Funds From Operations (FFO): Measure of REIT Profitability

August 25, 2024 3 min read Finance Real Estate REIT Profitability GAAP Depreciation Amortization

An in-depth exploration of Funds From Operations (FFO), a key measure of profitability for Real Estate Investment Trusts (REITs), including its calculation, significance, and associated terms.

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Funds From Operations (FFO) is a crucial metric used to gauge the profitability and performance of Real Estate Investment Trusts (REITs). Unlike net income, which follows Generally Accepted Accounting Principles (GAAP), FFO adjusts for noncash deductions such as depreciation and amortization of deferred charges to provide a clearer picture of a REIT’s operational performance.

Calculation of FFO

Funds From Operations (FFO) starts with the net income as reported under GAAP. It then adds back noncash deductions such as depreciation and amortization. The formula for FFO is:

\text{FFO} = \text{Net Income (GAAP)} + \text{Depreciation} + \text{Amortization} - \text{Gains (Losses) on Sale of Real Estate}

Example Calculation

Consider a REIT with the following financials:

Net Income (GAAP): $2,000,000
Depreciation: $500,000
Amortization: $200,000
Gain on Sale of Real Estate: $300,000

Using the FFO formula:

\text{FFO} = \$2,000,000 + \$500,000 + \$200,000 - \$300,000 = \$2,400,000

Significance of FFO

FFO is particularly significant for REITs due to the high depreciation expense associated with real estate assets, which can significantly diminish net income despite strong operational cash flows. By adjusting for these noncash deductions, FFO provides a more accurate measure of the income generated by the REIT’s core operations.

Special Considerations

Exclusions in FFO Calculation

Extraordinary items, such as losses or gains on the sale of real estate, are excluded from FFO to prevent one-time events from distorting the metric. This ensures that FFO reflects only the REIT’s operational performance.

Comparisons with Other Metrics

Net Operating Income (NOI)

While FFO adjusts net income for noncash deductions, Net Operating Income (NOI) is focused purely on the REIT’s revenue-generating property operations, disregarding expenses like depreciation, interest, and taxes.

Adjusted Funds From Operations (AFFO)

AFFO, often considered a more refined measure, adjusts FFO further by subtracting capital expenditures and maintenance costs. This provides a closer approximation of the cash generated by a REIT for distribution to shareholders.

Historical Context

The concept of Funds From Operations was introduced to provide a standardized measure for evaluating the financial performance of REITs. Its adoption gained traction through the 1990s and has since become an industry-standard metric recognized by the National Association of Real Estate Investment Trusts (NAREIT).

Real Estate Investment Trust (REIT): A REIT is a company that owns, operates, or finances income-producing real estate. REITs provide a way for individual investors to earn a share of the income produced through commercial real estate ownership.
Generally Accepted Accounting Principles (GAAP): GAAP refers to a set of accounting standards and principles used for financial reporting in the United States. These standards ensure consistency and comparability across financial reports.

FAQs

What is the main advantage of using FFO over net income?

FFO provides a clearer picture of a REIT’s operational performance by excluding noncash deductions like depreciation, making it a more reliable indicator of profitability.

How does FFO impact REIT valuations?

Investors often use FFO to assess the underlying health of a REIT, influencing their investment decisions and, consequently, the market valuation of the REIT.

References

National Association of Real Estate Investment Trusts (NAREIT) definitions and guidelines.
“Finance and Investments Handbook” by John Downes and Jordan Elliot Goodman.
Financial Accounting Standards Board (FASB) guidelines on GAAP.

Summary

Funds From Operations (FFO) is a critical measure for assessing the profitability of Real Estate Investment Trusts (REITs). By adjusting net income for noncash charges like depreciation and amortization, FFO provides a transparent view of a REIT’s operational performance, excluding the effects of extraordinary items and gains or losses on property sales. Its adoption and standardization have made FFO an indispensable tool for investors and analysts in the real estate market.