Procrustean bed

Funds from operations is a helpful metric to understand dividend behavior. But not all supplemental metrics are easy to gather and to analyze

October 20, 2016

About the author

Noam Ganel, CFA is the founder of Pen&Paper, a value-oriented, contrary-minded journal of the financial markets. Between 2010 and 2020, Ganel worked for Silvergate as Vice President in Capital Markets. He provides advisory services to family offices,  private companies, and financial advisors.

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While REITs are required to distribute 90 percent of their taxable income as dividends to shareholders, they tend to distribute more dividends than required. Their dividend policy is often related to cash flow, leverage, and firm size. To clarify dividend policy, management often supplements the financial statements with non-GAAP performance measures, aiming to provide additional resources beyond GAAP earnings to estimate future dividends.  

National Association of Real Estate Investment Trusts (NAREIT) defines Funds From Operations (FFO) as net income, excluding gains or losses and depreciation. An adjustment for unconsolidated partnerships and joint-ventures is deducted as well. Since the introduction of the definition in 1991, the term has come to be widely used by the industry. The intent behind the voluntary performance measure is to remove from earnings the effect of depreciation, which reduces the value of real estate over time. 

FFO is more helpful compared to reported earnings in explaining the dividend policy of Real Estate Investment Trusts (REITs), notes Danny Ben-Shahar of the Technion, Israel Institute of Technology. He extracted a data set of 590 REITs over the period 2001 and 2008. He concluded that indeed FFO is helpful to understand dividend policy.  And that the depreciation component affects the ability to predict the distribution of dividends. 

FFO excludes assumptions made by management on the real estate useful lives. Without these assumptions a better picture of cash flow arises. Accrual accounting is designed to reflect a better economic reality than cash accounting. But it was discovered that it provides investors with less information on dividend policy.  

Would Adjusted Funds From Operations (AFFO) show similar results? In the math behind AFFO, acquisition expenses and equity based compensation are added to FFO as well as non-recurring or non-cash expenses. These costs are unrelated to the operating performance of the real estate.

Yet the definition of AFFO varies from company to company. And because the real estate activity of REITs is different, the non-operating components of the financial statements can be large. So a REIT's reported AFFO needs to be meticulously analyzed in order to be compared to its peers. It is hard to do.