What is FFO?
Funds from Operations (FFO) is a measure of cash generated by a Real Estate Investment Trust (REIT).
In fact, the measurement itself was developed by NAREIT, the REIT lobby, in an attempt to reconcile accounting (GAAP) net income to a measure of profit most useful for the analysis of REITs.
Today, most REITs provide FFO reconciliations in their filings. Here is an example of a funds from operation reconciliation as reported by BRE Properties in their 10K:
Unlike many non-GAAP measurements, FFO does have a quasi “official” formula. Most REITs adhere to NAREIT’s definition and provide FFO reconciliations in their filings:
- Funds From Operations = Net income to common (calculated in accordance with US GAAP) + Depreciation – Gains on sale + Non-controlling (NCI) interest expense, net of NCI cash dividends
Though often misunderstood, FFO is not designed to be a measure of cash flow because it excludes working capital, capital expenditures and other cash flow adjustments
How to Calculate FFO
|Income statement||Net income to common|
|Cash flow statement||Depreciation|
|Cash flow statement||Gains on sale|
|Cash flow statement and Income Statement||Non-controlling (NCI) interest expense, net of NCI cash dividends|
How to Interpret Funds from Operations
Funds from operations is similar – but not identical – to cash from operations – it is a reconciliation starting with net income and adds back items similarly to the indirect cash flow method of arriving at cash from operations.
However, it is NOT designed to be a measure of cash flow because it excludes working capital, capital expenditures and other cash flow adjustments.
FFO vs. EBITDA
By ignoring working capital it has similarities to EBITDA – but it’s not exactly EBITDA either – the big difference is that EBITDA attempts to capture profitability from operations, while FFO is levered and captures the affect of taxes and preferred dividends.
FFO vs Net Operating Income (NOI)
While net operating income (NOI) is a very useful profit measure for analyzing real estate down to the property level, it ignores general & administrative expenses, taxes and leverage (interest expense) – all are expenses that FFO does factor into its calculation.
Why FFO Matters for REITs
“Because real estate values have historically risen or fallen with market conditions, management considers FFO [which ignores accounting depreciation and gains/losses] an appropriate supplemental performance measure”
FFO is a superior metric over EBITDA, net income, or cash from operations because REITs have distinct characteristics that make it harder to analyze if investors solely rely on the other aforementioned common measures of profits.
Specifically, REITs are highly levered, generate significant non cash income / losses from property sales. In BRE Properties’ 10K, they provide the rationale for using FFO: “Because real estate values have historically risen or fallen with market conditions, management considers FFO [which ignores accounting depreciation and gains/losses] an appropriate supplemental performance measure”
Adjusted Fund from Operations
Over time, analysts and REITs themselves have begun using slightly altered versions of FFO, generally called “adjusted FFO” or AFFO. The reason for this is that FFO included things like nonrecurring items and notably omitted key outflows like capital expenditures.
Adjusted FFO and Cash Available for Distribution (CAD)
Adjusted FFO Formula
While there remains some inconsistency across how these are calculated, the most common calculation is:
Adjusted funds from operations is also known as Cash available for distribution or “CAD”.
While NAREIT recognizes that many analysts add to the official definition of FFO in this way, it is not an officially recognized metric by NAREIT.
Conclusion: Other Real Estate Metrics
While FFO is used widely when analyzing REITs, the traditional property-level real estate measures of profit are also very important, namely:
Net operating income (NOI) – While FFO provides a levered measure of profit after taxes and overhead, NOI provides a pure, property level measure of profit.
Cap rates – Cap rates are the most widely used measure of value in real estate – both for valuing REITs and in property-level analysis. It is the equivalent of using EV/EBITDA multiples for valuing “regular” companies.