What do funds from operations mean?
Funds from operations (FFO) refers to the figure used by real estate investment trusts (REITs) to define the cash flows from their activities.
The FFO is calculated by adding depreciation and amortization to earnings, then subtracting any gain on sales. It is sometimes listed per share. The FFO per share ratio should be used in place of earnings per share (EPS) when valuing REITs and other similar investment trusts.
Operating Fund (FFO)
Understanding funds from operations (FFO)
FFOs are a measure of the cash flow generated by a REIT; real estate companies use FFOs as a benchmark for operational performance. The National Association of Real Estate Investment Trusts (NAREIT) was behind this figure, which is a non-GAAP measure.
The formula for FFO is:
FFO = net income + depreciation + depreciation – gains on sales of goods.
All the components of the calculation of FFO are listed in the income statement of the REIT. If, for example, a REIT had $ 20,000 in impairment, $ 40,000 in property sales gains and $ 100,000 in net income, its FFO would be $ 80,000. All REITs are required to present their FFO calculations in the public financial statements. They normally disclose the measure as a footnote on the income statement.
The FFO should not be confused with the REIT’s operating cash flows, which are reported in the company’s statement of cash flows and rather measure the net amount of cash and cash equivalents that enter a business based on regular and continuous commercial activities. FFOs should not be seen as an alternative to cash flow as a measure of liquidity.
Why FFO is a good measure of REIT performance
The FFO compensates for cost accounting methods that can inaccurately communicate the true performance of a REIT. GAAP accounting requires that all REITs depreciate their investment property over time using one of the standard depreciation methods. However, many investment properties actually increase in value over time, making the depreciation inaccurate in describing the value of a REIT. Depreciation and amortization must be added to net income to reconcile this problem.
The FFO also subtracts any gain on sales of goods because these types of sales are considered non-recurring. REITs must pay 90% of all taxable income in the form of dividends. Gains on sales of real estate are not added to the taxable income of a REIT and therefore should not be included in the valuation of value and return.
As mentioned above, FFO per share is sometimes provided by companies in addition to their EPS figure for the reasons mentioned above. Likewise, many analysts and investors assess the price-to-FFO ratio of a REIT as a supplement to the price-to-profit ratio.
Adjusted operating funds
Increasingly, real estate analysts are also calculating an REIT’s adjusted operating funds (AFFO). This calculation takes the FFO of a REIT and subtracts all recurring expenses that are capitalized and then amortized, as well as any linear alignment of rents. These recurring capital expenditures may include maintenance expenditures such as paint projects or roof replacements. AFFO has gained ground as a more accurate estimate of the profit potential of a REIT.
The AFFO measure was developed to provide a better measure of the cash or dividend capacity generated by a REIT. In addition to AFFO, this alternative measure is sometimes called funds available for distribution or cash available for distribution.
Example of a REIT’s FFO
The popular shopping center REIT Simon Property Group declared operating funds in its 2020 income statement of $ 4 billion, up 6% compared to 2020. The company’s net profit, meanwhile, amounted to $ 2.2 billion. To get to FFO, the company added about $ 1.8 billion in depreciation and amortization, and further adjusted for other smaller numbers – including a $ 5.3 million reduction in payment distributions and preferred dividends; and a portion of the non-controlling interest in depreciation and amortization which resulted in an additional reduction of $ 17.1 million. Simon also declared a diluted FFO per share of $ 11.21, compared to a diluted EPS of $ 6.24.