Funds From Operations (FFO)
Funds From Operations (FFO) is a financial metric used to assess the performance of Real Estate Investment Trusts (REITs). It begins with the net income calculated according to Generally Accepted Accounting Principles (GAAP) and then makes key adjustments to provide a clearer picture of a REIT’s profitability. Specifically, FFO adds back non-cash charges such as depreciation and amortization of deferred charges, as these deductions do not require actual cash outflows.
Importance
Securities analysts often argue that the traditional GAAP net income is not an accurate measure of the profitability for income-producing real estate. This is primarily because GAAP accounting mandates the inclusion of depreciation and amortization expenses, which do not represent real cash expenditures. Therefore, these analysts consider FFO to be a more appropriate and insightful measure of a REIT’s operational performance.
Examples
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Example 1: Basic Calculation
- Net Income: $1,000,000
- Depreciation: $200,000
- Amortization: $50,000
- Funds From Operations (FFO): $1,000,000 + $200,000 + $50,000 = $1,250,000
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Example 2: Exclusion of Extraordinary Items
- Net Income: $1,000,000
- Depreciation: $200,000
- Amortization: $50,000
- Extraordinary Gain from Sale of Property: $100,000
- Funds From Operations (FFO): $1,000,000 + $200,000 + $50,000 - $100,000 = $1,150,000
Frequently Asked Questions
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Why is FFO important for REIT investors?
- FFO provides a more accurate measure of a REIT’s operational performance by focusing on cash-generating activities, excluding non-cash expenses like depreciation and amortization.
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How is FFO different from net income?
- FFO adjusts net income by adding back non-cash expenses such as depreciation and amortization to offer a clearer understanding of cash flows from regular operations.
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Is FFO standardized across the industry?
- While FFO is generally accepted and used widely, slight variations can occur in its calculation. The National Association of Real Estate Investment Trusts (NAREIT) has established guidelines to standardize its definition.
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Can FFO include gains or losses on property sales?
- No, FFO typically excludes extraordinary gains and losses from the sale of real estate assets as these are not part of regular operational activities.
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Does a high FFO indicate better financial health for a REIT?
- Yes, a consistently high FFO can indicate strong operational performance and better financial health, making it a key metric for investors.
Related Terms
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Adjusted Funds From Operations (AFFO)
- A variation of FFO, further adjusted to include other factors such as maintenance capital expenditures and improvements.
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Net Operating Income (NOI)
- The income generated from property operations after deducting operating expenses but before deducting taxes and interest.
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Cash Available for Distribution (CAD)
- The actual cash available to be distributed to shareholders as dividends after accounting for maintenance and operating cash inflows.
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Generally Accepted Accounting Principles (GAAP)
- A standard framework of guidelines and principles for financial accounting used in the U.S.
Online Resources
- National Association of Real Estate Investment Trusts (NAREIT)
- Investopedia’s Guide on FFO
- Securities and Exchange Commission (SEC) Filings
- Google Finance - REITs
References
- National Association of Real Estate Investment Trusts (NAREIT)
- Securities and Exchange Commission (SEC)
Suggested Books for Further Studies
- “Investing in REITs: Real Estate Investment Trusts” by Ralph L. Block
- “The Handbook of Commercial Real Estate Investing” by John McMahan
- “The Intelligent REIT Investor Guide” by Stephanie Krewson-Kelly and R. Brad Thomas
- “Real Estate Investment Trusts: Structure, Performance, and Investment Opportunities” by Su Han Chan, John Erickson, and Ko Wang
Real Estate Basics: Funds From Operations (FFO) Fundamentals Quiz
### Do FFO calculations include gains or losses from the sale of real estate assets?
- [ ] Yes, gains and losses are always included in FFO.
- [x] No, gains and losses from sales are excluded.
- [ ] Sometimes, it depends on the accounting method.
- [ ] Always includes losses but not gains.
> **Explanation:** FFO typically excludes gains or losses from the sale of real estate assets as these are considered to be extraordinary items, not part of regular ongoing operations.
### What is the main purpose of excluding depreciation in the calculation of FFO?
- [ ] To reduce taxation.
- [x] To provide a more accurate measure of cash generated from operations.
- [ ] To increase reported earnings.
- [ ] To comply with legal requirements.
> **Explanation:** Depreciation is excluded to provide a more accurate measure of cash generated from operational activities, highlighting the true performance of a REIT.
### Is FFO commonly used in industries outside of real estate?
- [ ] Yes, it is universal.
- [ ] No, only real estate companies use it.
- [x] Primarily used in real estate, particularly REITs.
- [ ] Rarely used by any industry.
> **Explanation:** While conceivable elsewhere, FFO is primarily used within the real estate sector, particularly by REITs to measure their profitability.
### What does FFO start with in its calculation?
- [ ] Gross Revenue
- [x] Net Income
- [ ] Cash Flow
- [ ] Operating Income
> **Explanation:** FFO calculations begin with net income and then adjust for non-cash activities.
### Which regulatory body standardizes the definition of FFO?
- [ ] Financial Accounting Standards Board (FASB)
- [ ] International Accounting Standards Board (IASB)
- [ ] National Association of Securities Dealers (NASD)
- [x] National Association of Real Estate Investment Trusts (NAREIT)
> **Explanation:** NAREIT provides guidelines to standardize the definition of FFO.
### Does the FFO metric consider the effects of maintenance capital expenditures?
- [ ] Yes, it includes all types of capital expenditures.
- [ ] Yes, but not in the primary calculation.
- [x] No, these are typically included in Adjusted Funds From Operations (AFFO).
- [ ] It varies depending on the REIT's policy.
> **Explanation:** Maintenance capital expenditures are more commonly considered in Adjusted Funds From Operations (AFFO), not FFO.
### Why do some analysts prefer FFO over GAAP net income when evaluating REITs?
- [ ] Because it is simpler to calculate.
- [ ] Because it includes more expenses.
- [ ] To comply with federal regulations.
- [x] Because GAAP net income doesn't adjust for non-cash expenses accurately.
> **Explanation:** Analysts find FFO more accurate as it excludes non-cash expenses, which GAAP net income doesn't adjust.
### For what type of company is FFO most relevant?
- [ ] Manufacturing Companies
- [ ] Tech Start-ups
- [x] Real Estate Investment Trusts (REITs)
- [ ] Retail Businesses
> **Explanation:** FFO is most relevant for Real Estate Investment Trusts (REITs), providing a specialized profit metric.
### Do GAAP's depreciation and amortization schedules accurately reflect cash outflow for REITs?
- [ ] Yes, they are directly correlated.
- [ ] Somewhat accurately.
- [ ] They reflect only a minor part.
- [x] No, they do not represent actual cash outflows.
> **Explanation:** Depreciation and amortization as per GAAP do not represent real cash outflows, hence their exclusion in FFO calculations.
### What is adjusted first in FFO calculations when starting from net income?
- [x] Non-cash expenses like depreciation and amortization.
- [ ] Revenue from rents.
- [ ] Operating expenses.
- [ ] Cash on hand.
> **Explanation:** In FFO calculations, the first adjustments are for non-cash expenses like depreciation and amortization to reflect actual operational cash inflows.
