What is Funds From Operations (FFO)?
Funds From Operations (FFO) is a crucial financial metric primarily employed by Real Estate Investment Trusts (REITs) to gauge their operational cash flow. Unlike traditional profit measures such as net income, FFO offers a clearer picture of a REIT's operating performance by adjusting for various accounting anomalies, particularly those associated with real estate assets.
Key Takeaways
- Definition: FFO is a metric used by REITs to define cash flow generated from their core operations.
- Exclusion of Non-Recurring Incomes: FFO specifically excludes one-time gains or cash inflows, focusing instead on income derived from regular business activities.
- Adjusted FFO: A further refinement, known as adjusted funds from operations (AFFO), is used to present a more accurate depiction of a REIT's dividend-paying capacity by accounting for recurring capital expenditures.
Calculating FFO
The formula for calculating FFO is as follows:
FFO Formula
[ \text{FFO} = (\text{NI} + \text{D} + \text{A} + \text{PSL}) - \text{PSG} - \text{II} ]
Where: - NI = Net Income - D = Depreciation - A = Amortization - PSL = Property Sales Losses - PSG = Property Sales Gains - II = Interest Income
Calculation Steps
- Determine Net Income: Start with the net income figure, found at the bottom of the income statement.
- Add Back Depreciation and Amortization: These figures represent accounting practices that spread asset costs over time. Since they reduce net income, they are added back to reflect cash flow more accurately.
- Include Property Sales Losses: Add any losses incurred from the sale of properties. This is viewed as a non-recurring expense.
- Subtract Property Sales Gains: Any gains from property sales must be deducted, as they do not represent ongoing business activities.
- Exclude Interest Income: Finally, deduct any interest income, as it typically does not form part of a REIT's regular operations.
Example Calculation
Consider a REIT with the following financials: - Net Income: $100,000 - Depreciation: $20,000 - Gains on Property Sales: $40,000
Here, FFO would be calculated as:
[ \text{FFO} = (\$100,000 + \$20,000) - \$40,000 ] [ \text{FFO} = \$80,000 ]
Importance of FFO in REIT Evaluation
FFO as a Performance Benchmark
FFO serves as an essential performance benchmark for REITs. It was standardized by the National Association of Real Estate Investment Trusts (NAREIT) to better reflect the cash-generating ability of these companies relative to traditional metrics.
Unique Properties of FFO
- Operational Insight: FFO provides insight into a REIT's cash flow derived from its ongoing operations, excluding volatile one-time sales gains.
- Dividend Capability: Given that REITs are mandated to distribute at least 90% of their taxable income as dividends, FFO is crucial for assessing how much cash is available for these distributions.
- Avoiding Distorted Depreciation Effects: Since many properties tend to appreciate, FFO compensates for the potentially misleading effects of applying standard depreciation accounting.
FFO vs. Adjusted Funds From Operations (AFFO)
While FFO provides a solid foundational measure, many analysts and investors also look at Adjusted Funds From Operations (AFFO). This metric subtracts recurring capital expenditures and accounts for rent adjustments, offering even more clarity regarding a REIT's cash-on-hand for dividends and growth initiatives.
What is AFFO?
- Adjusted FFO (AFFO) quantifies a REIT's operational income after accounting for all capital expenditures necessary to maintain its existing property portfolio. This makes it a preferred choice for assessing potential dividends.
Example Use of FFO
A notable example is Simon Property Group, a leading retail REIT that reported FFO of $4 billion in 2017, an increase from the previous year. Their net income stood at $2.2 billion, highlighting the significant role that depreciation and amortization played in adjusting their cash flow insights.
Conclusion
Funds From Operations (FFO) play a critical role in assessing the operational performance of REITs, offering a clearer perspective than conventional financial measures. By filtering out distortions from accounting practices and focusing on cash flows generated from core business activities, FFO helps investors, analysts, and stakeholders make informed decisions regarding their investments in the real estate sector. Remember, you can find FFO calculations in the public financial statements of REITs, typically disclosed in the footnotes, allowing for easy evaluation during your investment analysis.