Funds From Operations: Defined and Explained The Motley Fool

There’s another problem with FFO — not every company defines it the same way NAREIT does. This makes it tricky to compare one REIT to another, and there’s no easy way around this problem. I recommend you check how each of your selected REITs calculates FFO before you make any comparisons.

FFO helps normalize a REIT’s earnings by adjusting for non-cash charges and one-time expenses that don’t fully reflect its underlying earnings. The figure gives investors a better picture of the recurring cash flow a REIT produces that it can use to make dividend payments. It reported funds from operations on its 2017 income statement of $4 billion, up 6% from 2016. The funds from operations measure the net amount of cash and equivalents that flows into a firm from regular, ongoing business activities. FFO should not be seen as an alternative to cash flow or as a measure of liquidity. Where AFFO is adjusted funds from operations, FFO is funds from operations, A is the accrued rent and C is the capital expenses.

Calculating FFO

Some may focus on residential properties while others may focus on office or industrial assets in filling out their portfolios. Each area of focus involves a different set of operating expenses and earning projections. Because of this, you may see other variations of FFO formulas, such as core FFO and normalized FFO on a REIT’s income statement or what is funds from operations prospectus. Specifically, REITs are allowed to write annual depreciation losses off against the net income generated by the REIT. Depreciation also means that capital gains and losses made by the fund through selling assets (property) aren’t a great predictor of how much income an investor can expect a given REIT portfolio to generate.

In fact, if all other investors agreed with our evaluation, XYZ’s price would be much higher because it would need a higher multiple to incorporate these growth expectations. Note that we are showing price divided by FFO, which is market capitalization (market cap) divided by FFO. In this example, XYZ’s market cap (number of shares times the price per share) is about $8 million. Let us understand the concept with the help of a suitable funds from operations example. FFO aids in assessing a REIT’s financial health, growth potential, and dividend-paying capacity.

FFO accomplishes that by stripping out one-time items that affect the cash flow from operations that a company reports on its financial statements. It also adjusts for things that reduce reported net income that don’t affect the underlying recurring cash generated by the business, such as a loss on an asset sale and depreciation. It may be easy to confuse a REIT’s funds from operations and the cash flow from operations.

1. Net income includes non-operational items, while FFO focuses solely on cash flow from a REIT’s core real estate operations.
2. So, while a REIT’s annual EPS might be targeted in the 12% range, the EPS for non-preferred equity shareholders might be closer to 7% or 8%, which is a big difference.
3. As mentioned earlier, FFO is an important metric when studying the financials of a company and assessing the operational efficiency of a company.

Is there any other context you can provide?

This metric measures the corporation’s profitability to net income by factoring out depreciation and amortization expenses, along with taxes and liability costs. Regardless of how industry professionals choose to compute adjusted funds from operations (AFFO), it is considered to be a more accurate measure of residual cash flow for shareholders than simple FFO. Though FFO is commonly used, it does not deduct for capital expenditures required to maintain the existing portfolio of properties, so it doesn’t quite measure the true residual cash flow. Professional analysts prefer AFFO because it takes into consideration additional costs incurred by the REIT—and additional income sources too, like rent increases. Thus, It provides for a more accurate base number when estimating present values and a better predictor of the REIT’s future ability to pay dividends. For real estate investment trusts (REITs), standard metrics like earnings per share (EPS) or price-to-earnings (P/E) ratios may not deliver the most accurate picture you need of performance and value.

Applying a Multiple to FFO/AFFO

The general calculation involves adding depreciation back to net income and subtracting the gains on the sales of depreciable property. Net income includes non-operational items, while FFO focuses solely on cash flow from a REIT’s core real estate operations. Depreciation – Depreciation is an expense allocated to cover capital expenditures (the acquisition of Property Plant and Equipment PP&E, or any fixed assets). Depreciation is a non-cash expense because it is only created for accounting purposes and does not match the timing of when cash was used to buy the asset. The National Association of Real Estate Investment Trusts (NAREIT) originally pioneered this figure, which is a non-GAAP measure.

Companies and investors use it as a benchmark against which the efficiency of the REIT is measured. ‘Funds from Operations’ (FFO) is an important term in the financial statement of a company. For those of you who invest in REIT (Real Estate Investment Trust), FFO is an even more common term and plays an important role in determining the operational efficiency of the investment. In this article, we’ll understand what funds from operations mean in more detail. REIT evaluation produces greater clarity when looking at FFO rather than net income. Prospective investors should also calculate AFFO, which deducts the likely expenditures necessary to maintain the real estate portfolio.

Generally accepted accounting principles (GAAP) require that all REITs depreciate their investment properties over time using one of the standard depreciation methods. However, many investment properties actually increase in value over time, making depreciation inaccurate in describing the value of a REIT. Depreciation and amortization must be added back to net income to reconcile this issue.