Ffo

What Is FFO?

Funds From Operations (FFO) is a key financial metric used primarily by real estate investment trusts (REITs) to define the cash flow generated from their operations. It is a non-Generally Accepted Accounting Principles (GAAP) measure that aims to provide a more accurate representation of a REIT's operating performance by adjusting net income for items that do not reflect the ongoing cash-generating ability of real estate assets. FFO is a crucial tool within the broader category of financial metrics and real estate finance, as traditional accounting methods like depreciation can distort a REIT's true economic performance. Real estate companies use FFO as an operating performance benchmark, and investors often consider it a more reliable indicator than earnings per share (EPS) when evaluating REITs.²⁵

History and Origin

The National Association of Real Estate Investment Trusts (Nareit) created FFO in 1991. The primary reason for its development was to address the limitations of U.S. GAAP, specifically the mandated historical cost depreciation and amortization of real estate and related assets.²³, ²⁴ GAAP requires that all REITs depreciate their investment properties over time, which can misrepresent the actual value of properties that often appreciate rather than depreciate. Nareit, after extensive consultation with its REIT members, financial statement users, and accounting firms, introduced FFO to promote a uniform, widely accepted supplemental industry-wide standard measure of equity REIT operating performance. The Securities and Exchange Commission (SEC) staff has accepted Nareit's definition of FFO as a performance measure and does not object to its presentation on a per-share basis.²²

Key Takeaways

• FFO is a non-GAAP financial metric primarily used by REITs to measure operating performance.
• It adjusts net income by adding back real estate-related depreciation and amortization and subtracting gains from property sales.²¹
• Nareit developed FFO to provide a more accurate view of a REIT's cash-generating ability, as real estate often appreciates, unlike typical depreciating assets.
• Investors often use FFO, particularly FFO per share, as a key indicator when analyzing and comparing REITs.
• REITs are required to disclose their FFO calculations in the footnotes of their financial statements.

Formula and Calculation

The formula for calculating Funds From Operations (FFO) typically starts with net income and makes specific adjustments for real estate-related items.

The general formula for FFO is:

Where:

• Net Income: The company's profit or loss after all expenses, taxes, and revenues have been accounted for, as determined by GAAP.
• Depreciation Expense: The non-cash expense allocated to cover the acquisition of property, plant, and equipment (PP&E) or other fixed assets. For REITs, this specifically refers to real estate-related depreciation.
• Amortization Expense: The expense recognized for the reduction in value of intangible assets over time. For FFO, this refers to real estate-related amortization.
• Losses on Sale of Assets: Losses incurred when a property is sold for less than its book value. These are added back because they are not part of ongoing operational cash flow.
• Gains on Sale of Assets: Profits realized when a property is sold for more than its book value. These are subtracted because they are considered non-recurring and not indicative of core operational performance.
• Interest Income: While some definitions may include it, Nareit's core FFO definition primarily focuses on operational adjustments to net income. Some interpretations may subtract interest income if it's considered non-operational in nature for the purpose of assessing the core real estate business.

It is important to note that public REITs are required to disclose their FFO on their financial statements, often in the footnotes, making it readily available to investors.

Interpreting the FFO

Interpreting FFO involves understanding what the number signifies for a REIT's financial health and operational performance. A higher FFO generally indicates stronger operational cash flow from a REIT's core property portfolio. Since FFO adds back non-cash expenses like real estate depreciation and amortization, it provides a clearer picture of the cash generated by a REIT's properties before accounting for these charges, which can be substantial for real estate companies.¹⁹, ²⁰

Investors often compare a REIT's FFO to its historical FFO, as well as to the FFO of its peers, to gauge its performance relative to its past and the industry. A growing FFO suggests that a REIT is effectively managing its properties, securing favorable leases, and expanding its income-generating assets. Furthermore, FFO is frequently used to evaluate a REIT's ability to pay dividends, as REITs are known for their high dividend payouts. While FFO is not a direct measure of cash flow or liquidity, it helps in assessing the sustainability of dividend distributions.¹⁸

Hypothetical Example

Consider a hypothetical REIT, "Diversified Properties Inc." For the most recent quarter, the company reported the following financial figures:

• Net Income: $10,000,000
• Real Estate Depreciation: $3,000,000
• Amortization of Lease Intangibles: $500,000
• Gain on Sale of Property: $1,500,000
• Loss on Sale of Property: $200,000

To calculate Diversified Properties Inc.'s FFO, we would apply the formula:

Net Income: $10,000,000
Add: Real Estate Depreciation: $3,000,000
Add: Amortization of Lease Intangibles: $500,000
Add: Loss on Sale of Property: $200,000
Subtract: Gain on Sale of Property: $1,500,000

FFO = $10,000,000 + $3,000,000 + $500,000 + $200,000 - $1,500,000
FFO = $12,200,000

In this example, Diversified Properties Inc. generated $12,200,000 in Funds From Operations for the quarter. This figure gives investors a clearer view of the operational profitability of its real estate holdings, excluding the impact of non-cash charges and one-time property sales. This FFO can then be compared to previous periods or to the FFO of other REITs to assess performance. This comparison often involves looking at FFO per share to normalize for different share counts.

Practical Applications

FFO serves several practical applications in the investment and financial analysis landscape, particularly within the real estate sector. Its primary use is in evaluating the financial performance of REITs, which are unique in their business model of owning or financing income-producing real estate.¹⁷

• REIT Performance Evaluation: FFO is the standard metric for assessing a REIT's operational efficiency. Unlike traditional net income, FFO provides a more accurate picture of the cash generated from a REIT's properties by excluding non-cash items like depreciation.¹⁶ This allows investors to compare the performance of different REITs more effectively.
• Dividend Sustainability Assessment: Investors frequently use FFO to gauge a REIT's ability to sustain its dividend payouts. Since REITs are legally required to distribute a significant portion of their taxable income to shareholders as dividends, a robust and consistent FFO is crucial for maintaining and growing these distributions.¹⁵
• Valuation Multiples: FFO is a key input for various valuation multiples specific to the REIT industry, such as price-to-FFO (P/FFO), which is analogous to the price-to-earnings (P/E) ratio for other companies. This helps analysts determine if a REIT's stock price is fairly valued relative to its operating cash flow.
• Industry Benchmarking: Nareit's established definition of FFO promotes consistency across the industry, enabling investors and analysts to benchmark a REIT's performance against industry averages and competitors.¹³, ¹⁴ This is evident in company announcements from major REITs, such as Healthpeak Properties and Alexandria Real Estate Equities, which regularly report FFO per share alongside net income.¹¹, ¹²

Limitations and Criticisms

While FFO is a widely accepted and valuable metric for evaluating REITs, it does have certain limitations and has faced criticisms. One primary concern is that FFO is a non-GAAP measure, meaning it is not standardized under Generally Accepted Accounting Principles. While Nareit provides a definition that is broadly followed, individual REITs may still interpret or adjust the calculation, potentially leading to variations and making direct comparisons challenging. For instance, some companies may report "Adjusted FFO" (AFFO) or "Normalized FFO," which can include further adjustments that may not be consistent across the industry.⁹, ¹⁰

Another criticism is that FFO, by adding back depreciation and amortization, may not fully capture the recurring capital expenditures necessary to maintain and upgrade real estate properties. While depreciation is a non-cash expense, buildings and infrastructure do require ongoing investment to remain competitive and operational. Ignoring these "maintenance capital expenditures" can overstate the true cash flow available for distribution.⁸ This is a reason why some analysts prefer metrics like Adjusted Funds From Operations (AFFO), which attempts to account for these recurring capital outlays.

Furthermore, the exclusion of gains and losses from property sales, while intended to focus on recurring operations, means that FFO might not reflect the full impact of a REIT's asset management strategy, which often includes strategic acquisitions and dispositions. While these sales are typically non-recurring, they can significantly influence a REIT's overall financial health and growth trajectory. The SEC has also issued guidance on the use of non-GAAP financial measures, cautioning against presentations that could be misleading, and emphasizing that per-share cash flow information is generally prohibited in SEC filings, although FFO per share is explicitly permitted.⁵, ⁶, ⁷

FFO vs. AFFO

Funds From Operations (FFO) and Adjusted Funds From Operations (AFFO) are both non-GAAP metrics used to assess the financial performance of Real Estate Investment Trusts (REITs), but AFFO provides a more conservative and often more accurate view of a REIT's true cash flow available for distribution.

While FFO is a good starting point for understanding a REIT's operating income, AFFO attempts to reflect the actual cash available to shareholders by deducting maintenance-related capital expenditures that are crucial for the long-term viability of real estate assets. This distinction is vital for investors seeking to understand a REIT's capacity to pay and grow its dividends sustainably. Understanding AFFO is therefore important for a comprehensive analysis of REITs.

FAQs

Why is FFO used instead of Net Income for REITs?

FFO is used instead of net income for REITs because traditional accounting principles (GAAP) require real estate assets to be depreciated over time. However, real estate often appreciates in value, making depreciation an artificial, non-cash expense that distorts a REIT's true operational performance and cash flow. FFO adjusts for this by adding back depreciation and other non-cash items, providing a clearer picture of the cash generated by the REIT's core property operations.³

Is FFO a GAAP measure?

No, FFO is not a GAAP (Generally Accepted Accounting Principles) measure. It is a non-GAAP financial measure developed by Nareit to provide a more relevant metric for analyzing REIT performance. While Nareit has established a widely accepted definition, and the SEC accepts its presentation, it is a supplemental measure and not a substitute for GAAP financial statements.²

Where can I find a REIT's FFO?

REITs are required to disclose their FFO in their public financial statements, typically in the footnotes to the income statement. You can often find this information in a company's quarterly or annual reports (10-Q or 10-K filings) submitted to the SEC.

How does FFO relate to dividends?

FFO is closely related to a REIT's ability to pay dividends. REITs are legally required to distribute a significant portion of their taxable income to shareholders, and FFO provides a good indication of the cash flow available from operations to support these distributions. A consistent and growing FFO can signal a REIT's capacity to maintain or increase its dividend payments.¹

What are some other metrics used to evaluate REITs?

Besides FFO, other metrics used to evaluate REITs include Adjusted Funds From Operations (AFFO), which further adjusts FFO for recurring capital expenditures, and Net Asset Value (NAV), which estimates the market value of a REIT's assets minus its liabilities. Additionally, metrics like debt-to-EBITDA and funds from operations payout ratio are important for assessing a REIT's financial health and dividend sustainability.