Cash flow is often confused with the term funds from operations (FFO). However, despite the semblance of terms, both these concepts are different.
While cash flow denotes the amount of cash that is coming in and out of business, FFO represents a specific approach to determine the total monetary amount a business generates, exclusive to Real Estate Investment Trusts (REITs).
Therefore, it is critical to learn about the fund from operations as an independent concept for the metric’s sound application into any sort of analysis.
Funds from operations, as a financial concept, is the total amount of cash a Real Estate Investment Trust (REIT) generates in a specific accounting period from its operations.
However, it is distinct from cash flow in the sense that it does not involve all types of cash flow, but only what it generates from core operations. The National Association of Real Estate Investment Trusts (NAREIT), based out of Washington D.C., pioneered the concept of FFO.
Therefore, the fund from operations figure does not account for cash flows that are generated from or expended for financing activities like interest income or expense, respectively.
Furthermore, since it explicitly relates to core operations, non-recurring cash flows like gains and losses from any sale of assets do not become a part of FFO calculation.
It is a critical measure of the operational performance of a business. When gauging REITs for prospective investments, entities often resort to its fund from operations in lieu of more standard metrics like Earnings per share (EPS).
One of the essential reasons why FFO is explicitly used for REITs over EPS is the inclusion of depreciation and amortisation.
As per GAAP guidelines, every business is required to depreciate their assets periodically. However, that practice might distort the operational performance of a Real Estate Investment Trust because its primary assets include land and building, which do not necessarily depreciate over time. Rather, on the contrary, lands and buildings typically appreciate in value with time.
The FFO method corrects this distortion by excluding depreciation and amortisation from its computation. Resultantly, it portrays a much clearer understanding of a REIT’s actual operational performance. Furthermore, entities also represent FFO on a per-share basis to function as a more effective metric.
In order to calculate FFO, one needs to consider a few pointers –
Therefore, to calculate funds from operations, one must deduct any interest income and non-recurring gains from the net income. Then they must add back interest expense, losses from the sale of assets, and depreciation & amortisation to the net income.
The funds from operations formula can, therefore, be written as –
Funds from operations = Net income – (Interest income + Gains on sale of assets) + Interest expense + losses from sale of assets + depreciation and amortisation
Once funds from operations are calculated individuals can also find the per-share value by dividing the total amount by the number of outstanding shares.
Funds from operations per share = Funds from operations / Total number of outstanding shares
Example:
Hasan Realty Group generated a net income of Rs.5 crores in the Financial Year 2019 – 20. In the same period, it also earned Rs.50 lakh as interest from its SPV and paid Rs.10 lakh as interest towards repayment of debt. Furthermore, it sold two of its assets in June and November. It realised a gain of Rs.3 crore from the second sale but suffered a loss of Rs.1.5 crore from the first sale. Additionally, Hasan Realty Group accounted for Rs.90 lakh as depreciation and amortisation, keeping up with GAAP guidelines. Hasan Realty Group has 10,00,000 outstanding shares.
The following table demonstrates the calculation of funds from operations of Hasan Realty Group from the data mentioned above.
| Particulars | Amount (in lakhs) | Amount (in lakhs) |
| Net income | Rs.500 | |
| Interest income | Rs.50 | |
| Gains from sale of asset | Rs.300 | |
| Total deduction | (Rs.350) | |
| Interest expense | Rs.10 | |
| Loss from sale of asset | Rs.150 | |
| Depreciation and amortisation | Rs.90 | |
| Total addition | Rs.250 | |
| Fund from operations | Rs.400 |
Ergo, Hasan Realty Group’s total fund from operations stands at Rs.4 crores. Further, to calculate FFO per share, one needs to divide Rs.4 crores by the total number of outstanding shares, i.e. 10 lakh. Thereby, FFO per share equals to Rs.4 (40000000 / 1000000).
It might be of concern whether deducting key cash flows and earnings from the net income can be trusted as a measure for operational efficiency of any business.
However, some of the conditions that characterise Real Estate Investment Trusts (REITs) necessitate the usage of FFO instead of other metrics, which are predominantly used as an analytical tool for other kinds of investments.
For instance, interest income is excluded from the fund from operations because if its source is a Special Purpose Vehicle, then it might be eligible for a pass-through status.
However, the most critical reason why FFO is the go-to metric for scaling the operational efficiency of a REIT is that depreciation and amortisation are added back to the net income. That way, it represents a much more exact picture of a Real Estate Investment Trust compared to the P/E ratio and the likes.
In particular cases, specific capital expenditures that are recurring might also appear in the books of a REIT. For instance, property maintenance-related expenses like roof repairing and painting, are recurring in nature. Therefore, even though these are capital expenditures, they are deducted from FFO to reach adjusted funds from operations. It allows investors to gain a truer understanding of a REITs true value.