How to Calculate Funds From Operations (FFO)

Funds From Operations (FFO) serves as a metric for evaluating the financial performance of Real Estate Investment Trusts (REITs). It offers a more accurate representation of a REIT’s profitability and cash-generating ability than traditional net income. This is because standard accounting practices (GAAP) require depreciation of real estate assets, even though properties often appreciate. FFO adjusts for this non-cash expense, providing a clearer picture of the cash flow derived from a REIT’s ongoing operations.

Key Components for FFO Calculation

Net income is the foundational element, representing a company’s total earnings after all expenses, including taxes and non-cash charges, have been deducted. This figure is typically found at the bottom of the income statement.

Depreciation and amortization are non-cash expenses that systematically reduce the book value of tangible and intangible assets over their useful lives. For FFO calculations, the focus is specifically on depreciation and amortization related to real estate assets. These expenses are added back to net income because they do not represent actual cash outflows in the current period and real estate properties often appreciate rather than depreciate in market value.

Gains or losses from property sales arise when an asset is sold for more (gain) or less (loss) than its book value. Such transactions are generally considered non-recurring events and are therefore excluded from FFO to reflect the recurring operational performance of the REIT. Gains from property sales are subtracted, while losses are added back, to normalize the income stream.

The Standard FFO Formula

The standard FFO formula, as defined by Nareit, provides a standardized approach to assessing REIT performance. The core formula begins with a company’s net income, then systematically adjusts it for non-cash and non-recurring items specific to real estate operations. This standardized calculation allows investors to compare the operating results of different REITs more effectively.

The standard FFO formula is: Net Income + Real Estate Depreciation and Amortization – Gains from Sales of Property + Losses from Sales of Property.

Adding back real estate depreciation and amortization removes the impact of this non-cash expense. Gains on property sales are subtracted, and losses are added back, to focus on recurring operational performance. This adjustment ensures that FFO focuses solely on the cash generated from the continuous operation of real estate assets.

Common Adjustments to FFO

While the standard FFO formula provides a foundational measure, many REITs make additional adjustments to arrive at metrics like Adjusted FFO (AFFO) or Core FFO. These refinements aim to provide an even more comprehensive view of recurring cash flow by accounting for non-cash items not fully addressed by basic FFO or by normalizing for certain operational elements. These adjustments help investors gain a more precise understanding of a REIT’s sustainable income.

One common adjustment involves straight-line rent adjustments, which account for differences between cash rents received and the average rent recognized over the life of a lease under GAAP. Another frequent adjustment is for recurring capital expenditures (CapEx) to maintain the property’s income-producing capacity. While FFO does not typically deduct these, AFFO often does to reflect the actual cash needed for ongoing property upkeep.

Other adjustments may include stock-based compensation, which is a non-cash expense that does not directly impact a REIT’s operating cash flow. Amortization of lease intangibles, such as above-market or below-market lease values, may be added back or subtracted to provide a clearer picture of operational performance. Impairment charges related to depreciable real estate assets are typically excluded from FFO, as they represent non-cash write-downs rather than ongoing operational expenses.

Illustrative Calculation Example

Consider a hypothetical REIT with the following financial figures: Assume the REIT reported Net Income of $50,000, real estate Depreciation and Amortization totaling $20,000, a Gain from the Sale of Property of $5,000, and no Losses from the Sale of Property.

Applying the formula: FFO = Net Income + Real Estate Depreciation and Amortization – Gains from Sales of Property + Losses from Sales of Property. Plugging in the hypothetical numbers, the calculation would be: FFO = $50,000 (Net Income) + $20,000 (Depreciation and Amortization) – $5,000 (Gain from Sale of Property) + $0 (Losses from Sale of Property).

This results in an FFO of $65,000 ($50,000 + $20,000 – $5,000). If we consider an optional adjustment for Adjusted FFO, such as $3,000 in recurring capital expenditures, the Adjusted FFO would be $62,000 ($65,000 FFO – $3,000 recurring CapEx). This example illustrates how FFO provides a different perspective on financial performance compared to net income, by focusing on the cash generated from a REIT’s core operations.