Funds from Operations
A widely accepted metric used to analyze the performance of a REIT. Funds from Operations, or FFO, accounts for the fact that net income on a REIT’s income statement may be an inaccurate representation of the REIT’s true performance. As such, net income is adjusted as follows to arrive at FFO:
FFO = Net Income + Depreciation + Amortization – Gain/Loss on Sale of Properties.
Funds from Operations is comparable to the Cash Flow from Operations metric, used in analyzing individual properties.
Putting ‘Funds from Operations’ in Context
Scenario Overview
MidWest Residential REIT, a publicly traded real estate investment trust, has recently acquired a Class B, market-rate multifamily property called Willow Creek Apartments, located in suburban Chicago, Illinois. The 300-unit garden-style property, built in 1995, was purchased for $60 million at a 5.5% cap rate based on the in-place net operating income (NOI). MidWest Residential REIT uses Funds from Operations (FFO) as a key metric to evaluate the performance of its real estate portfolio and communicate results to its investors.
Key Financial Details
- Acquisition Price: $60 million
- Net Income: $2.5 million per year
- Depreciation and Amortization: $800,000 per year
- Gain on Sale of a Previous Property: $0
Calculating Funds from Operations (FFO)
Funds from Operations adjusts net income to provide a clearer picture of the REIT’s operational performance, eliminating non-cash deductions and excluding one-time gains or losses. For Willow Creek Apartments, the FFO calculation is as follows:
Formula:
- FFO = Net Income + Depreciation + Amortization – Gain/Loss on Sale of Properties
Plugging in the numbers:
- FFO = 2,500,000 + 800,000 + 0 – 0; FFO = 3,300,000
Analysis
The FFO for Willow Creek Apartments is $3.3 million. This metric allows MidWest Residential REIT and its investors to understand the property’s contribution to the REIT’s overall cash-generating performance, excluding the effects of non-cash charges (e.g., depreciation) and irregular transactions (e.g., gains from property sales).
Frequently Asked Questions about Funds from Operations (FFO)
What is Funds from Operations (FFO)?
Funds from Operations is a metric used to evaluate the performance of a Real Estate Investment Trust (REIT). It adjusts net income by adding back non-cash expenses like depreciation and amortization and subtracting gains or losses from property sales.
How is FFO calculated?
FFO = Net Income + Depreciation + Amortization – Gain/Loss on Sale of Properties
For example, if net income is $2.5 million and depreciation is $800,000, with no gain/loss on sales, FFO = $3.3 million.
Why is FFO used instead of net income for REITs?
FFO is used because net income includes non-cash charges like depreciation, which can understate the true operating performance of real estate assets. FFO provides a clearer view of recurring cash-generating capability.
Is FFO similar to Cash Flow from Operations?
Yes. FFO is comparable to Cash Flow from Operations for individual properties, as both focus on the actual cash earnings from operations by adjusting for non-cash items.
How does a gain on property sale affect FFO?
Gains (or losses) from property sales are subtracted when calculating FFO because they are considered non-recurring and not reflective of ongoing operational performance.
How was FFO applied in the Willow Creek Apartments example?
MidWest Residential REIT reported net income of $2.5 million and depreciation of $800,000. With no gains from sales, the FFO was $3.3 million, highlighting the property’s true contribution to the REIT’s performance.
Click here to get this CRE Glossary in an eBook (PDF) format.