer, consumed in one year by one tranche. If C$500M matures again the following year on similar terms, the buffer is largely gone by year two and the payout ratio climbs above 90% with no change whatsoever in occupancy, rents or property performance.

This is the mechanism behind most distribution cuts. Nothing operational breaks. The debt simply reprices faster than rents grow.

The disclosures that matter

The maturity ladder. Every REIT publishes a table of debt maturities by year with weighted-average interest rates. Two questions: how much matures within 24 months, and what is the spread between the expiring coupon and current market rates for similar assets? The second question can be approximated from the REIT's own most recent financing, which is disclosed in the MD&A.

Weighted-average interest rate and term to maturity. A falling weighted-average term means the REIT is financing shorter, which is usually a signal that it is unwilling or unable to lock long-term rates.

Fixed versus floating mix. Floating debt reprices immediately. Some REITs hold significant floating balances on credit facilities used for development, and those are the fastest-moving exposure.

Interest coverage and debt service coverage covenants. These are disclosed, with the current ratio and the covenant threshold. The distance between them is the real margin of safety. A REIT operating at 2.1x coverage against a 1.5x covenant has room; one at 1.7x does not.

Unencumbered asset pool. Assets not pledged against specific mortgages can be financed in a stress. A large unencumbered pool is genuine optionality.

Sector-specific pressure points

• Multi-family. Rent growth has generally been the strongest defence against rate resets, but rent regulation varies by province and caps the offset in Ontario, British Columbia and Québec for existing tenancies. The turnover rate matters as much as the market rent.
• Industrial. Long leases with fixed escalators are a strength when rates fall and a weakness when they rise, because in-place rents lag market rents on a decade-long lease.
• Retail. Grocery-anchored centres have held occupancy well; the AFFO gap is the thing to watch, since leasing costs on non-anchor space are persistent.
• Office. Occupancy and capital intensity are both under pressure, and the FFO-to-AFFO gap is widest here.

A short checklist before buying yield

1. Payout ratio on AFFO, not FFO, with the REIT's own AFFO definition read.
2. Percentage of total debt maturing within 24 months.
3. Spread between the expiring coupon and the REIT's most recent financing rate.
4. Distance from the interest coverage covenant.
5. Floating-rate debt as a share of total.
6. Whether the distribution has been maintained through the last full rate cycle, and what the payout ratio was at the trough.

None of these require a subscription. All of them are in the quarterly MD&A. A yield that survives this checklist is an investment; one that does not is a countdown.