Investors put their resources into various investments to generate a return. They can choose from several types of these investments, which can lead to different results. For example, they can select between investing in stocks, bonds, commodities, etc. However, calculating the performance of these investments differs due to the different classes to which relate.
Therefore, investors need specific tools to measure how their investments perform. In most cases, the returns that investors get from those investments may suffice. However, calculating those may not be as straightforward. Nonetheless, estimating the operation performance of an investment is crucial for investors. This process can not only help them understand their returns but also make the comparison more straightforward.
The above discussion may apply to real estate investment trusts (REITs), where operating performance measures differ. REITs are investment funds or companies that own real estate that produces income. The performance metrics for these funds include the funds from operations (FFO) and adjusted funds from operations (AFFO).
What is Funds From Operations (FFO)?
Funds from operations (FFO) represents a metric used to measure the operating performance of real estate investment trusts. With this metric, investors can measure the cash flows they get from a REIT’s operations. Funds from operations don’t include cash flows from financing, for example, interest income or expense.
Similarly, funds from operations do not include any gains or losses from the disposition of an asset. On top of that, it also ignores any non-cash items, for example, depreciation or amortization. Therefore, funds from operations only consider the cash flows that a REIT generates through its operations. It represents one of the essential metrics to measure a REIT’s performance.
Funds from operations begin with the net income generated from a REIT’s operations. However, this figure does not represent the cash flows generated from operations. Instead, it is an accounting metric used to calculate how effective the trust is. After that, it adds any non-cash items to the net income figure. These items do not represent any cash flows but are accounting figures. These items include depreciation, amortization, and losses on deposing assets.
Funds from operations also remove any gains on the sale of assets. As mentioned, these losses and gains come from accounting estimates. Therefore, they do not represent actual cash flows. Consequently, it is crucial to adjust for them when calculating funds from operations. Lastly, this metric adds interest income to the net income since it represents cash flows from financing activities.
Overall, funds from operations is a metric used to measure the operating performance of a real estate investment trust. It is crucial for investors as it allows them to establish the actual cash flow from operations. Since it is cash flow-based, funds from operations adjusted for non-cash items. On top of that, it does not consider cash flows from financing activities but only focuses on operating cash flows.
How to calculate Funds from Operations?
Funds from operations require several elements. These include the net income, which represents the accounting earnings from operations. From there, it also requires non-cash items. Usually, they will consist of depreciation, amortization, and gains and losses on assets. Lastly, it requires any interest income, deducted to include cash flows from operations only.
Therefore, investors can use the following formula for funds from operations.
Funds from operations = Net income + (Depreciation + Amortization + Losses on sale of assets) – (Gains on sale of assets + Interest income)
The above funds from the operations formula cover all the necessary tools to calculate the cash flows from operations. In case any of these items are not a part of operations, the calculation will neglect them.
What is Adjusted Funds from Operations (AFFO)?
In some cases, funds from operations may not cover all the required items to gauge a trust’s operating performance. Therefore, it may be necessary to use the adjusted funds from operations. As the name suggests, this metric adjusts a REIT’s funds from operations to get a modified figure. This figure is crucial in analyzing a real estate investment trust.
Adjusted funds from operations measure the financial performance of a REIT. It also helps provide investors with an alternative method to gauge its performance. Compared to funds from operations, adjusted funds from operations provides a better measure of operating performance. Its primary advantage over the former is considering the maintenance cost of real estate property over its life.
However, adjusted funds from operations do not require a separate estimation of the performance. Instead, it bases its calculation on the existing funds from operations. Investors adjust the FFO figure by deducting recurring expenses for running and maintaining properties. This adjusted figure represents the adjusted funds from operations.
Apart from maintenance costs, adjusted funds from operations also consider the straight-lining of rents. This method distributes rent expense over the life of a property. Both of these figures are crucial for REITs as these costs are necessary for property investments. Therefore, by adjusting for these, investors can get a better view of the operating performance of a REIT.
Overall, adjusted funds from operations represent a better way of calculating a REIT’s operating performance. It considers recurring capital expenditures used to maintain the quality of the underlying property assets. Usually, these expenditures include maintenance costs and straight-lining of rents. However, it may also involve leasing costs and other material factors.
How to Calculate Adjusted Funds from Operations?
The adjusted funds from operations calculation require investors to measure the funds from operations first. Once they do so, they must adjust for recurring capital expenditures and maintenance costs necessary for the properties. Similarly, this calculation requires considering any rent changes for those properties.
Investors can use the following formula for adjusted funds from operations.
Adjusted funds from operations = Funds from operations – Straight-lined rents – Recurring capital expenditure – Routine maintenance costs
The above-adjusted funds from operations formula help investors adjust the funds from operations. Similar to the funds from the operations formula, any figures not available are not necessary for calculation.
Example
A real estate investment trust, ABC Co., reported a net income of $30 million from its operations. During this period, the company also charged depreciation of $2 million and amortization of $1 million. Similarly, the company sold two of its properties during the period.
One property led to a gain of $2.5 million, while the other made a loss of $1.5 million. Lastly, ABC Co. also recorded an interest income of $4 million during the period.
Overall, ABC Co.’s funds from operations were as follows.
Funds from operations = Net income + (Depreciation + Amortization + Losses on sale of assets) – (Gains on sale of assets + Interest income)
Funds from operations = $30 million + ($2 million + $1 million + $1.5 million) – ($2.5 million + $4 million)
Funds from operations = $28 million
During the same period, ABC Co. had straight-lined rent costs of $0.5 million. In addition to that, it also incurred $1.5 million on recurring capital expenditure. The routine maintenance costs reported by the company for the same period were $1 million. Therefore, ABC Co.’s adjusted funds from operations will be as follows.
Adjusted funds from operations = Funds from operations – Straight-lined rents – Recurring capital expenditure – Routine maintenance costs
Adjusted funds from operations = $28 million – $0.5 million – $1.5 million – $1 million
Adjusted funds from operations = $25 million
Conclusion
Funds from operations is a metric used to measure the operating performance of a real estate investment trust. However, it may not consider some other critical factors.
Therefore, the adjusted funds from operations provide a better view of its operations. AFFO considers factors such as straight-lined rent costs, recurring capital expenditure, and routine maintenance costs. It makes those adjustments to the funds from operations.
