Funds From Operations (FFO)

A measure of cash flow used in real estate.

What is FFO or Funds from Operations?

Funds from operations (FFO), is the actual amount of cash flow generated from business operations. In order to calculate the FFO, one must add the expenses or losses, which are not actually incurred from the operations, such as: depreciation, amortization, and any losses on the sale of assets, to net income.  Then subtract any gains on the sale of assets and interest income.  FFOs are  commonly used by companies that engage in Real Estate Investment Trusts (REITs), a business that primarily operates on income-generating real estate transactions. REIT companies are involved in commercial real estate – selling, leasing, and financing of office and apartment buildings, warehouses, hospitals, shopping centers, hotels and timberlands.

What is the Formula for FFO?

FFO = Net Income + (Depreciation expense + Amortization expense + Losses on sale of assets) – (Gains on sale of assets + Interest income)

To illustrate:

Obama Real Estate Company declared a net income of $10M last year, a depreciation expense of $2M, an interest amortization expense of $1M, an interest income of $500,000, and a gain on the sale of various assets of $1M. The actual cash flow from business operations resulted in $11.5M.

What are Depreciation, Amortization, and Losses on Sale of Asset?

These finance terms are the costs that need to be added back to net income for the purpose of determining the actual earnings generated from the core business operations. Non-operating expenses are excluded from the main business functions and therefore should be added back to net income where initially deducted.

Depreciation – expenses allocated monthly to cover capital expenditures  – acquisition of property, plant and equipment, or any fixed assets. This is a non-cash expense, because the monthly expense deducted from income does not involve a cash payment.

Amortization –loan and capital expense payments spread out over a specific period of time.

Losses on sale of asset – loss incurred when an asset is eliminated and the selling price is lower than the net book value of the asset sold.

What are Gains on the Sale of Asset and Interest income?

Gains on the sale of asset and interest income are both deducted from net income to calculate the actual cash flow from operations. These earnings are not from the main business.

Gains on the sale of asset – gain obtained when an asset is sold and the selling price is higher than the net book value of the asset.

Interest income – earnings from the interest of marketable securities, long-term investments, or cash maintained in checking accounts.

What is the Importance of FFO in business?

FFO measures the business’s operational efficiency or performance, especially for most REIT companies. The reason for this is that real estate values are proven to rise and fall with macroeconomic conditions, and any operating results computed when using the cost accounting method do not reflect the accurate measurement of performance. FFO is being used by real estate companies as an operating performance benchmark, while investors use this to determine the financial performance of a real estate company.