Funds from operations definition
/What are Funds from Operations?
Funds from Operations (FFO) is a key performance metric used primarily by Real Estate Investment Trusts (REITs) to measure the cash-generating capability of their core operations. It starts with net income and adds back non-cash expenses such as depreciation and amortization, which can be significant in real estate but do not reflect actual cash outflows. FFO excludes gains or losses from property sales, as these are not indicative of recurring operating performance. By focusing on sustainable cash flows, FFO provides investors with a clearer view of a REIT’s ability to pay dividends and support long-term growth.
How to Calculate Funds from Operations
Funds from operations does not include any financing-related cash flows, such as interest income or interest expense. It also does not include any gains or losses from the disposition of assets, or any depreciation or amortization of fixed assets. Thus, the calculation of funds from operations is:
Net income - Interest income + Interest expense + Depreciation
- Gains on asset sales + Losses on asset sales
= Funds from operations
A variation on the funds from operations concept is to compare it to the stock price of a company (usually an REIT). This can be used in place of the price-earnings ratio, which includes the additional accounting factors just noted.
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Understanding Funds from Operations
The funds from operations concept is needed, especially for the analysis of an REIT, because depreciation should not be factored into the results of operations when the underlying assets are appreciating in value, rather than depreciating; this is a common situation when dealing with real estate assets.
The funds from operations concept is considered to be a better indicator of the operational results of a business than net income, but keep in mind that accounting chicanery can impact a variety of aspects of the financial statements. Thus, it is always better to rely upon a mix of measurements, rather than a single measure that can potentially be twisted.
Example of Funds from Operations
The ABC REIT reports net income of $5,000,000, depreciation of $1,500,000, and a gain of $300,000 on the sale of a property. This results in funds from operations of $6,200,000.
Adjusted Funds from Operations
It is possible to adjust the formula even further for some types of capital expenditures that are recurring in nature; depreciation related to recurring expenditures to maintain a property (such as carpet replacements, interior painting, or parking lot resurfacing) should be included in the FFO calculation. This altered format results in lower profitability figures. This revised version of the concept is called adjusted funds from operations.