What is FFO (Funds From Operations)?

FFO is used to measure the cash flow from operations. Thus, it is similar to ‘Cash Flow from Operations.’Cash Flow From Operations.‘Cash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.read more However, it is generally used in reference to cash flows generated by ‘Real Estate Investment Trust’ (REIT).

  • For Real estate companies, FFO is used as a performance benchmark as real estate values are proven to fluctuate with macroeconomic conditions, and using the cost accounting examplesCost Accounting ExamplesCost accounting is a defined stream of managerial accounting used for ascertaining the overall cost of production. It measures, records and analyzes both fixed and variable costs for this purpose.read more to compute the financial conditions do not usually serve as an accurate measurement of performance.

  • It includes funds generated from business operations, excluding financing-related cash flows, such as interest income or interest expense. It does not include any depreciation or amortization of fixed assets or gains or losses from the disposition of assets.Real Estate Investment Trusts (REITs) is a business that primarily operates on income generated from real estate transactions. Such REIT companies are involved in commercial real estate. It includes selling, leasing, and financing offices and buildings, warehouses, hospitals, shopping centers, hotels, etc. Such companies commonly use FFO.

Funds From Operations Formula

All the factors used while calculating the Funds from operations can be found in the company’s income statement. These factors include net income, depreciation, amortization, and gains on sales of property and extraordinary items Extraordinary ItemsExtraordinary Items refer to those events which are considered to be unusual by the company as they are infrequent in nature. The gains or losses arising out of these items are disclosed separately in the financial statement of the company.read more.

FFO Formula = Net Income + Depreciation and Amortization of Real Estate Assets – Gains (losses) on Asset Sale + Losses (Gains) on Restructuring Debt or Extraordinary Items

FFO Calculation (Washington REIT Case Study)

Adjusted FFO

Adjusted funds from operations (AFFO) are calculated after making adjustments to net income and are intended to compensate for accounting methods. These methods might distort a real estate investment trust’s true performance. The calculation for AFFO subtracts from FFO any recurring expenditures that have been capitalized, such as projects for building improvements.

  • Identify the Net Income from the Income Statement We note above that the net income of Washington REIT for 2000 is $45,139. Likewise, its net income for 1999 and 1998 is $44,301 and $41,064, respectively.(please note the figures are in thousands) Identify Depreciation and Amortization of Real Estate Assets It is part of the Income Statement.Depreciation and Amortization (2000) = $22,723Depreciation and Amortization (1999) = $19,590Depreciation and Amortization (1998) = $15,339 Identify Gains (Losses) on Sales of Assets This figure is also part of the income statement.Gains on Sales of Assets (2000) = $3,567Gains on Sales of Assets (1999) = $7,909Gains on Sales of Assets (1998) = $6,764 Identify Gains (Losses) on Restructuring Items or Extraordinary Items There are no gains (losses) on restructuring expenses or extraordinary items in these three years. Apply Formula FFO Formula = Net Income + Depreciation and Amortization of Real Estate Assets – Gains (losses) on Asset Sale + Losses (Gains) on Restructuring Debt or Extraordinary ItemsFFO (2000) = $45,139 + $22,723 – $3,567 = $64,295FFO (1999) = $44,301 + $19,590 – $7,909 = $55,982FFO (1998) = $41,064 + 0$15,339 – $6,764 = $49,699

We note above that the net income of Washington REIT for 2000 is $45,139. Likewise, its net income for 1999 and 1998 is $44,301 and $41,064, respectively.(please note the figures are in thousands)

It is part of the Income Statement.Depreciation and Amortization (2000) = $22,723Depreciation and Amortization (1999) = $19,590Depreciation and Amortization (1998) = $15,339

This figure is also part of the income statement.Gains on Sales of Assets (2000) = $3,567Gains on Sales of Assets (1999) = $7,909Gains on Sales of Assets (1998) = $6,764

There are no gains (losses) on restructuring expenses or extraordinary items in these three years.

FFO Formula = Net Income + Depreciation and Amortization of Real Estate Assets – Gains (losses) on Asset Sale + Losses (Gains) on Restructuring Debt or Extraordinary ItemsFFO (2000) = $45,139 + $22,723 – $3,567 = $64,295FFO (1999) = $44,301 + $19,590 – $7,909 = $55,982FFO (1998) = $41,064 + 0$15,339 – $6,764 = $49,699

Generally Accepted Accounting Principles (GAAP) require depreciating the investment properties over time. However, real estate appreciates over time. For this reason, the required depreciation expense, which is charged as per GAAP, tends to make the net income appear artificially low.

FFO also adjusts for non- recurring itemsNon- Recurring ItemsNon-recurring items are income statement entries that are unusual and unexpected during regular business operations; examples include profits or losses from sale of asset, impairment costs, restructuring costs, and losses in lawsuits, and inventory write-off.read more as they do not occur in regular business scenarios. For instance, gains (or losses) on the sale of properties are to be removed/ added accordingly, as they are not like regular business operations and therefore do not contribute to the REIT’s ongoing dividend-paying capacity. In addition, some analysts further consider rent increases and certain CapexCapexCapex or Capital Expenditure is the expense of the company’s total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more for calculating adjusted Funds from operations (AFFO).

FFO per share is used as a carefully scrutinized metric to gauge a REIT’s profitability per unit of shareholder ownership. Funds From Operations is further used as general valuation multiple and P/E multiplesP/E MultiplesThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. read more. Thus it is a key driver of share prices as well.

Why is FFO Important for Real Estate?

  • While equity investors give importance to metrics like earnings per share EPSEPSEarnings Per Share (EPS) is a key financial metric that investors use to assess a company’s performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is.read more or a price-earnings ratio (P/E) while analyzing stocks, REIT investors decide based on FFO.

  • Before investing in a REIT, be sure of the price; the decision is not based solely on FFO or AFFO as the investment which looks good on the surface may not turn out to be a good decision in the future as the prices may decline due to too many investors buying it.Compared to conventional stocks, the earnings per share (EPS) for a REIT will be naturally low or even negative. Thus, the price-to-earnings (P/E ratio) of a REIT is not a good multiple, while making investment decisions should be considered a distant second metric when evaluating it

Differences Between CFO and FFO

  • As the name suggests, cash flow calculates the total amount of cash and cash equivalents generated from the operations of a business. However, FFO is a more important measure for the real estate business as these measures compensate for one important component, which is depreciation.For the real estate business, the value of properties always increases over time; thus, this isn’t an expense at all. As per IRS, when businesses own long-term assets such as equipment, computers, and buildings, these assets have to be depreciated to reflect the current financial position.However, when it comes to real estate, these properties don’t have a “shelf life” or, in other words, would never depreciate to a minimal value over the period. On the contrary, these assets would appreciate and, therefore, not count as an expense to be charged to the income statementIncome StatementThe income statement is one of the company’s financial reports that summarizes all of the company’s revenues and expenses over time in order to determine the company’s profit or loss and measure its business activity over time based on user requirements.read more.Thus operating cash flow and FFO are similar metrics. However, they’re not quite the same thing. Cash flow can be a great way to evaluate financial well-being. Still, when it comes to the real estate industry, the metrics differ from the regular business scenario.To assess whether a REIT is earning enough to cover its dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more, FFO is the way to go. It helps in getting a better picture than a regular CFO would.

Conclusion

Thus the funds from operations concept are required for the analysis of a REIT because when the underlying assetsUnderlying AssetsUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more increase in value, then depreciation should not be factored into the results of operations. It is considered to be a better indicator of the financial results of a business than net income; however, since the accounting chicanery can impact a variety of aspects of the financial statements, it is always better to rely upon a mix of measurements rather than a single measure while making investment decisions.

Even Though FFO is widely considered for determining REIT’s profitability; it can often be susceptible to accounting changes, restatementsRestatementsA restatement is the revision of already issued financial statements of one or more companies to correct errors with material inaccuracy due to non adhering and complying with the GAAP, accounting mistakes, fraud, or clerical errors affecting part of the entire financial statement requiring a completely new audit.read more, and manipulation. Therefore, please consider two or three metrics and other business factors before making an investment decision.

This has been a guide to what is FFO or Funds from Operations. Here we discuss the formula to calculate FFO and the Washington REIT example and why it is an important metric in real estate. You may learn more about cash Flows from the following articles –

  • Free Cash FlowHow to do Cash Flow Analysis?Cash on Cash Return