How Funds From Operations (FFO) Help in Real Estate Investment?

The total amount of cash that a Real Estate Investment Trust (REIT) generates is called the Funds from Operations. FFO helps companies in the real estate industry understand their operating performance in terms of the total money being spent and received. It does not let the capital costs like depreciation and amortisation impact the performance measurement. Hence, it gives a more realistic estimate of the returns generated by REITs. 

If you are planning to invest in the real estate industry, know what funds from operations are and how they can impact your investing decisions. Read on!

Why is FFO Important?

The FFO helps you understand the operational efficiency of REIT companies. The real estate industry has seen an upward trend, so investors prefer investing in REITs. However, with a slight change in the macroeconomic factors, the value of investments might decline sharply. Therefore, when you use technical accounting methods to understand the performance, you might not get a fair picture of the performance.

Additionally, per GAAP, all assets must be subjected to depreciation or amortisation. However, the GAAP principle does not consider that different kinds of assets, like land, property, etc., grow in value over time. Hence, these costs need to be added back while calculating the performance of an asset. The FFO is also important as it excludes all windfall gains and occasional losses to understand where the company stands. 

Therefore, companies and investors use FFO to get a clear picture of the business’s operating performance. It also gives an overall understanding of the financial position of the company. Investors also get a fair idea of how their investments are being used. Several companies are now considering funds from operations in management accounting as it presents a realistic picture of how well the companies in the real estate industry are performing.

Funds From Operations Formula

The formula for calculating the funds from operations is:

Funds from operations = Net Income – (Interest Income + Gains on Sale of Assets) + Interest Expense + Losses from the sale of assets + Depreciation and Amortisation.

Once you have the aggregate FFO value using the FFO formula, you can calculate the per-value share by using the following formula:

Funds from operations per share = Funds from Operations/ Total Number of Outstanding Shares

The formula considers readily available values that are not difficult to gather and calculate. 

How to Calculate Funds From Operations?

It would be best to consider a few factors before calculating the funds from operations. 

• Do not consider any money from funding and the expenses incurred in the financing activities.
• Do not include any profits or losses incurred from the non-recurring activities of the business, like gains from selling an asset, etc. 
• Ensure that you include the values of depreciation and amortisation in the funds from operations format while calculating the value.

You must deduct any interest or non-recurring items that might be a part of the company’s financials. All capital expenses must be added back to the net income to get the value of FFO. You must follow the following steps and include them in the funds from operations format for calculations.

• You must check the income statement of the REIT before calculating the FFO. Use the information to get the net income of the company.
• Companies use depreciation and amortisation to increase the expanse of their expenses and factor in the cost of holding an asset. Hence, they can reduce their net income. Therefore, you need to add back the depreciation and amortisation to come to the actual revenue of the REIT.
• Exclude all losses incurred due to non-recurring business activities like selling long-term assets like a plant, equipment, etc. 
• Also, subtract any windfall gains earned from property sales or other non-recurring business activity.
• Finally, subtract the interest income of the business as it is not a regular part of its operating activities.

See the example below to understand the fund flow statement problems and solutions.

An Example of Funds From Operations

Let’s take funds from operations examples to understand the calculation of FFO. 

Abhishek and Co., a realty company,  generated a net income of Rs.5,00,00,000 in the financial year 2021-22. During the period, the company also earned an interest income of Rs.10,00,000 from its debt instruments. The company also paid Rs.10,00,000 as interest on their borrowings. The company also sold two of its long-term assets in the year. 

The first asset was sold at a gain of Rs.3,00,00,000, and the company lost Rs.1,50,00,000 on selling the second asset. The company also accounted for Rs.90,00,000 as depreciation and amortisation expenses on their assets. 

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The following table represents the accurate method of FFO calculation:

Therefore, the total fund from operations for Abhishek and Co. stands at Rs.4,40,00,000. Now, if you have additional information that states that the company has 10,00,000 shares, you can calculate the FFO per share. In this funds from operations example, the FFO per share will be 4,40,00,000 / 10,00,000, i.e.Rs.44 per share.

Uses of Funds From Operations

Apart from the increase in the usage of funds from operations in management accounting, there are several other uses for operations. Here are some ways in which you can use the FFO:

1. Assessment of the Company

The funds from operations give a clear snapshot of how the company is performing and the kind of cash flows they have for the year. Therefore, you can use FFO to analyse how the company uses the cash it has in hand and if it can generate enough operating revenue. You can also use the metric to understand the business’s working capital requirements. Hence, you can use the FFO metric to understand the company’s actual performance.

2. Assessment of a REIT

When investing in a REIT, you should never consider the numbers calculated through traditional cost accounting methods. The cost accounting methods do not factor in the macroeconomic changes that might impact the trust.  

Therefore, you cannot rely on the net profit to understand the trust’s performance. You need to calculate the FFO to understand the performance of the fund and its efficiency. The FFO will better understand the funds flown into the REIT in that particular financial year. 

Difference Between Fund Flow and Cash Flow From Operations

You must understand the funds from operations problems and solutions to use the metric effectively. Many companies and investors interchange the terms funds from operations and cash flow from operations. The cash flow from operations is also included in the REIT statement of cash flow when examining REITs. The funds from operations should not be confused with this number, though. The terms “fund flow from operations” and “cash flow from operations” are extremely different.

FFO does not account for capital expenditures; instead, it measures the net cash inflow and its equivalents into the business due to operating activities. On the other hand, cash flow calculates the total gross cash that entered and left the company. It provides a complete picture of the organisation’s finances, including capital expenses.

Final Word

Before investing in REITs, you must consider the fund from operations to get a clear picture of the company’s operating performance and the trust. You must know the FFO formula to calculate the figure and then use the metric to compare different REITs. The higher FFO denotes better performance. Hence, when you compare the REITs, consider this fact.