Funds From Operations (FFO): Explained
Funds from operations (FFO) is a metric used by investors to evaluate the financial performance of a real estate investment trust ((REIT)). Continue reading to learn more about what it is and how its calculated.
What Is Funds From Operations (FFO)?
Funds from operations (FFO) is a measure of the amount of cash flow generated by a company's business operations. FFO is commonly used to evaluate the operating performance of a real estate investment trust (REIT), a business that primarily operates income-producing real property.
Since real estate companies commonly use FFO as a benchmark for performance, investors may also use FFO to evaluate a REIT equity investment before buying shares.
FFO is a useful tool for evaluating performance of an REIT because it only includes items central to business operations, and excludes non-cash items like depreciation and amortization, while also adjusting-out gains and losses on property sales. Interest income is also removed in calculating FFO.
Important: FFO should not be confused with cash flow from operations, which is found on the company's statement of cash flows. Furthermore, FFO is not based upon Generally Accepted Accounting Principles (GAAP); FFO originates from the National Association of Real Estate Investment Trusts (NAREIT).
The calculation for FFO can be made by retrieving accounting data found on the income statement and inserting this data into the FFO formula.
The FFO formula is:
FFO = Net Income + Depreciation + Amortization + Losses on Sales of Asset - Gains on Sales of Assets - Interest Income
How To Calculate FFO
In many cases, investors will not need to do their own FFO calculations because a REIT's FFO is typically included in the footnotes section of the income statement.
If you do need to calculate funds from operations, start by collecting all data needed from an income statement.
Step 1: Start With Net Income
This is the REIT's profit, or "bottom line," which can be found at the bottom of the income statement.
Step 2: Add Back Depreciation, Amortization and Losses on Sales of Assets
These items can be found in the operating expenses section of the interest statement. These values were deducted in reaching net income, and by adding these values back we are essentially adjusting them out of the calculation of FFO.
Step 3: Subtract Gains on Sales of Assets & Interest Income
Gains on sales of assets is adjusted, similarly to losses on sales, but by way of subtraction. Interest income, which also contributed towards net income, are also subtracted. Gains on asset sales is a field typically found in the "other income" section, while interest income is commonly included under revenues.
Important: Real estate assets often appreciate in value, as opposed to depreciating. The FFO measure captures this tendency by adding back the depreciation that was subtracted in calculating net income.
Funds From Operations Example
For an example of an REIT FFO calculation, let's say XYZ Property Group had $5M in net income, $1M in depreciation expenses, $500K in amortization expenses, $250K in interest income, $1M in gains of the sales of assets, and no losses on the sale of assets.
Starting with $5M net income, add $1.5M in depreciation and amortization, then subtract the $1M in gains on the sales of assets and the $250k in interest income. FFO for XYZ Property Group comes out to be $5.25M.
$5M + $1.5M - $1M - $250k = $5.25M
Applying Funds From Operations
Funds from operations (FFO) is a primary means of gauging how profitable a REIT's operations are and can be used in a similar manner to net income or earnings per share (EPS). Instead of viewing valuation on a Price/Earnings basis, REIT stocks are usually viewed on a Price/FFO basis.
A main reason that FFO is better for measuring performance of a REIT, compared to using net income or EPS, is that adjusts-out depreciation and amortization expenses. Real estate assets are generally appreciating assets, which means that depreciation expense may not be truly indicative economically. Adding back depreciation usually provides a more clear picture of REIT financial performance.
When evaluating funds from operations, a REIT investor may compare current FFO with the historical FFO numbers for the same company. They may also use FFO in conjunction with other financial metrics, such as debt-to-income ratio to evaluate REITs. REIT investors may also use a variation of FFO called 'adjusted funds from operations', or AFFO.
Adjusted funds from operations (AFFO) is a related metric that considers a REIT's capital expenditures (capex). Considering capex adds another level of detail in terms of measuring actual cashflow, as compared to FFO.
The calculation of AFFO for a particular REIT may not be standardized, given some variability in defining the capex number. AFFO can effectively be used to better measure a REIT's ability to pay dividends from its net earnings.
FFO vs. EBITDA
FFO and EBITDA are similar in that both metrics are used as an alternative to net income, and both adjust-out depreciation and amortization. The main difference between FFO vs EBITDA is that FFO is used to measure free cash flow from operations while EBITDA attempts to measure profitability from operations.
FFO vs. Net Operating Income
Net operating income (NOI) can be a useful calculation to measure the profitability of a REIT. But NOI ignores operational expenses, taxes and interest expenses while FFO does factor these expenses into its calculation. For this reason REIT investors will often prefer FFO to NOI.
Funds from operations, or FFO, is a valuation measure used to evaluate the operating performance of a real estate investment trust (REIT). Since a REIT is an income generating business, FFO can serve as a preferable alternative to net operating income or EBITDA.
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