What is FFO (Funds From Operations)?
Funds From Operations (FFO) is used to measure the cash flow from operations and thus is similar to ‘Cash Flow from Operations’, however it is used generally in reference to cash flows generated by ‘Real Estate Investment Trust’ (REIT).
- For Real estate companies, funds from operations (FFO) is used as a performance benchmark as real estate values are proven to fluctuate with macroeconomic conditions, and using the cost accounting method to compute the financial conditions do not usually serve as an accurate measurement of performance.
- Funds from operations include funds generated from business operations excluding financing-related cash flows, such as interest income or interest expense. It does not include any depreciation or amortization of fixed assets or gains or losses from the disposition of assets as well.
- Real Estate Investment Trusts (REITs) is a business that primarily operates on income generated from real estate transactions. Such REIT companies are involved in commercial real estate that includes selling, leasing, and financing of office and buildings, warehouses, hospitals, shopping centers, hotels, etc. Funds From Operations (FFO) is commonly used by such companies.
Funds From Operations Formula
All the factors used while calculating the Funds from operations (FFO) can be found in the company’s income statement. These factors include net income, depreciation, amortization, and gains on sales of property and extraordinary items.
Funds from Operations Formula = Net Income + Depreciation and Amortization of Real Estate Assets – Gains (losses) on Asset Sale + Losses (Gains) on Restructuring Debt or Extraordinary Items
FFO Calculation (Washington REIT Case Study)
Let us step by step calculate FFO of Washington RIET
Step 1 – Identify the Net Income from the Income Statement
We note from above that the net income of Washington REIT for 2000 is $45,139. Likewise, its net income for 1999 and 1998 is $44,301 and $41,064, respectively.
(please note the figures are in thousands)
Step 2 – Identify Depreciation and Amortization of Real Estate Assets
This has been provided in the Income Statement.
- Depreciation and Amortization (2000) = $22,723
- Depreciation and Amortization (1999) = $19,590
- Depreciation and Amortization (1998) = $15,339
Step 3 – Identify Gains (Losses) on Sales of Assets
This figure is also provided in the income statement.
- Gains on Sales of Assets (2000) = $3,567
- Gains on Sales of Assets (1999) = $7,909
- Gains on Sales of Assets (1998) = $6,764
Step 4 – Identify Gains (Losses) on Restructuring Items or Extraordinary Items
- There are no gains (losses) on restructuring expenses or extraordinary items in these three years.
Step 5 – Apply FFO Formula to Calculate Funds from Operations
FFO Formula = Net Income + Depreciation and Amortization of Real Estate Assets – Gains (losses) on Asset Sale + Losses (Gains) on Restructuring Debt or Extraordinary Items
- FFO (2000) = $45,139 + $22,723 – $3,567 = $64,295
- FFO (1999) = $44,301 + $19,590 – $7,909 = $55,982
- FFO (1998) = $41,064 + $15,339 – $6,764 = $49,699
Adjusted Funds from Operations
Adjusted funds from operations (AFFO) is calculated after making adjustments to net income, is intended to compensate for accounting methods. These accounting methods might distort a real estate investment trust’s true performance. The calculation for AFFO subtracts from FFO any recurring expenditures that have been capitalized, such as projects for building improvements.
Generally Accepted Accounting Principles (GAAP) requires to depreciate the investment properties over time. However, real estate actually appreciates over time, and for this reason, the required depreciation expense which is charged as per GAAP tends to make the net income appear artificially low.
Funds from operations (FFO) also adjusts for non- recurring items as they do not occur in regular business scenarios. For instance, gains (or losses) on the sale of properties which are to be removed/ added accordingly, as they are not in nature of regular business operations and therefore do not contribute to the REIT’s ongoing dividend-paying capacity. Some analyst further considers rent increases and certain capital expenditures for calculating adjusted Funds from operations (AFFO).
Funds from operations (FFO) per share is used as a carefully scrutinized metric to gauge a REIT’s profitability per unit of shareholder ownership. Funds From Operations is further used as general valuation multiple as well as P/E multiples. Thus it is a key driver of share prices as well.
Why FFO is Important for Real Estate?
- While equity investors give importance to metrics like earnings per share (EPS) or price-earnings ratio (P/E) while analyzing stocks, REIT investors decide on the basis of funds from operations (FFO).
- Before investing in a REIT be sure of the price, the decision is not based solely on funds from Operations (FFO) or AFFO as the investment which looks good on the surface may not turn out to be a good decision in future as the prices may decline due to too many investors are buying it.
- The earnings per share (EPS) for a REIT, when compared to conventional stocks, will be naturally low or even negative. Thus, price-to-earnings (P/E ratio) of a REIT is not a favorable multiple while taking investment decisions should be considered a distant second metric while evaluating it.
Differences between CFO and FFO
- Cash flow as the name suggest calculates the total amount of cash and cash equivalents generated from the operations of a business. However, Funds from Operations (FFO) is a more important measure when it comes to real estate business as this measures compensate for one important component which is depreciation.
- Since for real estate business, the value of properties always increases over the time, thus this isn’t an expense at all. As per IRS, when businesses own long-term assets such as equipment, computers, and buildings, these assets have to be depreciated to reflect the current financial position.
- However, when it comes to real estate, these properties don’t have a “shelf life” or in other words would never depreciate to a minimal value over the period. On the contrary, these assets would appreciate and therefore not counted as an expense to be charged to the income statement.
- Thus operating cash flow and FFO are similar metrics, however, they’re not quite the same thing. Cash flow can be a great way to evaluate the financial well-being of a business, but when it comes to the real estate industry the metrics differ from the regular business scenario.
- For the purpose of assessing whether a REIT is earning enough to cover its dividends, Funds from Operations (FFO) is the way to go. It helps in getting a better picture than a regular CFO would.
Thus the funds from operations concept are required for the analysis of a REIT, because when the underlying assets are increasing in value then depreciation should not be factored into the results of operations. The funds from operations concept is considered to be a better indicator of the financial results of a business than net income, however, since the accounting chicanery can impact a variety of aspects of the financial statements, it is always better to rely upon a mix of measurements, rather than a single measure while making investment decisions.
Even Though Funds From Operations (FFO) is widely considered for determining REIT’s profitability, it’s can also often be susceptible to accounting changes, restatements, and manipulation. Please consider two or three metrics and other business factors before taking an investment decision.
This has been a guide to what is FFO or Funds from Operations. Here we discuss FFO Formula, calculation of FFO using Washington REIT example and why it is an important metric in real estate. You may learn more about Cash Flows from the following articles –