Funds from operations (FFO) is a number used by real estate companies called real estate investment trusts (or REITs) to measure their operating performance. It is considered a more reliable measure of a REIT’s value than traditional metrics, such as earnings per share (EPS) or price-to-earnings (P/E) ratio.
REITs hold a portfolio of commercial real estate or real estate loans and are designed to provide small investors with access to income-producing commercial real estate. If you own a REIT or are looking to invest in one, it’s important to know its FFO.
Read on to learn how to calculate FFO, what this metric can tell you about a firm, and how FFO differs from other measures of performance and profitability.
What Is FFO?
FFO stands for “funds from operations” and describes cash flows produced by a REIT’s operations. FFO is calculated by adding depreciation and amortization and losses on sales of assets back to net earnings, and then subtracting any gains on sales of assets and any interest income.
It is sometimes quoted on a per-share basis, called the FFO-per-share ratio. To assess the value of a REIT, owners and investors are more likely to look at its FFO-per-share ratio than its EPS. Lenders might also look at a REIT’s FFO and FFO-per-share ratio when considering whether or not to issue a real estate business a small business loan.
While FFO is a valuable metric, it is not recognized by the Generally Accepted Accounting Principles (GAAP), the standardized set of principles public companies in the U.S. must follow.
FFO Formula
Calculating a REIT’s FFO is straightforward once you understand the terms and where to find the figures.
The FFO formula is:
FFO = (Net Income + Depreciation + Amortization + Losses on Property Sales) – Gains on Sales of Property – Interest Income
All the variables of the FFO formula can be found on a firm’s income statement.
FFO Calculation
The FFO calculation is important when assessing the cash flow of a REIT. How much a REIT can borrow with different types of small business loans might be based, in part, on its FFO because it indicates the company’s operational strength. Let’s look deeper into where to find each term in the FFO formula and explain its purpose.
• Net income: This is the company’s profit and is listed on the bottom line of the income statement. It’s a GAAP measurement, but it’s not always the best method for assessing the value of a REIT.
• Depreciation: This is an expense line item associated with the declining value of durable assets like property, plant, and equipment (PPE) and other fixed assets. However, real estate is different from most fixed-plant or equipment investments because property loses value infrequently. Instead, it often appreciates. Thus, it can make more sense to judge REITs by FFO, which excludes depreciation.
• Amortization: This is like depreciation but it’s done with intangible assets, such as licenses, patents, and copyrights. These items do decline in value over time (due to expiration), but since this is a non-cash expense, it does not impact cash flow.
• Losses and gains on property/asset sales: This typically includes long-term assets such as PPE. Because these losses and gains are considered one-time, or non-recurring, they are not part of normal operations and are not included in the FFO calculation.
• Interest income: Interest income is also considered a non-recurring item, and is removed to arrive at a REIT’s FFO.
Uses of FFO
FFO is a useful tool for evaluating the performance of a REIT because it only includes items central to business operations and excludes non-cash items (like depreciation and amortization) and gains and losses on property sales. Interest income is also removed in calculating FFO.
REIT owners, investors, analysts, and lenders all might use FFO when digging into the profitability of a REIT. FFO can help these stakeholders understand a business better. For example, if a REIT is trying to secure a small business loan, a lender might look at both its FFO and its debt-to-FFO ratio to determine how well the company would be able to manage additional debt.
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FFO vs EBITDA Compared
FFO is similar to another commonly used non-GAAP profitability metric called earnings before interest, taxes, depreciation and amortization, or EBITDA.
Both FFO and EBITDA are used as an alternative to net income, and both add back depreciation and amortization to net income. The main difference between FFO vs EBITDA is that FFO looks at free cash flow from operations, while EBITDA seeks to measure profitability from operations.
While a firm’s EBITDA is certainly important, REIT investors should use FFO vs EBITDA, since it’s more applicable to this unique corporate structure. Here’s a look at how FFO compares to EBITDA.
| FFO | EBITDA |
|---|---|
| Alternative to net income | Alternative to net income |
| Only includes items central to operations | Only includes items central to operations |
| Non-GAAP measurement | Non-GAAP measurement |
| Used to measure free cash flow from operations | Used to measure profitability from operations |
Pros and Cons of Using FFO
While FFO is a useful way to measure the actual amount of cash flow generated from a REIT’s business operations, it has some drawbacks. One of the biggest is that it does not deduct the cost of maintaining the existing portfolio of properties. Since real estate holdings must be maintained, FFO does not always represent the true cash flow after all expenditures.
| Pros of Using FFO | Cons of Using FFO |
|---|---|
| Measures operating performance | Non-GAAP |
| All items easily found on the income statement | Significant non-cash charges can cause net income to vary wildly from FFO |
What Makes FFO Good at Measuring REIT Performance?
FFO makes adjustments to standard cost-accounting methods that can inaccurately assess a REIT’s performance. While GAAP accounting requires companies to depreciate assets over time, many investment properties actually increase in value over time. As a result, depreciation isn’t accurate in describing the value of a REIT and it needs to be added back to net income to solve this issue.
In addition, FFO subtracts any gains on sales of property, since these sales are typically nonrecurring.
Adjusted FFO vs FFO
Adjusted funds from operations, or adjusted FFO, is a related metric that takes a REIT’s capital expenditures into account. These recurring capital expenditures might include maintenance expenses, such as painting apartments or roof replacements. Adjusted FFO was developed to provide a better measure of a REIT’s dividend-generating capacity. It’s sometimes referred to as cash (or funds) available for distribution.
| FFO | Adjusted FFO |
|---|---|
| Excludes non-recurring expenses | Adds back some non-recurring items |
| Doesn’t consider capital expenditures | Subtracts capital expenditures |
FFO Calculation Example
As an example, let’s calculate the FFO of XYZ REIT and see how it compares to net income.
Net income = $60 million
Depreciation and amortization expenses = $10 million
Loss from an asset sale = $5 million
Gains from an asset sale = $3 million
Interest income = $7 million
To calculate the company’s FFO, we must take the $60 million of net income and add back $10 million of depreciation and amortization expense and $5 million from the asset sale loss, then subtract $3 million in gains on asset sale and $7 million of interest income.
FFO = ($60 million + $10 million + $5 million) – $3million – $7 million = $65 million
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The Takeaway
The FFO formula is commonly used to measure the amount of cash flow generated by a REIT, a business that holds a portfolio of commercial real estate or real estate loans. FFO adjusts for one-time and non-standard income so that investors can get a better sense of true profitability. Lenders might also use the FFO gauge when determining whether to approve a REIT for a small business loan.
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FAQ
What is a good FFO for a REIT?
Most REITs will report FFO (funds from operations) per share. To determine whether a REIT is cheap or expensive, you’ll want to compare its price-to-FFO (P/FFO) ratio to its peers.
Is FFO the same thing as EBITDA?
No. FFO (funds from operation) is similar to EBITDA (earnings before interest, taxes, depreciation, and amortization) in that both look at income before depreciation and amortization expenses. Unlike EBITDA, however, FFO does not exclude interest expenses and taxes.
What is the difference between NOI and FFO?
Net operating income (NOI) is sometimes used in REIT valuation, but it does not take into account general & administrative expenses, taxes, and interest expenses. The FFO calculation includes those items.
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