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Funds from operations is an industry standard to compare and evaluate REITs performance.

June 9, 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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‍“Total FFO grew 5% to $156 million. Excluding the effect of exchange rate fluctuations, the FFO for 2015 increased by 17% and FFO per share increased by 15%,” said Gazit-Globe Chairman of the Board in the 2015 annual report. Placing FFO results on the first of 412 pages of the Annual Report to shareholders should demonstrate the importance of the measurement. 

Funds From Operations (FFO) is an earnings measure that excludes (1) depreciation charges, (2) deferred tax charges, and (3) gains or losses from sales of property and debt restructuring. Compared to net income measure, FFO better demonstrates the economic reality. While company assets such inventory and equipment lose value with time, real estate market value often increases. Transactional gains or losses are excluded from FFO.

While Net Operating Income (NOI) excludes financial leverage effects, FFO deducts the debt service from earnings. Leverage does not affect the value of a real estate property, but leverage does affect the value of REIT. In The Evolution of Debt Financing, Chris Czarnecki of Broadstone Real Estate, analyzes the evolution of debt financing.

One way to value a REIT is by comparing its market price multiple to its peers. If two REITs own similar real estate assets, have comparable management teams, and share similar risk profiles, common sense dictates to purchase the cheaper REIT; the one with the lower price multiple.

Table a: Calculating funds from operations

As a point of reference, price multiples in 1999 were 7 to 8 times. In 2007, price multiples reached 20 times. 

Pros and cons

Similar to Internal Rate of Return, FFO is not an absolute measure of value. It is questionable whether or not an increase in FFO translates to an increase in value. And there are more drawbacks. FFO does not adjust for capital expenditures; it is subject to accounting shenanigans and may hide value. FFO is unaffected by land and empty buildings, but they carry value.

FFO is widely accepted, it provides a comparison measure with other asset classes, and it is widely available in financial statements. For management compensation, the measure is essential. As an illustration, City Office, an office REIT notes: “If core funds from operations is less than 90% of our net taxable income, we will not be able to make sufficient distributions to maintain our REIT status.”