Funds from operations (FFO) is a measure of REIT’s (real estate investment trust) cash flows. Calculating funds from operations assists investors in making decisions about the profitability of particular REIT investment. FFO can be considered a decent proxy for net operating income, which is what most private real estate investors focus on when evaluating properties.
Funds From Operations - How To Calculate
The Funds from operations (FFO) metric is meant to be a performance benchmark used by all REITs. FFO and FFO per share figures are used for REITs as traditional stock metrics (earnings per share and P/E ratio) are not as useful for evaluating REITs. Keep in mind that the EPS for REIT could be negative, or perhaps, very low when compared to traditional stock investments. A large-cap consumer staples stock like Proctor & Gamble might seem expensive with a P/E of 20, while a REIT may not look too expensive until it exceeds 40 or even 50.
While there is not absolute standard for this equation, most REITs tend to calculate FFO roughly the same way. A REIT’s income statement contains all of the components essential for working out the FFO formula, including depreciation, amortization, net income, and gains on property sales.
A company’s main cash flow typically comes from rent and not one-time asset sales; therefore, those gains are eliminated in the FFO calculation. If a company refinances a property and takes out net proceeds, those gains are excluded as well. FFO does not consider those relevant cash flows to measure the ongoing profitability of the REIT. The funds from operations metric is only concerned with measuring stemming from ongoing rental operations. This is why FFO multiples are useful valuation tools. Investors should only pay high multiples for ongoing cash flow, not one-time windfalls.
While many REITs will add wrinkles to their reported FFO numbers, the following is the most common way to calculate a REIT’s Funds From Operations:
Net Income
+ Depreciation
+ Amortization
- Gains on Property Sales or Loan Refinancings
= Funds from operations (FFO)
Acquiring the information is typically a 3-step process. First you acquire the net income figure (the company’s profit). This can be found at the bottom of most income statements that REITs file publicly. Depreciation and amortization are accounting figure (not actual cash expenses) that spreads out asset value over its useful life. These expenses reduce net income from an accounting standpoint only. They don’t actually reduce the amount of cash a company receives from its properties.
Once depreciation and amortization charges are added back, an investor must then subtract any gains that came from the sale of the property.
GAAP (generally accepted accounting principles) rules require that over time, REITs depreciate their investment properties by using one of several depreciation methods as required by the IRS. Once again, these are just paper expenses, not actual cash leaving the company. Therefore, depreciation can mask and distort the actual property value, considering that investment properties usually appreciate in value. Consequently, both depreciation and amortization need to be added to the net income to reconcile this accounting treatment.
Picking REITs Using FFO
Unlike equity investors who look at the ratio of EPS (earning per share) price to earnings ratio during stock analysis, REIT investors use FFO. While there is no one magic number to pick winners (wouldn’t that be nice), a REIT’s FFO multiple (stock price divided by funds from operations) is probably as close as one can get. It defines the value an investor is getting from that REITs cash flows. Since REIT income (contractual rent obligations) are often stable, this backward-looking metric is often in line with near term future profits. Casual REIT investors should also look to analyst estimates (or guidance from the REIT) on forward FFO estimates just to make sure there hasn’t be a large sale of properties or material impact to the company’s ongoing operations.
Adjusted Funds From Operations (AFFO)
Adjusted funds from operations (AFFO) is arguably a better data point for predicting a REIT’s health. Reason being: AFFO accounts for large and ongoing capital expenses necessary to run the properties and generate ongoing profits into the future. Real estate that is neglected from a capital perspective will not continue generating rents. At some point, wear and tear and building systems will fail if landlords fail to reinvest back into their properties.
Unfortunately, most real estate investors (both retail and professional) overlook capital expense requirements when evaluating real estate. It’s easy to dismiss large capital expenses as “one-time items” or ongoing capital reserves as excessive. This can be a costly mistake that usually surfaces when that REIT starts running low on cash – despite reporting strong FFO figures – and either needs to reduce its dividend or issue more dilutive shares to fund operations.
Consequently, AFFO is often used by professional REIT investors and analysts as it’s a superior measurement of a REIT’s ability to pay dividends and sustain operations.
To calculate AFFO – which many REITs do not report on – investors must identify recurring costs for building improvements and subtract them from FFO.
Bottom Line
This will sound obvious, but make to consider the price you pay relative to future cash flows when buying REITs. If dividends are your priority, be sure to confirm that FFO / AFFO metrics are stable. Do not base your decision solely a high dividend yield REIT that looks great on paper but can’t be sustained.
