What are “Funds from Operations”?
Funds from Operations (FFO) is one of the main metrics used to understand and analyze the income statements of Real Estate Investment Trusts (REITs) and is generally used in reference to operating cash flows generated by it. A REIT is a company that owns, operates or finances income-generating real estate and it can be private or trade on a major stock exchange. FFO aims to address certain drawbacks associated with using net income, under generally accepted accounting principles (“GAAP”), as a measure of the operating performance of REITs.
FFO is the appropriate, more reliable or widely used metric to determine the profitability of an REIT, rather than net income. This is because, unlike other assets, real estate tends to appreciate over time which makes depreciation inaccurate in describing the value of an REIT (i.e. in such cases, depreciation should not be factored into the results of the operations). But the required depreciation expense is charged, as per GAAP, on the income statement. As a result, net income appears artificially low (i.e., as depreciation is deducted from net income).
Key Learning Points
- Funds from Operations (FFO) is a key metric used to understand and analyze the income statements of Real Estate Investment Trusts (REITs)
- The income statement of REITs could be misleading due to GAAP depreciation expenses so FFO is often preferred as a metric to show the ongoing regular business activities
- REITs also show gains and losses on asset sales on their income statement, which are purely accounting metrics with no actual cash flows
- Funds from Operations address both depreciation and gains and losses on real estate transactions
- FFO is a non-GAAP term, and there is some non-uniformity on how it is calculated.
- To calculate FFO, depreciation, amortization and losses on asset sales are added back to net income and any gains on asset sales and interest income are deducted.
Understanding FFOs in REITs
REITs are very asset-intensive, and their growth is driven by their balance sheet assets. As a result, they report large depreciation expenses on their income statements. However, there is a difference between the depreciation expenses of real estate businesses and other businesses.
In manufacturing or technology companies, one can make a case that as assets are being utilized they are likely to lose their value over time. However, that is not necessarily true in relation to real estate. Most real estate assets may appreciate over time. As a result, depreciation expenses on the income statement could be misleading and represent an accounting loss of value rather than a market loss.
Depreciation is a non-cash charge and deducting it doesn’t give a true picture of a company’s cash flows. Likewise, the gains and losses on real estate sales could also be misleading as these are purely accounting gains and losses and not actual cash flows.
Funds from operations address both depreciation and gains and losses on real estate transactions (refer to the formula below).
Formula: Funds from Operations
FFO is a non-GAAP term. As a result, there is some non-uniformity in how it is calculated. The usual formula for FFO is:
FFO = Net income + (depreciation + amortization + losses on asset sales) – (gains on asset sales + interest income)
FFO helps in comparing a REIT’s performance with other REITs. Asset sales here refers to real estate sales.
Given below is a basic income statement for a REIT. The FFO has been calculated, based on the same.
Using the formula above, the FFOs are calculated as follows:
From the aforesaid calculations, it is evident that the FFO is higher than net income. However, investors and analysts should treat FFO only as a supplemental metric to understand the operational income of this business. This can be used on a per-share basis.
FFO is not the same as a REIT’s Cash Flow from Operations (found on the Cash Flow) as this can also include the purchase and sale of assets.