Funds from operations

What Is Funds from Operations?

Funds from operations (FFO) is a key financial metric used predominantly by Real Estate Investment Trusts (REITs) to measure the cash flow generated from their operations. It serves as an adjusted measure of profitability that provides a more accurate picture of a REIT's recurring operational performance than traditional net income, particularly within the realm of Real Estate Finance. FFO was developed to address how standard Generally Accepted Accounting Principles (GAAP) can misrepresent the performance of companies that own income-producing real estate. While GAAP requires the depreciation of properties, real estate assets often appreciate in value over time, making depreciation a non-cash expense that can artificially lower reported net income for REITs⁴⁵. Funds from operations aims to strip out these non-cash and non-recurring items to offer a clearer view of core business profitability⁴⁴.

History and Origin

The concept of Funds from Operations was pioneered by the National Association of Real Estate Investment Trusts (Nareit) in 1991. The primary motivation behind Nareit's creation of FFO was to develop a standardized supplemental measure of operating performance for equity REITs that would overcome the limitations of GAAP's historical cost depreciation and amortization of real estate assets⁴², ⁴³. GAAP accounting implicitly assumes that real estate values diminish predictably over time, which often contradicts the reality of real estate markets where values can rise or fall with market conditions⁴¹.

Nareit sought to promote a uniform, widely-accepted standard for the industry, believing that while GAAP-reported results are important, supplemental Non-GAAP Measures like FFO could clarify financial results for investors³⁹, ⁴⁰. The Securities and Exchange Commission (SEC) has since recognized Nareit's definition of FFO as a standard non-GAAP gauge of financial performance for the real estate sector and permits its presentation on a per-share basis in company filings³⁸.

Key Takeaways

• Funds from Operations (FFO) is a specialized metric for Real Estate Investment Trusts (REITs) that provides insight into their operational performance.
• FFO adjusts net income by adding back real estate-related depreciation and amortization and subtracting gains from property sales, which are considered non-recurring³⁶, ³⁷.
• It offers a more accurate representation of a REIT's ability to generate cash from its core business activities and sustain dividends³⁴, ³⁵.
• Nareit developed FFO in 1991 to address the limitations of GAAP accounting for real estate, particularly regarding depreciation³³.
• While widely used, FFO is a non-GAAP measure and should be considered alongside, not as a substitute for, GAAP financial statements³².

Formula and Calculation

The formula for calculating Funds from Operations (FFO) typically starts with a REIT's net income and adjusts for specific non-cash and non-recurring items. The most commonly accepted formula, as defined by Nareit, is:

Each component of the formula plays a specific role:

• Net Income: This is the starting point, taken directly from the company's income statement, representing the company's profit according to GAAP³¹.
• Depreciation & Amortization (real estate-related): Since real estate properties generally appreciate over time or maintain value, the non-cash expense of depreciation (and sometimes amortization of real estate assets) is added back to net income. This adjustment reflects the view that the underlying asset's value is not truly diminishing in the way traditional accounting suggests³⁰.
• Losses on Property Sales: These are added back because they are considered non-recurring events and not indicative of the REIT's ongoing operational performance²⁹.
• Gains on Property Sales: Similarly, these are subtracted because they are non-recurring and do not represent income from the REIT's primary, ongoing business activities.

Some interpretations of the formula might also adjust for non-controlling interests or interest income, though the core adjustments remain depreciation/amortization and gains/losses on property sales²⁷, ²⁸.

Interpreting the Funds from Operations

Interpreting Funds from Operations involves understanding what the metric signifies about a REIT's operational health and its capacity to generate consistent income. A higher FFO generally indicates stronger operating performance and a greater ability for a REIT to cover its dividends. Investors often use FFO per share as an alternative to Earnings Per Share (EPS) when evaluating REITs, as it is considered a more relevant measure of profitability for this specific asset class.

When analyzing FFO, it is crucial to consider its growth rate over time, which can be a significant driver of a REIT's valuation and stock price performance²⁶. Comparing FFO across different REITs, especially within the same sub-sector (e.g., residential vs. industrial), can help investors benchmark operational efficiency and potential for dividend sustainability²⁴, ²⁵. However, it is important to remember that FFO is not a measure of cash flow or liquidity in the way a cash flow statement would present it, as it excludes changes in working capital and certain capital expenditures²², ²³.

Hypothetical Example

Consider "Diversified Properties REIT," which reported the following for the most recent fiscal year:

• Net Income: $50,000,000
• Depreciation and Amortization (real estate-related): $15,000,000
• Gain on Sale of Property: $5,000,000
• Loss on Sale of Property: $1,000,000

To calculate Diversified Properties REIT's Funds from Operations:

Start with Net Income: $50,000,000
Add back Depreciation and Amortization: +$15,000,000
Add back Loss on Sale of Property: +$1,000,000
Subtract Gain on Sale of Property: -$5,000,000

FFO = $50,000,000 + $15,000,000 + $1,000,000 - $5,000,000 = $61,000,000

In this hypothetical scenario, Diversified Properties REIT has an FFO of $61,000,000. This figure indicates the cash flow generated from the REIT's core property operations, providing a clearer picture of its ongoing financial performance than its reported net income of $50,000,000. Investors would use this FFO figure to assess the REIT's ability to maintain or increase its dividend payout and compare its operational efficiency against other REITs.

Practical Applications

Funds from Operations (FFO) serves several crucial practical applications in the analysis and valuation of Real Estate Investment Trusts.

• Performance Assessment: FFO is widely regarded as the industry-standard metric for assessing the operating performance of REITs. It provides a more accurate view of a REIT's recurring profitability by excluding non-cash expenses like depreciation and non-recurring gains or losses from asset sales²⁰, ²¹. This allows investors to gauge how well the REIT's core properties are generating income.
• Dividend Sustainability: A primary reason investors consider REITs is for their consistent dividend income. FFO helps investors evaluate a REIT's capacity to generate the cash needed to maintain or increase its dividends, given that REITs are legally required to distribute a significant portion of their taxable income to shareholders¹⁹.
• Comparative Analysis: Since Nareit developed FFO as a standardized measure, it facilitates meaningful comparisons of operational performance across different REITs, even those with diverse property portfolios or equity structures¹⁸. This standardization helps investors make informed decisions when comparing investment opportunities within the real estate sector.
• Valuation Multiples: In REIT valuation, FFO is often used in place of net income. Common valuation multiples include Price/FFO and Enterprise Value/FFO, similar to Price/Earnings (P/E) for traditional stocks¹⁶, ¹⁷. For example, a recent news report noted Healthcare Realty's Q2 Normalized FFO per share increased to $0.41, a figure used by analysts to assess current performance and future guidance¹⁵.

Limitations and Criticisms

While Funds from Operations (FFO) is a widely accepted and valuable metric for evaluating REITs, it does have certain limitations and has faced criticisms. One primary criticism is that FFO, despite its adjustments, does not fully represent a REIT's true cash flow or capacity to pay dividends¹³, ¹⁴. This is because FFO does not account for recurring capital expenditures necessary for maintaining properties, lease intangibles, or straight-lining of rents¹². These ongoing expenses can significantly impact a REIT's distributable cash.

The lack of standardization beyond Nareit's core definition can also lead to variations in how individual REITs calculate and present FFO, making direct comparisons difficult. While Nareit provides guidelines, companies may interpret these differently or make additional "smoothing" adjustments that can obscure the true operational picture¹⁰, ¹¹. The SEC has provided guidance on the use of non-GAAP measures in filings, aiming for greater clarity and consistency, but variations can still exist⁹.

Another point of contention is that FFO focuses primarily on recurring operational income and excludes the impact of non-recurring events like significant asset sales or impairments. While the intention is to provide a clean view of ongoing operations, these events can have substantial effects on a REIT's financial position and future prospects, and ignoring them completely might present an incomplete picture. Therefore, analysts and investors often look to additional metrics, such as Adjusted Funds from Operations (AFFO), which attempts to further refine FFO by accounting for these omitted items.

Funds from Operations vs. Adjusted Funds from Operations

Funds from Operations (FFO) and Adjusted Funds from Operations (AFFO) are both critical financial metrics for evaluating Real Estate Investment Trusts (REITs), but AFFO refines FFO to provide a more precise view of a REIT's distributable cash flow.

While FFO offers a better look at a REIT's operational performance by adjusting for non-cash depreciation and one-time property sales, Adjusted Funds from Operations (AFFO) goes a step further. AFFO aims to address FFO's shortcomings by deducting recurring maintenance capital expenditures and other non-cash items like straight-line rent adjustments. Th⁷, ⁸ese adjustments are crucial because, unlike depreciation, maintenance capital expenditures represent actual cash outflows necessary to keep properties in rentable condition and generate ongoing income. As such, AFFO is often seen as a more conservative and accurate estimate of a REIT's actual capacity to pay dividends and generate true cash for shareholders.

FAQs

Why is FFO important for REITs?

FFO is important for REITs because traditional net income calculations under GAAP often distort their true profitability due to large, non-cash depreciation expenses for properties that may actually appreciate in value. FFO provides a clearer, more representative picture of a REIT's ongoing operational performance and its ability to generate cash flow from its core real estate activities.

#⁶## Is FFO a GAAP measure?

No, Funds from Operations (FFO) is a Non-GAAP Measure. It was created by Nareit to provide a supplemental metric specifically for the real estate industry, as GAAP accounting principles, particularly those related to depreciation, do not fully capture the economic realities of real estate ownership and operations.

#⁴, ⁵## How does FFO relate to dividends?

FFO is closely watched by investors as an indicator of a REIT's ability to sustain and grow its dividends. Since REITs are required to distribute a significant portion of their taxable income to shareholders, a healthy and growing FFO suggests that the company has sufficient cash generated from operations to cover these distributions.

#², ³## Where can I find a REIT's FFO?

REITs are generally required to disclose their Funds from Operations. You can typically find this figure in their public financial statements, often in the footnotes of the income statement or in a dedicated section reconciling net income to FFO. It¹ is also frequently discussed in their earnings reports and investor presentations.