What are Funds From Operations
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When you want to evaluate the financial status of most companies, the first figure you want to know is, what is their net operating income. Because if they're not making much money, you don't need to know anything else. Nothing else is important. But for a REIT, you look first at the FFO.
When you're evaluating the financial status of Real Estate Investment Trusts, net operting income is not such an important figure, because of depreciation. Funds From Operations (FFO) is the preference.
Funds From Operations - Accounting Rules Try to Reflect Reality, but Reality is Too Complicated to Make That Easy
Nothing lasts forever, so depreciation is the accounting term for factoring the cost of replacing a worthless building. However, all physical objects in this universe -- including commercial real estate properties -- are declining every second. Therefore, businesses are allowed to count some depreciation as an expense every year.
However, depreciation is never exact, for the simple reason that we don't know the future. Well-maintained real estate continues to hold and increase in value most years.
Sooner or later, the house you're living in is going to be torn down, but it may be many years after your death. Some people in Europe are living in houses that are hundreds of years old.
By the way, depreciation refers to the gradual decline of a building as a whole. Of course, some upkeep and maintenance expenses are always inevitable. Carpets must be replaced in apartments, and so on. These items are included as normal expenses.
So in most years, a REIT that's maintaining its buildings, counts a certain amount of depreciation expense as a deducation from its net income, but doesn't lose any cash. This is required by the Securities and Exchange Commission and Generally Accepted Accounting Principles (GAAP).
Therefore, most real estate investors looking at REITs add the depreciation back to net income, to arrive at a more realistic view of how the company is handling its cash funds. Besides, in most years, good and well-maintained real estate properties appreciates (goes up) in value, not depreciates.
Also, when evaluating the year a REIT had, add back any money gained from selling off property.
Funds From Operations Calculations can Change a Lot in the Details
To add to the confusion, since FFO is an industry concept and not strictly defined as GAAP, different real estate trusts have calculated it in different ways.
Amortization is an accounting term that works like depreciation in that it spreads an expense out over the (estimated) life of a property. REITs might amortize leasing commissions paid to leasing agents, and tenant improvement allowances, which is the expense of remodeling a property to suit the needs of a particular tenant.
In 1999, the National Association of Real Estate Investment Trusts defined Funds From Operations as Net Operating Income (per GAAP), exclusing gains or losses from sales of properties, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures.
However, while NAREIT is a great industry organization, it has no power to force REITs to use their definition of FFO, and not all of them do use Funds From Operations universally.
Next: What are AFFO -- fine-tuning financial statements.
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