What is Funds from Operations (FFO)?

FFO is a financial performance metric widely used in the real estate industry to measure the cash flow generated from a REIT’s core business operations. It was developed by the National Association of Real Estate Investment Trusts (NAREIT) as a standard measure for comparing the operating performance of REITs.

Unlike ‘Net Income’, which includes depreciation and amortization, FFO focuses on the recurring, operational aspects of a REIT. Since real estate assets typically appreciate over time, deducting depreciation can skew the actual cash flow and profitability picture.

FFO should not be considered a substitute for cash flow or a measure of liquidity. For instance, while a company's cash flow may be affected by income from the sale of an asset, FFO excludes such gains. Additionally, if a company receives loan proceeds from a bank, this would appear as a cash inflow on the Cash Flow Statement, but FFO does not account for these inflows. Instead, FFO focuses solely on income generated from core business operations. It should also not be confused with Cash Flow From Operations (CFO) as that is derived using cash flow statement which also accounts for working capital changes.

Why is FFO Important for REIT Investors?

1. More Accurate Reflection of Cash Flow: FFO provides a more accurate picture of a REIT’s operational cash flow than net income. By excluding non-cash expenses such as depreciation, FFO shows how much cash is generated from regular real estate operations.
2. Comparability Across REITs: Since FFO is standardized by NAREIT, it allows for better comparisons across different REITs. Investors can use FFO to compare the performance of various REITs, even if they focus on different types of properties, such as commercial, residential, or industrial real estate.
3. Assessment of Dividend Sustainability: One of the main attractions of investing in REITs is the dividend income they provide. Since REITs are required by law to distribute at least 90% of their taxable income to shareholders, FFO helps investors assess the sustainability of dividend payments. Higher FFO indicates a greater ability to generate the cash needed to maintain or increase dividends.
4. Exclusion of Non-Recurring Items: FFO eliminates gains / losses from property sales, which are not recurring and can distort a REIT’s profitability. This provides a clearer view of the REIT's core operational performance.

How Financial Models Helps in Analyzing FFO

Financial modeling plays a critical role in understanding FFO and predicting future cash flows. By incorporating factors like property depreciation for existing and new properties, changes in occupancy rates, and capital structure (which impact the interest), financial models allow analysts to simulate various scenarios and see how these factors will impact a REIT's FFO. This helps REITs plan their leasing strategies, assess potential acquisitions, and forecast dividend payouts.

Formula for Calculating FFO

The formula for calculating FFO is:

FFO = Net Income + Depreciation and Amortization − Gains / (Losses) from Property Sales

Metrics calculated using FFO

1. FFO Growth: When analyzing a REIT, look for consistent growth in FFO over time. This indicates that the REIT is successfully increasing its rental income and managing its property portfolio effectively.
2. Price to FFO Ratio: Similar to the Price-to-Earnings (P/E) ratio for stocks, the Price-to-FFO ratio helps investors determine whether a REIT is fairly valued. A lower ratio could indicate that the REIT is undervalued, while a higher ratio might suggest overvaluation.
3. FFO Payout Ratio: This metric compares the REIT’s dividends paid to its FFO. A lower payout ratio indicates that the REIT is retaining more cash to reinvest in its portfolio or weather economic downturns, while a higher ratio suggests that the REIT is distributing a larger portion of its earnings as dividends.

Conclusion

Funds from Operations (FFO) is a critical metric for evaluating REIT performance. By focusing on the cash flow generated from core operations and excluding non-cash expenses, FFO offers a clearer understanding of a REIT’s ability to generate income and sustain dividend payments. For investors, FFO is a powerful metric that helps in comparing REITs, assessing dividend sustainability, and making informed investment decisions.