What are Funds From Operations?

Funds From Operations

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Funds From Operations

Funds From Operations (FFO) is a financial performance measure often used in the Real Estate Investment Trust (REIT) industry. It gives an indication of the cash generation ability of a REIT. FFO is defined by the National Association of Real Estate Investment Trusts (NAREIT) as net income (computed in accordance with Generally Accepted Accounting Principles), excluding gains (or losses) from sales of property, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures.

The FFO metric is used because the standard net income metric, as defined by GAAP, includes a deduction for depreciation of real estate assets. However, real estate assets typically appreciate, rather than depreciate, in value over time, making depreciation a misleading expense. Therefore, the depreciation expense is added back into net income to calculate FFO.

The FFO measure is not perfect because it doesn’t account for necessary capital expenditures to maintain the quality of the REIT’s underlying assets, but it does provide a better measure of the REIT’s operating performance than net income.

In essence, FFO helps investors understand the cash flow that a REIT is generating from its operational activities, which is important because it indicates how much money is available for the REIT to distribute as dividends to its shareholders.

Example of Funds From Operations

Let’s imagine a hypothetical REIT called “Sunset Properties”. Sunset Properties owns a portfolio of commercial and residential properties that it rents out to tenants. The company’s financials for a given year might look something like this:

  • Net Income: $10 million
  • Depreciation and Amortization: $3 million
  • Gain on Sales of Property: $1 million

According to the NAREIT definition, Funds From Operations (FFO) would be calculated as follows:

FFO = Net Income + Depreciation and Amortization – Gain on Sales of Property

So for Sunset Properties:

FFO = $10 million + $3 million – $1 million = $12 million

This $12 million represents the amount of money that Sunset Properties generated from its real estate operations over the year, after adjusting for the sale of properties and the non-cash depreciation expense.

This gives investors a clearer idea of the amount of cash Sunset Properties has available to distribute as dividends or reinvest in its business. Remember, this is a simplified example and real-world calculations might involve other adjustments depending on the specifics of the REIT’s operations and accounting practices.

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