What it means
Ordinary net income does a poor job of describing a property business. Buildings are depreciated every year under accounting rules, even though well-maintained property often holds or increases its value.
That depreciation reduces reported profit without taking any cash out of the bank. FFO fixes this by adding back real estate depreciation and amortisation.
It also takes out gains or losses from selling properties, because those are one-off events rather than the steady income from renting space. What is left is a figure that reflects the recurring performance of the rental business.
Investors use FFO per share much as they would use earnings per share for other companies. They compare it to the share price to see how much they are paying for each dollar of recurring property income, and they compare it to dividends to judge whether payouts are covered.
Industry bodies publish a standard definition so that results can be compared between companies, which is why most REITs present FFO in the same basic format. FFO has limits, and analysts know them.
It ignores the money that must be spent on maintaining and refurbishing buildings, so a company can report strong FFO while spending heavily to keep its properties competitive. Because of this, many investors also look at adjusted FFO, which deducts recurring capital spending.
A final nuance is that FFO is a non-GAAP style measure, so companies must reconcile it to net income in their reports. Reading that reconciliation is worth the effort, as it shows exactly what was added back and what was removed, and it is the quickest way to spot an unusually generous adjustment.
In practice
Real-world examples.
Example
An investor is comparing two office property companies. One reports net income of $15 million, but its FFO is $38 million after adding back depreciation. The investor sees that the company generates far more recurring income than the headline profit suggests.
Example
A REIT sells a warehouse for a $9 million gain, which lifts its net income for the year. The finance team removes the gain when calculating FFO, so the figure reflects only rent and operating results. Management explains this in the earnings release.
Example
A lender assessing a shopping centre owner looks at FFO to judge how comfortably the business can service its loans. The owner shows FFO of $12 million against annual interest of $4 million. The lender approves the loan at a modest margin, because FFO covers the interest bill three times over and the business has room for a bad year.
Formula
Calculation
FFO = net income + depreciation and amortisation of real estate - gains on property sales (+ losses on property sales)
Suppose a REIT reports net income of $40 million, real estate depreciation and amortisation of $25 million, and a $6 million gain on selling a building. FFO = 40 + 25 - 6 = $59 million. If the company has 20 million shares, FFO per share = 59 / 20 = $2.95. If the share price is $59, the price to FFO multiple is 59 / 2.95 = 20 times.Case study
Seen in the real world.
Greenfield Property Trust is an illustrative, fictional REIT that owns a portfolio of apartment buildings. In one year, its reported net income fell sharply, and a newspaper columnist described the trust as struggling.
The chief financial officer pointed out that the fall was caused by higher depreciation after a large acquisition and by the absence of a gain on sale that had boosted the previous year. FFO, which stripped out both items, had risen by 8% because rents and occupancy had improved.
In this illustrative scenario, the trust used the FFO reconciliation in its annual report to explain the difference. Analysts then focused on the maintenance spending the trust still needed, and asked for adjusted FFO as well, which gave a fuller view of the business. The chief financial officer agreed to publish both measures side by side from then on.
Watch out
Common mistakes.
- Treating FFO as the same as cash flow, when it ignores changes in working capital and the cost of maintaining and improving buildings.
- Comparing FFO between companies without checking that they have used the same definition and adjustments.
- Adding back all depreciation, including depreciation on non-property assets such as office computers and vehicles, when the standard definition concerns real estate related depreciation.
Questions
People also ask.
Why is depreciation added back for real estate?
Because property often keeps its value over time, so the accounting charge overstates the true economic cost of owning the building.
What is the difference between FFO and adjusted FFO?
Adjusted FFO, sometimes called AFFO, deducts recurring capital spending and other items, so it comes closer to the cash available to pay dividends.
Is FFO used outside real estate?
It is rarely used outside property and similar asset-heavy sectors, where depreciation and cash earnings differ widely.
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