Summary:
FFO is the most definitive measure of evaluating the performance of REITs helping us gain deep insights into their financial health. In this blog, we will explore what FFO encompasses, how we can calculate it, and its significance for REITs. We are hoping to help both investors and real estate professionals with this.
Funds From Operations (FFO) is a financial metric. It is primarily used in the domain of the real estate investment trust (REIT) to help gauge the generated cash flow by the core operations of the industry. Compared to traditional accounting metrics like net income, FFO paints a significantly more accurate picture of the financial performance of a REIT. As a result, it has found wide usage by investors and analysts when evaluating a REIT’s financial health and profitability. In this blog, we shall explore how FFO is calculated and what it represents for businesses.
Calculating FFO
You can use the following formula to calculate FFO for a REIT:
| Net Income + FFO = Depreciation and Amortisation of Real Estate Assets - Gains (or + Losses) on the Sale of Real Estate |
Now let us unravel what each of these factors indicates.
- Net Income: This shows the net earnings of the REIT as per its financial statement reports.
- Depreciation and Amortisation of Real Estate Assets: Depreciation is a non-cash expense. And since most real estate assets like buildings and properties are subject to gradual depreciation, it is crucial.
- Gains (or Losses) on the Sale of Real Estate: Gains realised by the REIT on real estate assets represent a one-time, non-operating gain. Similarly, losses are also represented as non-recurring losses.
Steps of calculating FFO
Now that you have a basic understanding of the elements involved, let us explore how you will calculate the FFO for a REIT.
Step 01:
Retrieve the net income figure, representing the company's profit. You can locate it at the bottom of the REIT’s income statement.
Step 02:
Identify the depreciation and amortisation. These are a portion of the REIT’s expenses towards tangible (physical) and intangible assets throughout the duration of the reporting period. Over time, these measures evenly distribute the costs associated with assets. We need to add depreciation and amortisation to the REIT’s net income to ascertain the actual revenue generated from operations or its real cash inflow. This is because these expenses reduce the net income for the accounting period.
Step 03:
Now, let’s look at losses. Include any losses incurred from the sale of business property. Most commonly, losses would involve assets like property, plant, and equipment (PP&E) that are long-term in nature. Since these are classified as one-time and non-recurring events that fall outside the scope of regular operations, you don’t need to factor them into the FFO calculation.
Step 04:
Next, any gains or revenue made from property sales from the overall sum of net income, depreciation, and amortisation need to be removed. This is critical to determining the funds from operations within the given timeframe.
Step 05:
Finally, you must subtract any interest that’s earned by the REIT as the associated income does not typically constitute a routine component of its regular operations. Make sure to eliminate it from the final FFO calculation.
What FFO Represents
FFO represents a definitive metric that can be leveraged to gauge the cash generation of a REIT. With its origins in the National Association of Real Estate Investment Trusts (NAREIT), most real estate firms today have commonly adopted FFO as a key performance indicator. However, note that FFO is a non-GAAP measure.
Also understand that while FFO indicates the net cash and equivalents derived from a company's routine, ongoing business operations, it cannot be considered a substitute for the company’s cash flow or as an indicator of its liquidity.
Significance of FFO for a REIT
For a REIT, FFO is a critical metric that serves as an accurate representation of its cash flow. There are several reasons behind its significance:
- Regulatory Compliance: First, many REITs are legally mandated to report FFO along with other traditional financial metrics by the regulatory authorities.
- Comparison Across REITs: FFO removes several accounting differences and focuses solely on the key income-generating aspects of REITs. Thus, they pave the way for more straightforward comparisons of different REITs.
- Cash Flow Emphasis: The domain of real estate is often a cash-flow-intensive business. Since FFO reflects the cash generated by a REIT's operations, it provides a better picture of a REIT's ability to generate cash and pay dividends to its investors.
- Real Estate Focus: FFO focuses on the core operations of owning and managing the income-generating real estate properties that REITs generally invest in. Here, the effects of depreciation and gains/losses on the sale of properties are not considered.
In Conclusion
Despite its key traits, you must note the limitations of FFO. For example, an FFO calculation does not consider:
- All operating expenses of the REIT including interest payments
- Changes incurred over time in the value of the properties of a REIT
Therefore, investors often use FFO in conjunction with other financial metrics, such as adjusted funds from operations (AFFO). This helps to get a more comprehensive view of the financial health and performance of a REIT. Moreover, you should further adjust FFO for certain recurring capital expenditures and other items that have an impact on cash flows.