Funds from operations (FFO) is an accounting term that refers to the cash flows generated by the operations of a business. In the investment community, FFO is commonly used in reference to the cash flows from a real estate investment trust (REIT). Calculating funds from operations of a REIT can help an investor decide if they should invest in it or not.
Funds From Operations Calculation
Real estate companies use funds from operations (FFO) as a performance benchmark, which is why investors can use FFO for the same purpose when considering a REIT as an investment. All the factors in the FFO formula can be found in the company's income statement. These factors include net income, depreciation, amortization, and gains on sales of property.
Here is the formula for funds from operations:
FFO = Net Income + Depreciation + Amortization - Gains on Sales of Property
The rules within the generally accepted accounting principles (GAAP) accounting requires that REITs depreciate their investment properties over time using one of the standard depreciation methods. Since this is is a non-cash transaction, it must be added back to net income, along with any amortization expense.
Picking the Best REITs With FFO
While equity investors may look at earnings per share (EPS) or a price-earnings ratio (P/E) when analyzing stocks, REIT investors look at FFO. In either case, there is no magic number you are looking for but you do want to see a history of increasing FFO for REITs, just as you would want to see increasing EPS for stocks, on a quarterly basis. Also, you want to look for REITs that have an FFO that beats earnings estimates from analysts.
REIT analysts and investors have been increasingly looking at adjusted funds from operations (AFFO), which is arguably a better data point for predicting the health of a REIT, more specifically as a measure for the REIT's ability to generate cash and pay dividends. The calculation for AFFO subtracts from FFO any recurring expenditures that have been capitalized, such as projects for building improvements.
Fortunately, you don't need to be an expert REIT analyst or look at income statements to get the FFO or AFFO for REITs that are publicly traded. You can let the experts do the work for you and simply look at the calculations yourself online. So, if you wanted to find details on a large REIT like Prologis (PLD) or Simon Property Group (SPG), you could simply do a Google search for "Prologis FFO" or "Simon Realty AFFO" and get all the numbers you need.
Looking Further at the REIT
Before buying shares of a REIT based solely upon its FFO or AFFO, be sure to pay attention to the price. Although the FFO, AFFO, and yield are key figures for REIT investors, you don't want to jump into a high-yielding REIT that looks good on the surface then see a big decline in price because too many investors bought shares, which pushed the price too high, only to precede a big correction.
With that said, the price-to-earnings (P/E ratio) of a REIT should be considered a distant second metric in evaluating a REIT. The earnings per share (EPS) for a REIT will be naturally low or even negative in comparison to conventional stocks. For example, a large-cap stock might begin to look expensive with a P/E of 17, whereas a REIT might not look expensive until it surpasses 40 or 50.
The Bottom Line
First and foremost, never invest in something that you don't understand. The evaluation of REITs can be simple to understand once you learn the math and valuation metrics. However, there are many different types of REITs, such as mortgage REITs, commercial property REITs, and residential property REITs, and each has its own unique qualities that differentiate from the others.
A good way for many investors to gain access to the REIT market is through the purchase of exchange-traded funds (ETFs,) such as iShares Cohen & Steers REIT (ICF) and Vanguard REIT (VNQ). These ETFs provide diversified exposure to REITs and offer the income and growth you may be looking for while eliminating the need for research and analysis.