Funds From Operations (FFO) is a crucial financial metric used primarily in the real estate industry to assess the performance and profitability of Real Estate Investment Trusts (REITs). FFO is derived from the net income of REITs after adding back depreciation and amortization, as these non-cash expenses do not accurately reflect the actual cash flow generated by the properties.
Importance of Funds From Operations in Real Estate
Real Estate Investment Trusts (REITs)
Definition of REITs
Real Estate Investment Trusts (REITs) are companies that own, operate, or finance income-producing real estate across a range of property sectors. They provide individuals the opportunity to invest in large-scale, diversified portfolios of real estate assets without the need for individual ownership.
Role of FFO in REITs Analysis
FFO is a standardized measure commonly used to evaluate the performance of REITs. It provides investors with insights into the cash generated by the REIT’s core operations and excludes the effects of financing and accounting decisions.
Calculating Funds From Operations
Basic Formula for FFO
Net Income
Net Income is the total profit of a company, typically found at the bottom of the income statement.
Depreciation and Amortization
- Depreciation: The reduction in the value of tangible assets over time.
- Amortization: The process of expensing the cost of an intangible asset over its useful life.
Adjusting for Gains/Losses
Gains or losses on the sales of properties are excluded from FFO as these transactions are not indicative of the ongoing operational performance of the REIT.
Example Calculation
Assume a REIT reports the following for a fiscal year:
- Net Income: $500,000
- Depreciation and Amortization: $200,000
- Gain on Sale of Properties: $50,000
In this example, the FFO for the REIT would be $650,000, indicating a more accurate picture of the operational efficiency and cash-generating ability of the REIT.
Historical Context and Evolution of FFO
The concept of FFO was developed to address the limitations of using net income to evaluate REITs. Standard accounting practices necessitate depreciation, which does not reflect the current market values or operational capabilities of real estate properties. The National Association of Real Estate Investment Trusts (NAREIT) has standardized FFO calculations to ensure consistency and comparability among REITs.
Applicability and Comparison
Comparisons to Other Financial Metrics
- Net Operating Income (NOI): Measures the profitability of income-generating properties. Unlike FFO, NOI does not account for corporate-level expenses or interest.
- Adjusted Funds From Operations (AFFO): Refines FFO by adjusting for capital expenditures and routine maintenance costs. It provides a more precise measure of available cash flow.
Related Terms in Finance and Real Estate
- EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization. Similar to FFO but used more broadly across various industries.
- Cash Flow from Operations (CFO): Cash generated from core business operations.
FAQs
Why is depreciation added back in the FFO calculation?
Can FFO be used for non-REIT companies?
What are the limitations of using FFO?
References
- National Association of Real Estate Investment Trusts (NAREIT)
- Financial Accounting Standards Board (FASB)
- “Real Estate Investing for Dummies” by Eric Tyson and Robert S. Griswold
- Investopedia: Funds From Operations (FFO)
Summary
Funds From Operations (FFO) is an essential metric for analyzing the financial performance of REITs, providing insights into the cash from core operations by excluding non-cash items like depreciation and amortization. It enables investors to evaluate the operational efficiency and profitability of REITs more accurately, ensuring informed investment decisions.
