Understanding Funds From Operations (FFO)
Funds From Operations (FFO) is a critical metric used to assess the performance of real estate investment trusts (REITs). Unlike other traditional financial measures, FFO provides a clearer picture of cash generated by a REIT’s operations, excluding gains or losses from sales of properties and other extraordinary items.
How to Calculate FFO
The basic formula to calculate FFO is:
FFO = Net Income + Depreciation + Amortization - Gains on Sales of Properties
This formula adjusts net income by adding back expenses like depreciation and amortization, which are non-cash items, and subtracting gains on sales of properties, to focus purely on the operating performance.
Why FFO Matters for Investors
FFO is especially valuable for investors for several reasons:
- Reflects Operational Performance: By focusing on operational performance, FFO offers a more accurate view of how well a REIT is generating cash from its leasing activities.
- Excludes Non-Cash Items: Depreciation and amortization can significantly affect net income but are non-cash charges. FFO adds these back to give a better understanding of cash flow.
- Standard Measure: As a widely recognized metric, FFO allows investors to compare different REITs on a like-for-like basis.
Real-World Example of FFO Calculation
Imagine XYZ REIT has a net income of $5 million, depreciation of $1 million, amortization of $500,000, and a gain on the sale of a property of $2 million. The FFO calculation would be:
FFO = $5,000,000 + $1,000,000 + $500,000 - $2,000,000 = $4,500,000
Thus, XYZ REIT’s FFO is $4.5 million, highlighting its capability to generate cash purely from its operational activities.
Sitting apart: Adjusted Funds From Operations (AFFO)
While FFO is fundamental, some investors prefer using Adjusted Funds From Operations (AFFO), which goes a step further by factoring in capital expenditures and other routine maintenance costs.
The more detailed formula for AFFO is:
AFFO = FFO - Capital Expenditures - Routine Maintenance Costs
AFFO provides a more refined understanding of a REIT’s actual cash flow, considering the expenses necessary to maintain and extend the life of properties.
Frequently Asked Questions
Q: What makes FFO different from net income?
FFO differs primarily because it adds back non-cash expenses like depreciation and amortization to net income while excluding gains on the sale of properties. This provides a clearer picture of operational cash flow.
Q: How often should investors review FFO?
Investors typically review FFO on a quarterly basis when REITs release their earnings reports to track ongoing operational performance.
Q: Can FFO be negative?
While rare, it is possible for FFO to be negative if the net income is significantly impacted by high operating expenses or unusual adjustments, indicating potential operational issues in the REIT.
Q: Is FFO the only metric to evaluate REITs?
Though vital, FFO is one of many metrics investors should consider. Metrics such as Net Operating Income (NOI) and Adjusted Funds From Operations (AFFO) also provide valuable insights.
Related Terms: Net Operating Income, Adjusted Funds From Operations (AFFO), Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), Real Estate Investment Trusts (REITs).
