Get to know why FFO is the go-to metric for measuring the financial performance of REITs.
With the rising cost of real estate, investing in property has become a challenge for most investors. Amidst all this, Real Estate Investment Trusts (REITs) have emerged as a popular alternative investment option.
REITs offer diversification into real estate at a nominal rate. It is readily tradable on the exchange and provides regular dividends to its investors. However, while REITs share some similarities with stocks, relying solely on metrics such as Earnings Per Share (EPS) to measure their success may not be the most accurate approach.
Can you use EPS to measure the success of a REIT? Only sometimes, because EPS is a standard metric used to analyse stocks, it isn’t always the best option for REITs.
A metric called Funds From Operations (FFO) is considered while measuring the financial performance of REITs.
So let’s dive into everything you need to know about FFO and why it’s the go-to metric for measuring the financial performance of REITs.
A REIT is an entity registered with SEBI that raises money from investors and invests it in commercial properties. These properties are managed by the REIT and are rented out to tenants.
When a REIT earns revenues from the rental income, they deduct any expenses incurred and distribute the amount of the profits among the unit holders (investors) as dividends.
To qualify as a REIT, SEBI requires that at least 80% of the funds raised by the company are invested in completed properties that can be rented out. Additionally, the REIT must distribute at least 90% of its income to investors through dividends. Because of these unique characteristics, REITs have gained massive popularity.
What are Funds From Operations (FFO) in REITs?
Funds From Operations (FFO) is a metric used to gauge the cash generated by a REIT.
A cash flow tracks the cash going in and out of business. Instead, FFO focuses specifically on the cash generated by the REIT from its operations.
To understand this even better, let’s take an example. For a bakery, income from renting out unused kitchen space or a one-time sale of bakery equipment could be considered non-operating income. But, removing such non-operational transactions gives us the funds from operations, which is the company’s primary source of revenue from its core business of baking and selling baked goods.
Similarly, for a REIT company, income from a one-time property sale or a gain from an investment could be considered non-operating income. Removing such non-operational transactions gives you the funds from operations, which is the company’s primary source of revenue from its core business of owning and renting real estate properties.
To calculate FFO, we use this formula:
FFO = Net Income + Depreciation + Amortisation – Gains or Losses from Sales
You might wonder why depreciation and amortisation expenses are added to the FFO formula. According to accounting principles, depreciation and amortisation are deducted. But real estate assets often appreciate over time and don’t experience the same depreciation as other assets. Hence, depreciation is added back.
Let’s understand the FFO calculation with the help of an example.
Imagine a REIT operating in India that earned Rs 50 lakhs in net income over a year. During that time, the REIT sold one property for a profit of Rs 5 lakhs and another for a loss of Rs 1 lakh, resulting in a net gain of Rs 4 lakhs. Additionally, the REIT recorded a depreciation of Rs 1 lakh and amortisation of Rs 75,000 for the year.
Using the FFO formula, we can calculate the cash generated by the REIT as follows:
FFO = Rs 50 lakhs (net income) + Rs 1 lakh (depreciation) + Rs 75,000 (amortisation) – Rs 4 lakhs (net gain from property sales) which comes to Rs 47.75 lakhs.
So, based on this calculation, the REIT generated Rs 47.75 lakhs in cash over the year through its daily operations.
What Do Funds From Operations Tell Us?
Regarding Real Estate Investment Trusts (REITs), the value of their properties can fluctuate with changes in the country’s macroeconomic trends. Also, there might be a case where the net profit of the REIT may not reflect its true operating picture as it includes various components. In such cases, FFO is considered a reliable indicator to analyse a REIT. Also, it can be used as a benchmark to measure the REIT’s efficiency.
The FFO shows the funds earned by the REIT in a financial year, and a higher FFO amount is generally considered better for investors.
In conclusion, while investing in REITs can be lucrative, it’s crucial to understand the right metrics to measure their financial performance accurately. FFO can help you evaluate a REIT better, which can help them make informed investment decisions.
So, if you’re looking to invest in REITs, remember to remember FFO as a reliable indicator to analyse a REIT’s financial performance!
Note: Teji Mandi originally wrote this article for ET Markets. You can find the originally published article here: https://ecoti.in/6ebKBZ