FFO (Funds from Operations)

What is FFO (Funds From Operations)?

FFO (Funds from Operations) usually refers to the cash flows generated by Real Estate Investment Trust (REITs) and is calculated by subtracting Interest income and gain on the sale of assets from the net income during the period and adding the Interest expense, Depreciation, and Losses on the sale of assets to it.

FFO is used to measure the cash flow from operations and thus is similar to ‘Cash Flow from Operations.’Cash Flow From Operations.'Cash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.read more However, it is generally used in reference to cash flows generated by ‘Real Estate Investment Trust’ (REIT).

Funds From Operations Formula

All the factors used while calculating the Funds from operations 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 Extraordinary ItemsExtraordinary Items refer to those events which are considered to be unusual by the company as they are infrequent in nature. The gains or losses arising out of these items are disclosed separately in the financial statement of the company.read more.

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 Calculation (Washington REIT Case Study)

Funds from Operations FFO Calculation - 1

  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)

  2. Identify Depreciation and Amortization of Real Estate Assets


    It is part of the Income Statement.

    Depreciation and Amortization (2000) = $22,723
    Depreciation and Amortization (1999) = $19,590
    Depreciation and Amortization (1998) = $15,339

  3. Identify Gains (Losses) on Sales of Assets


    This figure is also part of 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

  4. Identify Gains (Losses) on Restructuring Items or Extraordinary Items


    There are no gains (losses) on restructuring expensesGains (losses) On Restructuring ExpensesRestructuring Cost is the one-time expense incurred by the company in the process of reorganizing its business operations. It is done to improve the long term profitability and working efficiency. This expenditure is treated as the non-operating expenses in the financial statements.read more or extraordinary items in these three years.

  5. Apply Formula


    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 FFO

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 appreciates over time. For this reason, the required depreciation expense, which is charged as per GAAP, tends to make the net income appear artificially low.

FFO also adjusts for non- recurring itemsNon- Recurring ItemsNon-recurring items are income statement entries that are unusual and unexpected during regular business operations; examples include profits or losses from sale of asset, impairment costs, restructuring costs, and losses in lawsuits, and inventory write-off.read more as they do not occur in regular business scenarios. For instance, gains (or losses) on the sale of properties that are to be removed/ added accordingly, as they are not in the 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 CapexCapexCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more for calculating adjusted Funds from operations (AFFO).

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 multiplesP/E MultiplesThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. read more. Thus it is a key driver of share prices as well.

Why is FFO Important for Real Estate?

Differences Between CFO and FFO

Conclusion

Thus the funds from operations concept are required for the analysis of a REIT because when the underlying assetsUnderlying AssetsUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more are increasing in value, then depreciation should not be factored into the results of operations.  It 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 FFO is widely considered for determining REIT’s profitability; it can often be susceptible to accounting changes, restatementsRestatementsA restatement is the revision of already issued financial statements of one or more companies to correct errors with material inaccuracy due to non adhering and complying with the GAAP, accounting mistakes, fraud, or clerical errors affecting part of the entire financial statement requiring a completely new audit.read more, and manipulation. Please consider two or three metrics and other business factors before making an investment decision.

This has been a guide to what is FFO or Funds from Operations. Here we discuss the formula to calculate FFO along with Washington REIT example and why it is an important metric in real estate. You may learn more about Cash Flows from the following articles –

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