What Is FFO? Funds From Operations Explained

FFO Is the REIT’s Version of Earnings

FFO, funds from operations, is the number REIT analysis is built on. It exists because a REIT’s net income does not tell you what the business earns. Nareit, the US REIT industry body, defined it in 1991 to fix one distortion: accounting depreciation writes a REIT’s buildings down every year on a fixed schedule, whether or not they have lost value, and the charge is big enough to swamp the income statement. Net income ends up far below the cash the portfolio throws off. FFO strips the charge out, so the sector is valued on price-to-FFO where almost everything else uses price-to-earnings.

A REIT quoted on a multiple is almost always quoted on FFO. Get clear on what FFO includes, and what it leaves out, before anything else.

The Nareit Definition

Nareit publishes the definition, which is what makes FFO comparable across REITs. It builds up from net income:

FFO = net income + real estate depreciation & amortisation − gains on property sales + impairments of depreciable real estate

Each adjustment removes something that misstates operating performance. Real estate depreciation goes back in because it assumes the buildings are wearing out when they usually are not. Gains and losses on property sales come out because they are one-offs: leave them in and a year of heavy disposals looks like a year of strong operations. Impairments of depreciable real estate go back in for the same reason as depreciation, since they are non-cash write-downs of the same buildings. What remains is the portfolio’s recurring income.

Why Net Income Fails for a REIT

Depreciation is the whole reason FFO exists. A company that owns well-located, well-maintained buildings must depreciate them anyway, on a schedule unrelated to their value. For a large REIT the charge runs to hundreds of millions a year, deducted from income while the buildings may be appreciating. So a REIT can grow its cash flow and report thin or falling net income in the same year, purely because of an accounting convention.

FFO removes that distortion and leaves the rest of the income statement alone. It is net income with property depreciation, disposal gains and impairments taken out, and nothing else. The narrowness helps. With few, defined adjustments, FFO stays comparable from one REIT to the next in a way a more heavily massaged number would not.

How FFO Is Used

FFO does two jobs. It is the denominator of price-to-FFO (P/FFO), the sector’s equivalent of the P/E ratio: a REIT trading at 15 times FFO is priced at fifteen years of its current funds from operations. And it is the base for payout analysis. A REIT’s dividend is measured against FFO, or better against AFFO, because earnings are the distorted number FFO exists to replace.

Comparing REITs on P/FFO works only because both FFO figures follow the same Nareit rulebook. One line further down, at AFFO, that stops being true.

Where FFO Stops: The Handover to AFFO

FFO has one large blind spot, and it is why a second metric exists. It adds back all the property depreciation, but a landlord does spend cash each year to keep the buildings let: maintenance capital, tenant improvements, leasing commissions. FFO ignores that spending, so it overstates the cash available for a dividend. AFFO, adjusted funds from operations, puts the spending back. It measures distributable cash better, at the cost of no longer being a defined, comparable number. The full comparison, and why AFFO is worth the loss of comparability, is in the FFO vs AFFO guide.

Start with FFO because it is standardised, then move to AFFO before judging a dividend. A payout that FFO covers and AFFO does not is being paid with money the buildings need.