What Is Considered a Good FFO for a REIT?

Real Estate Investment Trusts (REITs) are companies that own, operate, or finance income-generating real estate. Unlike traditional businesses, REITs have unique accounting considerations due to their substantial real estate assets. This makes Funds From Operations (FFO) a more relevant indicator of their operational performance and capacity to pay dividends than traditional net income. FFO helps investors understand the recurring profitability of a REIT, providing a clearer picture of its financial health.

Understanding Funds From Operations (FFO)

Funds From Operations (FFO) is a non-Generally Accepted Accounting Principles (GAAP) measure that quantifies the cash generated by a REIT’s operations. The National Association of Real Estate Investment Trusts (NAREIT) developed FFO to offer a more accurate representation of a REIT’s performance. Traditional GAAP net income can be an inadequate measure for REITs because it includes depreciation and amortization expenses. These are non-cash accounting expenses that reduce reported net income, even though real estate properties often appreciate in value over time rather than depreciate.

FFO adjusts net income by adding back real estate-related depreciation and amortization, as these do not represent actual cash outflows. Additionally, FFO subtracts any gains from the sale of properties and adds back any losses from property sales. This adjustment is made because property sales are considered non-recurring events and do not reflect the ongoing operational cash flow from a REIT’s core business. By making these adjustments, FFO aims to represent the actual cash flow generated from a REIT’s regular, ongoing activities, which is useful for assessing a REIT’s ability to pay dividends, a requirement for their tax structure.

Calculating Funds From Operations (FFO)

Calculating FFO begins with the REIT’s net income, found on its income statement. The primary adjustments involve non-cash expenses and non-recurring gains or losses related to property transactions. Real estate-related depreciation and amortization expenses are added back to net income. These are non-cash charges that reduce reported earnings.

Any gains from property sales are subtracted, and any losses are added back. This is because sales are considered one-time events, not part of the REIT’s recurring operational income. The calculation provides a clearer view of the cash generated from the REIT’s ongoing rental operations.

Assessing FFO and Determining What Constitutes “Good”

Investors frequently use FFO to evaluate a REIT’s performance, as it offers a clearer picture of recurring operational income than net income. FFO per share, calculated by dividing total FFO by the number of outstanding shares, is a widely used metric, similar to earnings per share. This figure is often used in valuation multiples like the price-to-FFO ratio. Another important metric is the FFO payout ratio, calculated by dividing dividends per share by FFO per share. This ratio indicates the proportion of FFO a REIT distributes to its shareholders as dividends, which is relevant since REITs are typically required to distribute at least 90% of their taxable income.

A “good” FFO is not a static number; rather, it depends on several contextual factors. Consistent year-over-year FFO growth indicates a REIT is effectively increasing its rental income and managing its property portfolio. The stability and predictability of FFO are also important, as steady cash flows suggest a reliable income stream. Comparing a REIT’s FFO to its peers within the same sub-sector provides valuable insights into its relative performance. A REIT’s FFO yield, which is FFO per share divided by the share price, helps assess how well FFO supports dividend payments.

While FFO is a valuable metric, Adjusted FFO (AFFO), also known as Funds Available for Distribution (FAD) or Cash Available for Distribution (CAD), is often considered an even more refined measure. AFFO builds upon FFO by accounting for recurring capital expenditures (CapEx) necessary to maintain properties, as well as straight-line rent adjustments. These adjustments provide a more conservative view of a REIT’s recurring cash flow and its capacity to sustain or grow dividends. Although there is no single standardized formula for AFFO across all REITs, it aims to reflect the true cash flow available to shareholders after essential property upkeep.

Factors Influencing FFO

A REIT’s FFO is influenced by a variety of operational, economic, and market factors. Occupancy rates play a significant role, as higher occupancy translates to increased rental income, directly boosting FFO. Similarly, a REIT’s ability to increase rental rates on its properties positively impacts revenue and, consequently, FFO. These are direct drivers of income generated from the core real estate portfolio.

Property acquisitions and dispositions also have a substantial effect on FFO. Acquiring new income-generating properties increases FFO, while selling off properties can reduce it unless proceeds are quickly reinvested into higher-performing assets. Efficient management of operating expenses, such as property taxes, utilities, and maintenance costs, leads to higher net operating income and higher FFO.

Interest rates can also influence FFO, particularly for REITs that rely on debt to finance acquisitions or refinance existing loans. Rising interest rates increase borrowing costs, which can reduce the net income available to contribute to FFO. Strong economic conditions lead to higher occupancy and rent growth, which can offset the impact of rising interest rates. Broader economic conditions, including demand for real estate, directly affect a REIT’s ability to maintain high occupancy and rental rates. While FFO excludes capital expenditures, significant CapEx can impact a REIT’s financial health and its capacity to generate future FFO.