Price to ffo ratio

What Is Price to FFO Ratio?

The price to FFO ratio is a widely used valuation metric in Real Estate Investment Analysis, particularly for Real Estate Investment Trusts (REITs). It calculates the value of a REIT's shares relative to its Funds From Operations (FFO) on a per-share basis. Unlike traditional businesses, REITs own and operate income-producing real estate, making standard earnings metrics less relevant due to the significant impact of non-cash charges like depreciation on their net income. Therefore, the price to FFO ratio provides a more accurate picture of a REIT's operating performance and ability to generate cash from its properties.

History and Origin

The concept of REITs was established in the United States when President Dwight D. Eisenhower signed legislation in 1960, allowing individual investors to participate in large-scale, income-producing real estate⁵. This legislative act aimed to provide a structure for real estate investment similar to how mutual funds enable investment in stocks. Over time, as REITs grew in popularity, the investment community recognized the limitations of standard Generally Accepted Accounting Principles (GAAP) in valuing these unique entities. GAAP requires companies to record depreciation and amortization for real estate assets, which significantly reduces reported net income but does not reflect the actual cash generated by the properties.

To address this, the National Association of Real Estate Investment Trusts (Nareit) developed Funds From Operations (FFO) as a supplemental non-GAAP measure of operating performance. Nareit introduced FFO to provide a clearer representation of the cash-generating ability of REITs by adjusting net income to account for the non-cash nature of real estate depreciation and other non-recurring items⁴. This development provided analysts and investors with a more appropriate metric, leading to the widespread adoption of the price to FFO ratio for valuation purposes within the real estate sector.

Key Takeaways

The price to FFO ratio is a primary valuation multiple for Real Estate Investment Trusts (REITs).
It adjusts for non-cash expenses like depreciation, which can distort traditional earnings for real estate companies.
A lower price to FFO ratio might indicate an undervalued REIT, while a higher ratio could suggest overvaluation.
The ratio helps investors assess a REIT's ability to generate cash flow from its operations and support dividend payouts.
Comparisons of the price to FFO ratio are most meaningful among REITs within the same sector or with similar business models.

Formula and Calculation

The price to FFO ratio is calculated by dividing a REIT's current share price by its Funds From Operations (FFO) per share.

First, FFO must be determined. Nareit's definition of FFO starts with net income and makes specific adjustments:

\text{FFO} = \text{Net Income} + \text{Depreciation} + \text{Amortization} - \text{Gains on Sale of Property} + \text{Losses on Sale of Property}

After calculating total FFO, the FFO per share is derived:

\text{FFO Per Share} = \frac{\text{Total FFO}}{\text{Number of Diluted Shares Outstanding}}

Finally, the price to FFO ratio is calculated as:

\text{Price to FFO Ratio} = \frac{\text{Current Share Price}}{\text{FFO Per Share}}

For example, if a REIT has a share price of $50 and an FFO per share of $4, its price to FFO ratio would be 12.5x. Understanding these calculations is crucial for analyzing a company's cash flow and financial health.

Interpreting the Price to FFO Ratio

Interpreting the price to FFO ratio involves comparing it to historical values for the same REIT, to its peers within the same sector, or to the broader REIT market. A lower price to FFO ratio generally suggests that a REIT may be undervalued, meaning its stock price is low relative to the cash flow it generates. Conversely, a higher price to FFO ratio could indicate that the REIT is overvalued, or that investors expect significant future growth.

Investors often use this ratio as a primary indicator in income investing strategies focused on REITs. However, context is vital. A higher ratio might be justified for a REIT with strong growth prospects, premium asset management, or a highly desirable property portfolio. Conversely, a very low ratio could signal underlying problems not immediately apparent, such as significant upcoming capital expenditures or declining rental income.

Hypothetical Example

Consider "Diversi-REIT," a hypothetical residential REIT.

Current Share Price: $75.00
Net Income: $200 million
Depreciation and Amortization: $80 million (non-cash charge)
Gains on Sale of Property: $10 million (one-time gain from selling a non-core asset)
Number of Diluted Shares Outstanding: 100 million

Step 1: Calculate Total FFO
Using the FFO formula:

\text{FFO} = \text{Net Income} + \text{Depreciation} + \text{Amortization} - \text{Gains on Sale of Property} + \text{Losses on Sale of Property}

In this case, there are no losses on sale of property.

\text{FFO} = \$200 \text{ million} + \$80 \text{ million} - \$10 \text{ million} = \$270 \text{ million}

Step 2: Calculate FFO Per Share

\text{FFO Per Share} = \frac{\text{\$270 million}}{100 \text{ million shares}} = \$2.70 \text{ per share}

Step 3: Calculate Price to FFO Ratio

\text{Price to FFO Ratio} = \frac{\text{\$75.00}}{\text{\$2.70}} \approx 27.78\text{x}

This hypothetical example illustrates how the price to FFO ratio is derived, providing a specific metric for evaluating Diversi-REIT's market price relative to its operational cash flow. This metric is a key part of assessing a REIT's financial health, often considered alongside other data from the company's financial statements.

Practical Applications

The price to FFO ratio is primarily applied in the analysis and real estate investing of REITs. Investors and analysts use it to:

Compare Valuation: It provides a standardized metric to compare the relative valuations of different REITs, especially within the same property sector (e.g., residential, retail, industrial). This helps identify potentially overvalued or undervalued opportunities.
Assess Income Potential: Since FFO represents the cash flow available from operations, the price to FFO ratio helps in gauging a REIT's ability to sustain or grow its dividend payouts, which are a major component of REIT investor returns.
Guide Investment Decisions: Many institutional investors and portfolio managers specializing in real estate incorporate the price to FFO ratio into their quantitative models for screening and selecting REITs. For example, major companies regularly report their FFO and provide future FFO guidance to the market, which analysts then use to inform their price to FFO ratio analyses³.

While essential for REITs, this ratio is less relevant for companies outside the real estate sector, which typically rely on traditional earnings per share or price-to-earnings ratios for valuation.

Limitations and Criticisms

While the price to FFO ratio is a superior valuation metric for REITs compared to the traditional price-to-earnings ratio, it has its own limitations and criticisms. One primary criticism is that FFO, despite its adjustments, may not fully capture all necessary operating expenses required to maintain a property portfolio. For instance, it often excludes recurring capital expenditures that are necessary to preserve the value of the underlying real estate assets². These ongoing investments, while vital for the long-term health of a property, are not always deducted in the standard FFO calculation, which can make a REIT's FFO appear higher than its true sustainable cash flow.

Furthermore, FFO is a non-GAAP measure, meaning its definition and adjustments can vary slightly among different REITs or over time, potentially impacting comparability. The lack of strict, universal GAAP guidelines for FFO can introduce inconsistencies, making careful scrutiny of each REIT's specific FFO reconciliation important. It also does not account for changes in working capital or non-recurring items beyond property sales, which can influence a company's financial flexibility¹. Therefore, relying solely on the price to FFO ratio without examining a REIT's full financial statements and qualitative factors can lead to an incomplete or misleading assessment.

Price to FFO Ratio vs. Price-to-Earnings (P/E) Ratio

The primary distinction between the price to FFO ratio and the Price-to-Earnings (P/E) ratio lies in how each metric accounts for the unique financial characteristics of real estate.

Price-to-Earnings (P/E) Ratio: This is a fundamental valuation multiple used across most industries. It divides a company's share price by its earnings per share. The core assumption of the P/E ratio is that earnings (net income) accurately reflect a company's profitability. However, for real estate companies, GAAP mandates that assets like buildings be depreciated over their useful life. This non-cash expense significantly reduces reported net income, even if the property is appreciating in market value and generating substantial cash. This makes the P/E ratio less relevant for REITs.
Price to FFO Ratio: Developed specifically for REITs, this ratio addresses the P/E ratio's shortcomings by adjusting net income to derive Funds From Operations (FFO). FFO adds back depreciation and amortization and excludes gains or losses from property sales, providing a clearer measure of the actual cash flow generated by a REIT's core rental operations. This makes the price to FFO ratio a more appropriate and widely accepted valuation metric for REITs, as it better reflects their ability to generate distributable cash and pay dividends to shareholders, which is a key driver for investors in this sector.

In essence, while the P/E ratio works well for businesses where depreciation accurately reflects asset consumption, the price to FFO ratio is tailored for REITs, acknowledging that real estate often appreciates and its "depreciation" is a significant non-cash accounting entry, not a reflection of cash outflow or true economic decline.

FAQs

What is a good Price to FFO ratio for a REIT?

There isn't a single "good" Price to FFO ratio, as it varies significantly by real estate sector (e.g., residential, industrial, retail), market conditions, and the REIT's growth prospects. Generally, a ratio below the industry average might suggest undervaluation, while one significantly above could indicate overvaluation. Investors typically compare a REIT's ratio to its peers and historical averages to assess its relative value in real estate investing.

Why is FFO used instead of Net Income for REITs?

FFO is used because standard accrual accounting for real estate includes substantial non-cash depreciation and amortization expenses. While these reduce reported net income, they do not represent actual cash outflows or a decline in the value of income-producing real estate. FFO adjusts for these non-cash items, providing a more accurate measure of a REIT's cash flow generated from its operations, which is crucial for assessing its ability to pay dividends.

Does the Price to FFO ratio include capital expenditures?

The basic definition of FFO, as defined by Nareit, typically does not deduct all capital expenditures (CapEx). It primarily adds back depreciation and amortization. Some analysts and REITs may report "Adjusted Funds From Operations" (AFFO) or "Cash Available for Distribution" (CAD), which do subtract recurring CapEx necessary to maintain properties, providing an even more conservative view of a REIT's distributable cash.

Can the Price to FFO ratio be negative?

The Price to FFO ratio can be negative if a REIT has negative FFO per share. This would occur if the REIT's expenses, even after adjustments for non-cash items, exceed its revenue, indicating an operational loss. A negative FFO is generally a strong red flag, suggesting the REIT is not generating enough cash flow from its properties to cover its costs.