FFO: Funds From Operations Explained

FFO, or Funds From Operations, is a crucial financial metric, primarily used to evaluate the performance of Real Estate Investment Trusts (REITs). Unlike net income, FFO aims to provide a more accurate picture of a REIT’s true cash-generating ability. It’s often considered a better indicator of profitability for REITs than earnings per share (EPS) because it excludes items like depreciation and amortization, which are significant non-cash expenses for real estate companies.

Why Use FFO for REITs?

REITs own and operate income-producing real estate. A significant portion of their assets are buildings and land. Accounting rules require these assets to be depreciated over time. Depreciation is an expense that reduces net income but doesn’t represent an actual cash outflow. Since REITs’ core business is generating cash flow from rentals and property operations, depreciation can distort the picture of their financial health. FFO removes this distortion, offering a clearer view of the cash available to distribute to shareholders, which is a primary objective of REITs.

How is FFO Calculated?

The most common formula for calculating FFO is:

FFO = Net Income + Depreciation & Amortization – Gains from Sales of Property + Losses from Sales of Property

Let’s break down each component:

• Net Income: This is the company’s profit after all expenses, including depreciation, interest, and taxes, have been deducted.
• Depreciation & Amortization: This is added back to net income because it’s a non-cash expense. It reflects the reduction in value of assets over time but doesn’t involve an actual cash outflow.
• Gains from Sales of Property: These are subtracted from net income. Gains from selling properties can significantly inflate net income in a given period. Since these gains are often one-time occurrences and don’t reflect the ongoing operating performance of the REIT, they are removed to provide a more sustainable view of earnings.
• Losses from Sales of Property: Conversely, losses from property sales are added back to net income. These losses, like gains, can distort the picture of ongoing operations.

Adjusted Funds From Operations (AFFO)

While FFO is a helpful metric, some analysts prefer to use Adjusted Funds From Operations (AFFO) for an even more refined analysis. AFFO takes FFO a step further by also adjusting for recurring capital expenditures necessary to maintain the properties. These expenditures, such as roof repairs or renovations, are necessary to keep the properties competitive and generate income but aren’t always reflected in FFO. AFFO is generally calculated as FFO less these recurring capital expenditures.

Using FFO for Investment Decisions

Investors use FFO to assess a REIT’s ability to pay dividends. A key ratio is the payout ratio, calculated as dividends paid divided by FFO (or AFFO). A high payout ratio might indicate that the REIT is distributing a large portion of its cash flow and may have limited resources for future growth or unexpected expenses. A low payout ratio might suggest the REIT has more financial flexibility but could also indicate potential for higher dividend payouts in the future.

Limitations of FFO

While FFO is a valuable tool, it’s essential to remember its limitations. It’s a non-GAAP (Generally Accepted Accounting Principles) measure, meaning its calculation isn’t standardized. Different REITs may use slightly different formulas, making direct comparisons challenging. Investors should also consider other factors, such as occupancy rates, lease terms, and debt levels, when evaluating REITs.

In conclusion, FFO is a key financial metric for understanding the performance of REITs. By excluding non-cash expenses like depreciation and gains/losses from property sales, it provides a clearer picture of the cash-generating ability of these real estate-focused companies, ultimately aiding investors in making more informed investment decisions.

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