Funds From Operations (FFO): Measure of Cash Generated by a REIT

Funds From Operations (FFO) is a key financial metric used to evaluate the performance of Real Estate Investment Trusts (REITs) by measuring the cash generated from their operations.

Funds From Operations (FFO) is a widely-recognized financial metric used to assess the performance of Real Estate Investment Trusts (REITs). It measures the cash generated from the core operations of a REIT, thereby providing an insight into its operational efficiency and ability to generate profit. Unlike net income, FFO adds back certain non-cash items like depreciation and amortization, which is particularly relevant for real estate investments, where these items do not necessarily reflect the economic realities of the properties.

Key Elements of FFO

Definition and Formula

Funds From Operations can be calculated using the following formula:

$$ FFO = Net\ Income + Depreciation\ and\ Amortization - Gains\ (or\ Losses)\ on\ Sales\ of\ Assets $$

This formula highlights the primary components of FFO — the net income, adjustments for non-cash charges, and the exclusion of gains or losses from asset sales.

Importance in Real Estate

FFO is an essential metric for REITs because it:

• Evens Out Volatility: By adjusting for depreciation and amortization, FFO provides a clearer picture of a REIT’s operating performance.
• Enhances Comparability: It allows investors to compare performance across different REITs by focusing on cash-generating operations.
• Assesses Dividends: Since REITs are mandated to distribute a significant portion of their income as dividends, FFO gives investors an idea of the cash available for these distributions.

Types of FFO

There are various adaptations of FFO which cater to different analytical needs:

• Adjusted Funds From Operations (AFFO): This version further refines FFO by subtracting recurring capital expenditures and straight-lining rents.
• Normalized FFO (NFFO): Adjusts FFO by excluding one-time events and non-recurring items to provide a more normalized income stream.

Historical Context

The concept of FFO was developed in response to the unique financial structures of REITs. Traditional accounting metrics often misrepresented the operational profitability of REITs due to the substantial non-cash expenses. Thus, the National Association of Real Estate Investment Trusts (NAREIT) introduced FFO as a standardized metric.

Applicability

Investors and Analysts

For investors and analysts, FFO is a critical metric for:

• Evaluating the strength of a REIT’s earnings.
• Making informed decisions about buying or holding REIT stocks.
• Comparing performance across different REITs and sectors.

REIT Managers

For REIT managers, FFO is used to assess operational effectiveness and communicate financial health to stakeholders.

Comparisons with Other Metrics

Net Income

Unlike net income, FFO excludes non-cash expenses, providing a clearer picture for capital-intensive real estate operations.

Cash Flow from Operations (CFO)

Both FFO and Cash Flow from Operations (CFO) focus on cash-generating activities, but FFO includes specific adjustments relevant to real estate.

Related Terms

• Capitalization Rate (Cap Rate): A rate used to estimate the return on investment in a real estate property.
• Net Operating Income (NOI): Income generated from property operations, excluding financing and income taxes.

FAQs

Why is FFO preferred over Net Income for REITs?

FFO is preferred because it adjusts for non-cash expenses like depreciation, providing a more accurate reflection of the REIT’s operational performance.

How does AFFO differ from FFO?

Adjusted Funds From Operations (AFFO) takes FFO a step further by subtracting recurring capital expenditures and amortizing lease incentives, thus offering a more refined measure.

Is FFO applicable to non-REIT companies?

While FFO is primarily used for REITs, its principles can help analyze any company with substantial non-cash expenses.

References

1. National Association of Real Estate Investment Trusts (NAREIT): Definition of FFO
2. Investopedia: Funds From Operations (FFO) Definition
3. Various Financial Analytics Textbooks.

Summary

Funds From Operations (FFO) serves as a vital metric for evaluating the performance of REITs by focusing on cash flows from core operations. By adjusting for depreciation, amortization, and excluding one-time gains or losses, FFO offers a clearer, more comparable financial indicator. This metric is essential for investors, analysts, and REIT managers in assessing the financial health and profitability of real estate investments.