What is a REIT’s Funds From Operations (FFO) and how can investors use this metric to their advantage

Nick Sundich Nick Sundich, April 17, 2024

ASX REITs often use the metric Funds From Operations (FFO). Investors new to investing in REITs may wonder what it is given that few non-property stocks use it on one hand, but just about all property stocks do on the other. And so it can raise quite a few eyebrows belonging to investors looking at REITs for the first time.

It is important to note at the outset that this is not merely a fancy way of describing ‘profit’, this is a distinct measure and one that just about all ASX REITs use – in fact, they judge payouts as a percentage of this metric. In this article, we recap what this metric is and how can investors use it to their advantage!

 

What is meant by the term Funds from Operations (FFO)?

FFO is an important metric used to measure the financial performance of a real estate investment trust (REIT). It measures the amount of cash generated from the core operations of an ASX-listed REIT, including rental income, any proceeds from property sales and other related activities. It allows investors and analysts to gain insight into the profitability of a REIT and to compare it with similar companies.

FFO may appear similar to any other company’s profit, but it is a distinct measure – indeed, property stocks will report these measures separately. Unlike profit, it does not include non-cash charges such as depreciation and amortisation, which can distort the true level of profitability. Therefore, by removing these non-cash expenses, this metric is considered to be a more reliable indicator of the operating performance of a REIT. It is commonly the metric through which dividends are calculated – they are paid as a proportion of this metric (typically 90-95% if not 100%).

To make a long story short, this metric can provide investors with valuable information about the long-term sustainability of a particular REIT business model and its ability to generate consistent returns for shareholders.

 

What about Adjusted Funds from Operations?

You might also hear REITs talk about Adjusted Funds From Operations (AFFO). You see, non-adjusted FFO takes into account non-cash expenses, such as depreciation and amortisation, which can distort the picture on traditional income statements. AFFO also accounts for certain one-time or non-recurring items that may have a large effect on reported earnings but are unlikely to repeat in future periods.

Examples include gains and losses from asset sales, impairments, discontinued operations, and other one-time events or extraordinary items. This helps investors get an indication of what the REIT’s core operating performance looks like without these one-off factors affecting the results.

 

How to use FFO to your advantage as an investor

The key is using the Price to FFO multiple (P/FFO) multiple. It works similarly to the Price to Earnings (P/E multiple) but it uses FFO instead of Earnings Per Share. It is used similarly to the P/E multiple in that investors may calculate a company’s P/FFO multiple and use this number, along with the multiples of close peers, and determine that a REIT is either overvalued or undervalued. You may also use it to try and predict a dividend payout. Because REITs tend to pay out 90-100% of FFO, investors can look at guidance a company has provided for the year ahead and use it to predict what the payout will be.

But just like the P/E multiple, while this metric can give investors an idea of how well a company has performed in the past, it should not be relied upon solely when making investment decisions. Investors should use other decisions such as yield, P/NTA and the quality of the REIT’s portfolio. There are several ways to judge portfolio quality that multiples do not account for. These include occupancy, carbon footprint, flagship tenants and the locations of all the individual properties.

Also, keep in mind what we said earlier, that FFO does not take into account one-time costs or non-cash expenses that could impact the company even if they aren’t a cash-outflow. However, we think P/FFO is more reliable than P/NTA because it looks at a REIT’s core operations. The latter may be able to hide flaws in the operating model, but the former can’t.

 

Conclusion

We recommend all REIT investors keep their eyes on this metric and multiple because of the insights it provides into a REIT’s performance and how much of a payout it might make. But of course, as with all individual metrics used to judge a potential investment, it should not be used as the only factor in your investment decisions, even if sits near the top of the one’s list – as it probably should.

 

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