Funds from Operations (FFO): What is It, Calculation, Limitations & More

Funds from Operations (FFO) is a financial metric widely used to evaluate the performance of real estate investment trusts (REITs). It measures a company’s cash flow generated from operations, providing a clearer picture of profitability than traditional net income.

Since net income includes non-cash expenses like depreciation and amortization, FFO adjusts for these to reflect the actual performance of a REIT. It helps investors assess how much cash a company generates from its core business.

• Commonly used by REITs to evaluate cash flow.
• Excludes depreciation, amortization, and gains/losses from property sales.
• Provides a more accurate view of operational performance than net income.

The FFO formula is standardized by the National Association of Real Estate Investment Trusts (NAREIT) to ensure consistency across the industry.

FFO = Net Income + Depreciation and Amortization − Gains on Sales of Property

Key Elements in the Formula:

• Net Income: The starting point, representing the REIT’s earnings after all expenses.
• Depreciation and Amortization: Non-cash charges added back to reflect the non-operational nature of these deductions.
• Gains on Sales of Property: Subtracted to exclude one-time, non-recurring income from asset sales.

To understand the concept better, let’s consider an example:

A prominent REIT, XYZ Properties, reported the following for the fiscal year:

• Net Income: $120 million
• Depreciation and Amortization: $40 million
• Gain on Property Sales: $10 million

Using the formula:

FFO = 120 + 40 − 10 = 150 million

The FFO of $150 million indicates strong operational performance. When divided by 30 million outstanding shares, the FFO per share is:

FFO per share = 150 / 30 = 5

This value enables investors to evaluate the REIT’s profitability on a per-share basis.

This measure helps investors gauge the cash-generating capacity of REITs, ensuring better decision-making. For investors seeking income stability, FFO remains an indispensable tool.

The real estate industry’s unique nature, involving significant depreciation and asset sales, can distort conventional profitability metrics like net income. FFO adjusts for these distortions by excluding depreciation, amortization, and non-recurring gains or losses on asset sales, providing a clearer picture of a REIT’s financial health. 

True Profitability

Since real estate assets tend to appreciate over time, standard accounting practices that factor in depreciation often underestimate the actual performance of REITs. FFO adjusts for these distortions, offering a more accurate representation of a company’s financial health.

Comparable Performance

FFO provides a standardized metric, making it easier to compare the performance of REITs within the industry. Investors rely on this uniformity to benchmark potential investments.

Dividend Sustainability

REITs are required to distribute a significant portion of their earnings as dividends. FFO helps determine whether a company can sustain these payouts, aligning with investor priorities for consistent returns.

FFO interpretation depends on several factors, including growth trends, industry comparisons, and historical performance.

• A rising FFO over time indicates strong business growth and effective asset management.
• A declining FFO may suggest operational inefficiencies or challenges.

• Investors compare FFO across different REITs to assess relative financial strength.
• Higher FFO compared to peers signals competitive advantage.

• AFFO refines FFO further by deducting maintenance costs and capital expenditures.
• It provides a more realistic measure of cash available for dividends.

A high FFO relative to share price suggests undervaluation, while a declining FFO can indicate problems in cash flow generation.

A good FFO depends on industry standards, company performance, and investor expectations. Here are key factors:

• A REIT with consistent FFO growth is considered financially healthy.
• Declining FFO may indicate operational issues.

• A REIT should generate sufficient FFO to cover dividends, ensuring long-term sustainability.
• If dividends exceed FFO, the REIT may struggle to maintain payouts.

• FFO should be relatively stable over time.
• Large fluctuations suggest unpredictable cash flow.

• A higher FFO relative to competitors indicates a well-performing REIT.

Investors should analyze trends over multiple quarters to assess long-term stability.

In addition to FFO, many analysts use Adjusted Funds from Operations (AFFO), which refines the metric further by accounting for:

• Capital Expenditures (CapEx): Recurring costs to maintain properties.
• Straight-Lining of Rent: Adjustments for rental income spread over lease terms.

Formula for AFFO:

AFFO = FFO − Recurring Capital Expenditures − Straight-Lining Adjustments

AFFO is considered a better indicator of a REIT’s ability to pay dividends over the long term.

FFO vs. Net Income

Net income includes all revenues and expenses, including non-cash items like depreciation and one-time events like asset sales. FFO removes these distortions, focusing on recurring income from core operations.

FFO vs. Adjusted FFO (AFFO)

While FFO is widely used, many investors prefer Adjusted FFO (AFFO) for greater precision. AFFO adjusts FFO further by deducting recurring capital expenditures and straight-line rent adjustments, offering a more refined measure of a REIT’s ability to pay dividends.

Dividend Analysis: REITs are legally required to distribute at least 90% of taxable income as dividends. FFO helps investors determine if a REIT generates enough operational cash flow to sustain its dividends.

Performance Comparison: Investors use FFO to compare REITs within the same sector, as it standardizes performance measurement.

Valuation Metric: FFO per share, calculated by dividing total FFO by the number of outstanding shares, is used to evaluate a REIT’s valuation against peers.

Trend Analysis: Tracking FFO growth over time offers insights into a REIT’s operational improvements or challenges.

While FFO is a useful metric, it has certain limitations that investors should be aware of.

• Does Not Account for Capital Expenditures: FFO does not deduct maintenance costs, which are essential for property upkeep. Ignoring these expenses can overstate a REIT’s financial health.
• Can Be Manipulated: Some REITs may adjust depreciation estimates to boost FFO, leading to misleading financial results. Investors should verify reported figures carefully.
• Does Not Reflect Liquidity: FFO measures profitability, not liquidity. A company may report high FFO but still struggle with cash shortages.
• Ignores Debt Obligations: FFO does not consider interest payments and debt servicing costs, which are crucial for evaluating financial risk.
• Limited Use for Non-REIT Companies: FFO is primarily used for REITs. It is not a suitable metric for evaluating companies outside the real estate sector.

InvestingPro offers detailed insights into companies’ Funds from Operations (FFO) including sector benchmarks and competitor analysis.

Yes, FFO is primarily used in the real estate sector, especially for REITs, as it adjusts for the peculiarities of real estate accounting.

While net income reflects a company’s profitability after accounting for all expenses, FFO excludes non-cash items like depreciation and one-time gains to provide a clearer picture of operational performance.

Depreciation is a non-cash expense that does not reflect the actual wear and tear of real estate assets, which typically appreciate in value.

AFFO goes beyond FFO by accounting for recurring capital expenditures and adjustments for rent, offering a more refined view of cash flow sustainability.

FFO helps gauge a REIT’s profitability and dividend sustainability but should be combined with other metrics for a comprehensive analysis of stock performance.