REITs and the Fallacy of FFO

Includes: AMB, HCP, PLD
by: Richard Woon

While most stocks are evaluated according to their earnings, Real Estate Investment Trusts (REITs) are evaluated according to Funds From Operations (FFO). Analysts believe that FFO provides for the best measure of value for REITs like ProLogis (NYSE:PLD), Simon Property Group (NYSE:SPG) and HCP, Inc. (NYSE:HCP). I argue the opposite is true under current market conditions. In a declining real estate market FFO grossly overstates the value of a REIT’s earnings, particularly when acquisitions were made at the height of the market.

What is FFO?

In their online glossary, the National Association of Real Estate Investment Trusts [NAREIT], a REIT trade and lobbying group, defines FFO as follows:

Funds From Operations (FFO) The most commonly accepted and reported measure of REIT operating performance. Equal to a REIT's net income, excluding gains or losses from sales of property, and adding back real estate depreciation.

Basically, you get FFO by taking Net Income per Generally Accepted Accounting Principles (GAAP) and reversing gains or losses from sales and depreciation expense. It is the latter that will greatly distort the value of a REIT in difficult times.

What is the Rationale for the Use of FFO?

Analysts believe that FFO is a better measure of a REIT's health than net income because of the belief that real estate consistently appreciates in value. According to the NAREIT's white paper on Funds From Operations (2002):

Historical cost accounting for real estate assets implicitly assumes that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen or fallen with market conditions, many industry investors have considered presentations of operating results for real estate companies that use historical cost accounting to be insufficient by themselves.

The term Funds From Operations was created to address this problem. It was intended to be a standard supplemental measure of REIT operating performance that excluded historical cost depreciation from — or "added it back" to — GAAP net income.

Thus, Depreciation is reversed because, in theory, real estate values increase over time so it is unfair to subtract depreciation from income because such assets would likely be sold for a profit at a later date and would not depreciate to zero like equipment. I believe it is a fallacy to reverse depreciation expense in a down real estate market. Particularly when it is known fact that a real estate asset has decreased in value, depreciation should be accelerated and included in FFO.

Consider the hypothetical case of a REIT A that owns one asset: a residential home that is leased for income. REIT A purchased the home on January 1, 2005 for $375,000 (assume $100k is attributable to land & $275K is attributable to building). The home rents for $3,000 per month or $36,000 per year for 2005 and 2006 (assume constant rents for 2005 & 2006 (for simplicity)). Interest, taxes and insurance are $500 per month or $6,000 per year. Here is the 2005 & 2006 Income Statement for REIT A:

REIT A has 10,000 outstanding shares of common stock. Thus, earnings per share (EPS) is $6k / 10,000 or $0.60. However, REIT A would also report an FFO calculation by reversing the depreciation expense. Thus, FFO for REIT A would be:

* = Assume 27.5 year straight line depreciation ($275,000 ÷ 27.5 = $10,000)

Per share FFO will be $1.60 per share ($16K ÷ 10,000 shares = $1.60). You can see that the majority of the FFO number is a result of the reversal of depreciation. Indeed, this might be fair in a rising or stable real estate market.

However, assume that the rental home was purchased in 2005 in Stockton, California where home prices have dropped 50%-60%. Also, assume that the excess in inventory has also hurt rent pricing and the home can only be rented for $2,750 per month ($33,000 per year). Here is the Net Income for 2007 in that case:

You can see that Net Income has been cut in half from $6k to $3k. Now, let’s take a look at FFO for 2007:

You can see that FFO decreases very little in comparison with Net Income. FFO only drops 18.75% as compared to a 50% decrease in Net Income.

Is it really fair to continue accepting NAREIT's FFO metric when we actually know for a fact that that an asset has significantly depreciated in value much faster than the 27.5 year straight line depreciation schedule? FFO's continued use does not make any common sense, yet analysts continue to rely on it as dogma and refuse to challenge its validity.


Analyst’s continued emphasis on FFO has incented REITs to continue to acquire assets without regard to long-term cash profitability because a REIT will get more depreciation reversal if it grows its balance sheet. This motivation combined with the availability of credit over the past few years has resulted in irresponsible acquisitions from a sustainable business standpoint. Unfortunately, credit is not as easy to obtain now, so many REITs will suffer from real cash problems regardless of the FFO games.

Disclosure: Short PLD & HCP, No Position in SPG or AMB

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