Funds From Operations

What is Funds From Operations (FFO)?

Funds From Operations (FFO) is a critical financial metric used predominantly in the real estate industry, especially for Real Estate Investment Trusts (REITs). It serves as a more accurate indicator of a real estate company's operating performance and cash flow than traditional net income, which is calculated under Generally Accepted Accounting Principles (GAAP). FFO adjusts net income by adding back non-cash expenses like depreciation and amortization, and subtracting gains from property sales, to provide a clearer picture of the cash generated from a property's ongoing operations.

The rationale behind FFO stems from the unique nature of real estate assets. While depreciation is a legitimate accounting expense for most businesses, it often doesn't reflect the true economic decline in value for well-maintained real estate, which can even appreciate over time. By adding back depreciation, FFO aims to show the actual cash available to a REIT for distributions, capital expenditures, and debt repayment, making it a more relevant measure for investors evaluating real estate performance.

Why FFO is Important for Real Estate Investors

For real estate investors, particularly those interested in REITs, FFO is an indispensable tool for several reasons:

• Accurate Profitability Assessment: FFO strips away non-cash charges that can distort a real estate company's true earnings, offering a more realistic view of its operational profitability.
• Dividend Sustainability: REITs are legally required to distribute at least 90% of their taxable income to shareholders as dividends. FFO provides a better measure of a REIT's capacity to pay and sustain these dividends, which are often a primary draw for investors.
• Comparative Analysis: FFO allows investors to compare the performance of different REITs and real estate companies on a more level playing field, as it standardizes the impact of depreciation across the industry.
• Valuation Tool: Investors often use FFO per share as a basis for valuing REITs, similar to how earnings per share (EPS) is used for traditional stocks, by calculating price-to-FFO multiples.

Calculating Funds From Operations (FFO)

The National Association of Real Estate Investment Trusts (NAREIT) provides a widely accepted definition and formula for FFO. The calculation typically starts with net income and makes specific adjustments.

FFO Formula

FFO = Net Income + Depreciation & Amortization (real estate related) - Gains from Sale of Property + Losses from Sale of Property

Step-by-Step Calculation Process

1. Start with Net Income: Begin with the company's net income (or loss) as reported on its income statement, which is a GAAP measure.
2. Add Back Real Estate Depreciation and Amortization: Identify and add back all depreciation and amortization expenses related to real estate assets. This is the core adjustment that removes the non-cash charge.
3. Subtract Gains from Property Sales: If the company sold properties for a gain, subtract this amount. These are typically non-recurring events and not part of ongoing operations.
4. Add Back Losses from Property Sales: Conversely, if the company incurred losses from property sales, add this amount back. This also removes non-recurring events from the operational cash flow.

Real-World Example: Calculating FFO for a REIT

Let's consider a hypothetical REIT, "Prime Properties REIT," for the fiscal year 2023. Here's their financial data:

• Net Income: $50,000,000
• Real Estate Depreciation & Amortization: $25,000,000
• Gain from Sale of Property: $5,000,000
• Loss from Sale of Property: $0
• Number of Shares Outstanding: 100,000,000

Using the FFO formula:

FFO = $50,000,000 (Net Income) + $25,000,000 (Depreciation & Amortization) - $5,000,000 (Gain from Sale) + $0 (Loss from Sale)

FFO = $70,000,000

To get FFO per share, we divide the total FFO by the number of shares outstanding:

FFO per Share = $70,000,000 / 100,000,000 shares = $0.70 per share

This $0.70 FFO per share provides a clearer picture of Prime Properties REIT's operational cash flow compared to its potentially lower GAAP EPS, which would be $0.50 per share ($50M Net Income / 100M shares).

Adjusted Funds From Operations (AFFO) vs. FFO

While FFO is a valuable metric, some investors prefer to use Adjusted Funds From Operations (AFFO), also sometimes referred to as 'Cash Available for Distribution' (CAD) or 'Funds Available for Distribution' (FAD). AFFO takes FFO a step further by making additional adjustments to account for recurring capital expenditures (CapEx) and tenant improvements (TI) that are necessary to maintain the property's value and generate future income. These are real cash outflows that FFO does not capture.

AFFO is generally considered a more conservative and comprehensive measure of a REIT's ability to pay sustainable dividends because it reflects the true recurring cash flow after essential maintenance and tenant-related costs. Investors often look at both FFO and AFFO to get a complete understanding of a REIT's financial health and dividend coverage.

Limitations and Considerations

Despite its utility, FFO has certain limitations:

• Non-GAAP Measure: FFO is not standardized by GAAP, meaning companies may have slight variations in their calculation, which can make direct comparisons challenging. Always review a company's specific FFO definition.
• Excludes Capital Expenditures: As mentioned, FFO does not account for recurring capital expenditures needed to maintain properties, which can be significant. This is why AFFO is often preferred.
• Does Not Reflect Debt Repayment: FFO focuses on operational cash flow and does not directly indicate a company's ability to repay debt, which is crucial for long-term financial stability.
• Potential for Manipulation: While less common, companies could potentially manipulate FFO by classifying certain expenses differently to present a more favorable picture. Diligent analysis of financial statements is always recommended.