Thursday, 1 November 2012

Funds from Operations (FFO) of REITS

What It Is:

Funds from Operations (FFO) is a measure of cash generated by a real estate investment trust (REIT). It is important to note that FFO is not the same as Cash from Operations, which is a key component of the indirect-method cash flow statement.

How It Works/Example:

The formula for FFO is:
Funds from Operations = Net Income + Depreciation + Amortization - Gains on Sales of Property
Let's assume Company XYZ is a REIT that owns several properties. Last year, Company XYZ's income statement looked like this:

Using the formula above, we can calculate Company XYZ's FFO as follows:

$2,500,000 + $2,000,000 - $200,000 = $4,300,000

REITs and similar trusts typically disclose FFO in the footnotes to their financial statements (and in many cases in the headlines of their press releases), and they are required to show their calculations.

Why It Matters:

In general, the adjustments FFO makes to net income are intended to compensate for accountingmethods that may distort a real estate investment trust's true performance. This is especially true ofdepreciationGAAP accounting requires REITs to depreciate their investment properties over time. However, many REIT properties actually appreciate over time, and for this reason, the required depreciation expense tends to make net income appear artificially low. FFO also adjusts for gains (or losses) on the sale of properties because they are not recurring and therefore do not contribute to the REIT's ongoing dividend-paying capacity (REITs are required to pay out 90% of their taxable income in dividends). Some analysts go a step further and calculate AFFO (Adjusted Funds from Operations), which adjusts FFO for rent increases and certain capital expenditures.

Many analysts prefer to examine FFO instead of net income when measuring a REIT's financial performance. Similar to EPS (earnings per share), FFO per share is a carefully scrutinized metric that is often used as a barometer to gauge a REIT's profitability per unit of shareholder ownership. Meanwhile, the interpretation of price/FFO multiples may generate valuation insights similar to those generated by P/E multiples. As such, FFO is a key driver of share prices.

Though FFO is widely considered to be the most popular method of quantifying a real estate firm's profitability, it's important to remember that FFO can often be susceptible to manipulation, accounting changes, and restatements. Nevertheless, FFO remains the industry standard in determining investment-trust profitability for shareholders.

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