What it means
Accounting rules require companies to depreciate buildings over a fixed life, treating them as though they steadily wear out and lose value. For most property companies that assumption is unhelpful, because well-maintained buildings in good locations often hold or increase their value over decades.
Net profit for a property business can therefore look far worse than the actual cash coming in. FFO fixes this by adding depreciation and amortisation back to net profit, and by removing profits or losses from selling assets.
Selling a building can produce an enormous one-off gain that has nothing to do with how the remaining portfolio is performing, so leaving it in would make one year look brilliant and the next look poor. What remains is a cleaner picture of recurring rental performance.
Investors and analysts use FFO in place of earnings when valuing property companies, so the price-to-FFO multiple does the job that the price-to-earnings ratio does elsewhere. Dividend cover is also usually assessed against FFO rather than net profit, because that is the measure most closely linked to the cash available to distribute.
Property company results announcements almost always lead with FFO rather than statutory profit. A refinement called adjusted funds from operations, or AFFO, goes a step further by subtracting recurring capital spending needed to keep buildings lettable, along with the straight-lining effect of rent-free periods.
AFFO is generally the better guide to sustainable dividends because roofs, lifts and heating systems genuinely do need replacing. FFO is the more standardised and more widely quoted figure, while AFFO varies more between companies.
The main caution is that FFO is not defined by accounting standards in the same binding way that net profit is, so definitions differ at the edges. Two property companies can both report FFO and include slightly different items, which makes reading the reconciliation to net profit essential before comparing them.
Treat the headline number as a starting point rather than a settled fact.
In practice
Real-world examples.
Example
A logistics warehouse REIT reports a statutory loss of $6,000,000 but FFO of $71,000,000, the gap explained almost entirely by depreciation on newly built distribution centres. The board declares its usual dividend because FFO comfortably covers it.
Example
A retail property group sells three shopping centres for a $95,000,000 gain, which triples reported profit for the year. Analysts strip the gain out and note that FFO actually fell 4%, which is the figure that moves the share price.
Example
A pension fund screening property investments ranks candidates by price-to-FFO rather than price-to-earnings, because earnings comparisons are distorted by how aggressively each company depreciates its buildings.
Think of it
“FFO is funds from operations-how much cash a REIT really generates.
Formula
Calculation
FFO = net profit + real estate depreciation and amortisation + losses on property sales - gains on property sales
A fictional office REIT reports net profit of $42,000,000 for the year. It charged $58,000,000 of depreciation and amortisation on its buildings, and it booked a $12,000,000 gain on selling one office block.
FFO = $42,000,000 + $58,000,000 - $12,000,000 = $88,000,000.
With 40,000,000 shares in issue, FFO per share is $88,000,000 / 40,000,000 = $2.20. If the shares trade at $33.00, the price-to-FFO multiple is $33.00 / $2.20 = 15.0 times, which is the number an analyst would compare against other property companies.Case study
Seen in the real world.
This is an illustrative and clearly fictional scenario. Marlow Yard Properties, an invented REIT holding twelve suburban business parks, spent two years being described in the trade press as a loss-making business. Its statutory accounts showed losses because a large refurbishment programme had pushed annual depreciation to $64,000,000 against rental income that was growing steadily.
The fictional management team began leading every results presentation with FFO, showing $51,000,000 of funds from operations against a $9,000,000 statutory loss, and publishing a line-by-line reconciliation between the two. Analysts who had been valuing the company on its non-existent earnings switched to a price-to-FFO basis, and the shares re-rated over the following year.
The lesson Marlow Yard's invented board drew was that the reconciliation mattered more than the headline. Investors accepted FFO only once they could trace every adjustment back to an audited figure.
Watch out
Common mistakes.
- Treating FFO as a cash flow figure, when it is an adjusted profit measure that still includes non-cash items such as straight-lined rent.
- Comparing FFO across two property companies without reading each one's definition and reconciliation, since the adjustments are not fully standardised.
- Using FFO to assess a non-property business, where adding back depreciation on machinery that genuinely wears out would badly overstate performance.
Questions
People also ask.
Why not just use EBITDA for property companies?
EBITDA ignores interest, and property companies are usually heavily financed by debt, so a measure that sits after interest costs gives a far more honest view.
Is FFO or AFFO the better guide to dividend safety?
AFFO is generally better because it subtracts the recurring capital spending needed to keep buildings lettable, though FFO is more consistently defined across companies.
Does FFO appear in the audited financial statements?
Not as a primary figure, since it is a non-statutory measure, but listed property companies normally publish a reconciliation from net profit to FFO alongside their results.
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