Funds from Operations (FFO) is a critical financial statistic used largely in the real estate investment trust (REIT) industry to assess the cash earned by a company’s operating activities. FFO gives investors a better understanding of a REIT’s operating performance by removing non-cash factors and property value variations.
Components of Funds From Operations
1) Net income:
- The net income shown on the income statement serves as the starting point for computing FFO.
2) Depreciation and Amortization:
- Recover depreciation and amortization expenditures. These non-cash expenses are crucial for REITs since real estate assets often gain over time rather than depreciate, thus these deductions may not accurately reflect actual performance.
3) Gains and Losses in Sales:
- Exclude earnings or losses from the sale of property. Such transactions are regarded non-recurring and may affect the REIT’s genuine operational profitability.
Formula.
FFO = Net Income + Depreciation and Amortization − Gains on Sale of Property + Losses on Sale of Property
Importance of FFO
1) Performance Measurement:
- FFO is regarded as a more reliable indicator of a REIT’s operational performance than net income. It focuses on core activities while excluding non-recurring and non-cash items that have no impact on the REIT’s cash-generating potential.
2) Investor Insights:
- Investors use FFO to assess the sustainability of dividend payments. Given that REITs are mandated to release a considerable amount of their earnings as dividends, understanding the cash flow available for distribution is critical.
3) Valuation Metrics:
- FFO is commonly employed in valuation metrics such as the FFO multiple (price/FFO), which is analogous to the price/earnings (P/E) ratio used for other types of equities. This allows investors to compare REITs on a regular basis.
Example:
Assume a REIT reports a $10 million net income, $2 million in depreciation and amortization, and a $1 million gain on the sale of property. The FFO would be calculated as follows:
FFO = $10 million + $2 million − $1 million = $11 million
Conclusion:
Funds from Operations is an important statistic for analyzing REIT performance because it provides a more realistic view of operational efficiency and cash-generating capacity. By removing non-cash and non-recurring factors, FFO assists investors in determining the sustainability of dividends and comparing the relative value of various REITs. Understanding FFO is critical for anyone considering investing in or studying real estate investment trusts.
