Funds From Operations (FFO)
Funds From Operations (FFO) is the primary earnings metric used to evaluate real estate investment trusts (REITs), calculated by adding depreciation and amortization back to net income and excluding gains or losses on property sales, providing a clearer picture of a REIT's recurring cash-generating ability than GAAP net income.
FFO was standardized by the National Association of Real Estate Investment Trusts (NAREIT) in the early 1990s to address a fundamental problem with applying standard GAAP accounting to real estate companies. Under GAAP, real estate assets are depreciated over time, which reduces reported net income even when the underlying properties are actually appreciating in value. For a manufacturing company, depreciation of equipment is economically meaningful because machines genuinely wear out. For a well-maintained commercial property in a strong market, depreciation is largely an accounting convention that can deeply distort earnings comparisons.
The FFO formula reverses this distortion. Starting from GAAP net income, FFO adds back real estate depreciation and amortization, then subtracts gains on sales of properties (since these are one-time events, not recurring income). The result is a figure that better reflects the cash a REIT is generating from its ongoing operations of leasing and managing real estate.
Formula: FFO = Net Income + Depreciation and Amortization - Gains on Property Sales
For example, Realty Income Corporation (O), one of the largest net-lease REITs in the United States, consistently reports FFO well above GAAP net income because of the large depreciation charges associated with its portfolio of thousands of retail and commercial properties. Investors and analysts use FFO per share as the REIT equivalent of earnings per share (EPS) for ordinary corporations, and the price-to-FFO ratio serves the same benchmarking function as the price-to-earnings ratio.
REIT dividends are also frequently evaluated relative to FFO. A payout ratio expressed as dividends divided by FFO gives investors a sense of how much of recurring operating cash flow is being distributed versus retained. A ratio below 100% generally indicates the REIT can sustain its dividend from operations, while a ratio above 100% raises questions about dividend sustainability.
While FFO is a major improvement over net income for REIT analysis, it still has limitations. FFO does not subtract capital expenditures needed to maintain properties in rentable condition. It can also include certain non-cash revenues. These limitations led to the development of Adjusted Funds From Operations (AFFO), which attempts to capture a truer free cash flow figure. Nonetheless, FFO remains the primary standardized metric that REIT management teams, analysts, and data providers use when comparing performance across the sector.