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ASX REITs often use the metric Funds From Operations (FFO). Investors new to this space may wonder what it is given that few non-property stocks use it. In this article, we recap what this metric is and how can investors use it to their advantage!
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Funds from Operations?
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 a REIT, including rental income, any proceeds from property sales and other related activities.
FFO allows investors and analysts to gain insight into the profitability of a REIT and to compare it with similar companies. Unlike net income, it does not include non-cash charges such as depreciation and amortization, 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%).
In 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 amortization, 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. 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 including 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. So, keep your eye on this metric and multiple if you are a REIT investor, although don’t use it as the only factor in your investment decisions.
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