Understanding Funds From Operations (FFO)
Funds From Operations (FFO) is a crucial metric for assessing the profitability of a real estate investment trust (REIT). Unlike traditional net income calculations that adhere to Generally Accepted Accounting Principles (GAAP), FFO provides a clearer picture of a REIT’s actual earnings by making specific adjustments. These adjustments include adding back non-cash deductions such as depreciation and amortization, making it a more accurate reflection of operational efficiency and cash flow.
Why FFO Matters
Securities analysts favor FFO as the preferred measure of a REIT\u2019s performance over net income. The key reason is that GAAP-based net income can be distorted by non-cash expenses like depreciation and amortization, which do not affect actual cash flow. FFO, on the other hand, realigns these figures to present a more precise evaluation of recurring earnings from income-producing real estate. By excluding gains and losses from property sales, it focuses more accurately on ongoing business activities.
Benefits of Using FFO
- Transparency: By excluding non-cash charges, FFO offers a straightforward look at the operating performance of REITs.
- Reliability: Investors and analysts rely on FFO as it provides a stabilized view of income without the volatility of one-time gains or losses.
- Comparability: It allows for easier comparison between different REITs by normalizing income figures across varying accounting treatments and exceptions.
How to Calculate FFO: An Example
Let’s break down a typical FFO calculation with an example:
Net Income: $500,000
Depreciation Deductions: $100,000
Amortization of Deferred Charges: $50,000
Gains on Property Sales: $0
Non-Recurring Losses: $0
FFO Calculation:
\> $500,000 (Net Income) + $100,000 (Depreciation) + $50,000 (Amortization) = $650,000
Thus, the FFO in this scenario is $650,000.
By using FFO, the final figure excludes the distortive effects of non-cash charges, rendering a more consistent and reliable measure of earnings.
Frequently Asked Questions
What is the primary difference between FFO and net income?
The main difference lies in the adjustments that FFO makes for depreciation and amortization, which are non-cash items. It provides a clearer picture of the operational cash flow of a REIT, unlike GAAP-based net income.
Why don\u2019t analysts rely solely on GAAP net income for REITs?
GAAP mandates deductions for depreciation and amortization, which can substantially skew the actual financial performance. Analysts prefer FFO as it eliminates these non-cash adjustments.
Is FFO a real-time measure of profitability?
Yes, FFO offers a near real-time measure as it primarily focuses on regular income flow and excludes atypical adjustments related to asset sales or other non-recurring gains or losses.
How frequently is FFO reported?
REITs generally report FFO quarterly, in line with their regular financial reporting schedules.
Can we use FFO to compare different REITs?
Absolutely, FFO is particularly useful in comparing the financial performance of different REITs on a like-for-like basis, since it neutralizes the effects of varied acquisition histories and asset depreciation rates.
Related Terms: Net Income, Generally Accepted Accounting Principles, GAAP, Depreciation Deductions, Amortization.
