Funds from Operations (FFO)

Definition

Funds from Operations (FFO) is a financial performance metric used primarily by real estate investment trusts (REITs) to measure their cash generated from operations. It adjusts net income by adding back depreciation and amortization expenses, along with any losses on sales of properties, providing a clearer picture of a REIT's operating performance and cash flow. This metric is crucial in evaluating the financial health of REITs, especially when comparing different types and structures.

5 Must Know Facts For Your Next Test

1. FFO is commonly used by investors to evaluate the operating performance of REITs, as it provides a better indication of cash flow than net income due to its adjustments.
2. The formula for calculating FFO is: Net Income + Depreciation and Amortization - Gains on Sales of Properties.
3. Unlike traditional corporations that might rely heavily on net income, REITs focus on FFO because they typically have significant depreciation expenses related to their property holdings.
4. FFO can be impacted by various factors including property acquisition or disposition activities, as well as changes in rental income.
5. Many analysts consider FFO a key metric when assessing dividend sustainability for REITs since it reflects the cash available for distributions to shareholders.

Review Questions

• How does FFO differ from net income, and why is this distinction important for evaluating REITs?
  • FFO differs from net income because it adjusts for non-cash items like depreciation and amortization, which are significant for real estate assets. This distinction is important because it provides investors with a clearer understanding of the actual cash flow generated by a REIT's operations. Since REITs are required to distribute at least 90% of their taxable income as dividends, understanding FFO helps assess whether they can sustain these payouts based on real operating performance rather than accounting adjustments.
• Discuss how FFO impacts investment decisions when comparing different types of REITs.
  • FFO plays a crucial role in investment decisions as it allows investors to compare the operational efficiency and profitability of different types of REITs, such as equity REITs versus mortgage REITs. Equity REITs generate revenue primarily through leasing space and collecting rents, while mortgage REITs earn income from mortgage interest. By analyzing FFO, investors can identify which type of REIT might offer better returns based on their operational performance. Furthermore, investors can use FFO to gauge growth potential and make informed decisions based on current market conditions.
• Evaluate the significance of adjusted funds from operations (AFFO) in relation to funds from operations (FFO) when assessing the financial health of a REIT.
  • Adjusted funds from operations (AFFO) provide an even deeper insight into a REIT's financial health compared to FFO by accounting for necessary capital expenditures that maintain property value. While FFO shows operating performance, AFFO reflects the actual cash available for distribution after considering these costs. This makes AFFO a more conservative measure when evaluating a REIT's ability to sustain dividends over time. Investors often prefer AFFO as it gives a clearer picture of true cash flow and dividend sustainability in the context of ongoing property management needs.

Related terms

Net Income: The total profit of a company after all expenses, taxes, and costs have been subtracted from revenue.

Real Estate Investment Trust (REIT): A company that owns, operates, or finances income-producing real estate and allows investors to buy shares in the company to gain exposure to real estate markets.

Adjusted Funds from Operations (AFFO):

A more refined measure than FFO that accounts for capital expenditures necessary to maintain the quality of the underlying assets, offering an even clearer view of the REIT's cash flow.