Funds from Operations (FFO) is a critical metric for evaluating the financial performance of Real Estate Investment Trusts (REITs). Unlike traditional financial metrics, FFO provides a more accurate reflection of a REIT’s operating performance by excluding non-cash expenses like depreciation and amortization. Understanding FFO is essential for investors looking to assess the true earning power of a REIT.
What is FFO?
FFO is a measure of the cash generated by a REIT’s operations. It starts with net income and adds back depreciation and amortization of real estate assets. These add-backs are crucial because real estate often appreciates over time, contrary to the depreciation recorded on financial statements. By excluding these non-cash charges, FFO offers a clearer picture of a REIT’s operational efficiency and its ability to generate cash flow.
Why is FFO Important?
- Accurate Performance Measurement: Traditional net income metrics can be misleading for REITs due to the significant impact of depreciation and amortization. FFO adjusts for these factors, providing a more accurate representation of a REIT’s performance.
- Dividend Sustainability: REITs are required to distribute a significant portion of their income as dividends. FFO helps investors evaluate whether a REIT can sustain its dividend payments. A higher FFO indicates a stronger ability to generate cash flow and pay dividends.
- Comparison Across REITs: FFO standardizes the measurement of operating performance, making it easier to compare different REITs. This is especially important in the real estate sector, where properties and portfolios can vary widely.
Calculating FFO: An Example with ILAM Fahari I-REIT
Consider the performance of ILAM Fahari I-REIT for H1’2024. The REIT reported a basic earnings per unit of Kshs 0.3 million, down from Kshs 0.5 million in the same period the previous year. This decline was influenced by a decrease in total income and a reduction in operating expenses.
To better understand the REIT’s performance, we calculate FFO by adding back non-cash expenses like depreciation and amortization. ILAM Fahari I-REIT reported Kshs 53.8 million in comprehensive profit and Kshs 109.8 million in total operating expenses during H1’2024. By excluding depreciation and amortization, we get a more accurate measure of cash flow:
FFO = Net Income + Depreciation + Amortization (Fair Value Adjustment on Investment Property)
If depreciation and amortization for ILAM Fahari I-REIT totalled Kshs 30 million, the FFO calculation would be:
FFO = 𝐾𝑠ℎ𝑠 53.8 million + 𝐾𝑠ℎ𝑠 30 million
FFO=Kshs 83.8 million
This adjusted figure provides a more realistic view of ILAM Fahari I-REIT’s cash-generating ability.
Using FFO in Investment Decisions
When evaluating REITs, investors should consider the FFO per share, which divides the total FFO by the number of outstanding shares. This metric allows for a per-share comparison across different REITs. Additionally, investors should look at the growth in FFO over time to assess the REIT’s ability to increase its cash flow and, consequently, its dividends.
FFO vs. Net Income: A Comparative Analysis
To further illustrate the importance of FFO, let’s compare two REITs: REIT A and REIT B. Both have reported a net income of Kshs 40 million. However, REIT A has Kshs 20 million in depreciation and Kshs 10 million in amortization, while REIT B has Kshs 10 million in depreciation and Kshs 5 million in amortization.
For REIT A:
FFO = Kshs 40 million + Kshs 20 million + Kshs 10 million = Kshs 70 million
For REIT B:
FFO = Kshs 40 million + Kshs 10 million +Kshs 5 million = Kshs 55 million
Despite having the same net income, REIT A has a significantly higher FFO, indicating it generates more cash from operations and potentially has a better capacity to pay dividends.
Funds from Operations (FFO) is an essential metric for analyzing REITs, offering a more accurate picture of their operating performance by excluding non-cash expenses like depreciation and amortization. By understanding and utilizing FFO, investors can make more informed decisions, assess the sustainability of dividend payments, and compare REITs effectively especially at this time when they are releasing their H1’2024 financial statements. This metric is a cornerstone for anyone looking to invest in the real estate sector, providing critical insights into the true earning power of REITs.
