What are 'Funds From Operations - FFO'
Funds from operations (FFO) refers to the figure used by real estate investment trusts (REITs) to define the cash flow from their operations. It is calculated by adding depreciation and amortization to earnings, subtracting any gains on sales, and is sometimes quoted on a per-share basis. The FFO-per-share ratio should be used in lieu of EPS when evaluating REITs and other similar investment trusts.
BREAKING DOWN 'Funds From Operations - FFO'
FFO is a measure of the cash generated by a REIT but is not to be confused with a REIT's cash flow from operations. Real estate companies use FFO as an operating performance benchmark. The National Association of Real Estate Investment Trusts (NAREIT) originally pioneered this figure, which is a non-GAAP measure.
The formula for FFO is as follows: FFO = Net Income + Depreciation + Amortization - Gains on Sales of Property. Many leading REITs believe that the FFO calculation is the best presentation of operating results. This is because real estate historically rises and falls with macroeconomic conditions, and any operating results calculated using the cost accounting method are not an accurate measure of performance.
Using the FFO Calculation
All components of the FFO calculation are listed on a REIT's income statement. If, for example, a REIT had depreciation of $20,000, gains on sales of property of $40,000, and net profit of $100,000, its FFO would be $80,000. All REITs are required to show their FFO calculations on public financial statements. They normally disclose the measure as a footnote on the income statement.
The benefit of FFO is that it compensates for cost accounting methods that may inaccurately communicate a REITs true performance. For example, GAAP accounting requires that all REITs depreciate their investment properties over time, using one of the standard depreciation methods. However, many investment properties actually increase in value over time, making depreciation inaccurate in describing the value of a REIT. Depreciation and amortization must be added back to net income to reconcile this issue.
FFO also subtracts any gains on sales of property, because these types of sales are considered to be non-recurring. REITs must pay out 90% of all taxable income in the form of dividends. Gains on sales of property do not add to a REITs taxable income and should therefore not be included in a measurement of value and performance.
Adjusted Funds From Operations
Some real estate analysts also calculate a REIT's adjusted funds from operations (AFFO). This calculation takes a REIT's FFO and subtracts any recurring expenditure that is capitalized and then amortized, as well as any straight-lining of rents.