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Comparing REITs? Why "Funds From Operation" Matters


Using this metric can turn earnings into a much more meaningful method for evaluating REIT performance on an operating basis.

Funds From Operations, or FFO, is the most widely watched performance metric when evaluating real estate investment trusts (REITs). As defined by NAREIT, a real estate trade group and lobbying organization, FFO is "The most commonly accepted and reported measure of REIT operating performance. Equal to a REIT's net income, excluding gains or losses from sales of property, and adding back real estate depreciation." Essentially, FFO tries to boil down how a REIT's regular operations are faring, or as the name would suggest, how much cash the properties (or mortgages) are kicking off. (For more on different REIT types, read: Are REITS Right for Your Investor Type?)

Here is a snapshot of some major REITs and how their respective FFOs per share for 2011 stack up, according to Standard and Poor's, along with their 2011 stock price performance:
  • Vornado Realty Trust (VNO) -- $5.38 per share (-7.6%)
  • Public Storage (PSA) -- $5.86 per share (+31.2%)
  • AvalonBay Communities (AVB) -- $4.59 per share (+15.3%)
  • Equity Residential (EQR) -- $2.45 per share (+9.1%)
FFO is generally equated with the concept of "earnings" that traditional equity investors are familiar with when analyzing a company's financial performance over a finite period of time. Specifically, FFO measures how much cash its portfolio of properties is generating, once operating expenses have been backed out. Since property values are based primarily on net cash flow, and a key benefit of REIT ownership is the right to dividends, operating cash flow is essential to understanding a REIT's value.

But before we jump into how to use FFO to examine and compare REITs, it's important to understand why FFO excludes gains or losses from sales of property and adds back real estate depreciation.

Since selling a building at a gain or loss in a given year is more representative of the owner's relative success with that individual investment over a distinct ownership period rather than how operations are faring at a given moment in time, it's reasonable to exclude sales from a measure of operating performance. If property sales were not excluded from FFO, REIT managers would liquidate properties during bad years to prop up earnings numbers, even if selling into a demand vacuum meant lousy exit prices.

The reasons for adding back in depreciation to calculate FFO are a bit trickier to understand. Generally Accepted Accounting Principles assume that properties depreciate, or decline in value over time. Bean counters, in their infinite wisdom, live in a world where properties wear out: roofs start leaking, wood rots away and buildings generally decay. Accountants have even gone so far as to have determined that properties will actually depreciate to a zero value in 27.5 years. As a result, property owners can take a non-cash loss of 1/27.5th of their property's value each tax year (it should be said that with any tax-related issue, this statement barely scratches the surface of depreciating real estate assets, but is sufficient for the purposes of this piece). This loss does not impact cash flow, but does drag down taxable income and therefore traditional earnings measurements. So to get down to how a REIT is actually performing on a cash flow basis, depreciation, which is a completely allowable non-cash-loss item, is added back to arrive at FFO.

So by stripping out property sales and depreciation, FFO can turn earnings into a much more meaningful method for evaluating REIT performance on an operating basis.

As one would imagine, there are critiques of the widespread use of FFO just as there are investors who believe that traditional earnings-based analysis falls short for traditional equity investing.

A primary drawback of FFO is that it does not incorporate property appreciation or depreciation. That means in years when properties are actually falling in value, stripping our depreciation can artificially inflate REIT shares and mask underlying problems. In other words, slight drops in FFO stemming from higher vacancies or lower rents may pale in comparison to the risks posed to investors by falling property values.

To better understand this, let's take a quick look at how commercial real estate is typically valued, using capitalization rates, or "cap rates" in industry jargon. The easiest way to think about a cap rate is the return generated by a property, after operating expenses, if you owned the property outright (ie, no debt). For example, if you buy an office building for $1,000,000 that takes in $10,000 per month, or $120,000 per year in rent, that costs $60,000 per year to operate (utilities, management fees, taxes, insurance, maintenance etc), your net operating income would be $60,000, or a 6% cap rate ($60,000/$1,000,000).

To see how a drop in FFO can mask falling property values, let's consider a year where vacancies run higher than normal and the building takes in $110,000 rather than $120,000. If operating costs remain the same, net operating income would be $50,000 rather than $60,000. Applying that same 6% cap rate to value the property arrives at a value of $833,000 ($50,000 / 0.06), so the mere $10,000 drop in net income equated to an almost $170,000 drop in value. This is, of course, an oversimplified example, but shows that small changes in FFO -- depending, of course, on what caused them -- can imply large changes in the value of the underlying real estate a REIT owns.

Another drawback in using FFO is that it understates the capital required to maintain buildings, since many capital improvements (heating systems, new floors, etc) are depreciated and thus added back in to arrive at FFO. And since REIT managers may treat these maintenance items differently, FFO can quickly become a less-than-ideal measure for comparing different REITs performance on an apples-to-apples basis.

There are, of course, several additional ways to look at REIT performance, such as adjusted funds from operations, called FFO, cash available for distribution, or CAD, and net asset value, or NAV. Next time, we will compare several major REITs using FFO along with these performance metrics to see how each one tells a slightly different story, and that only together can they paint an accurate picture of a REIT, or basket of REITs.

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