Understanding Funds From Operations

Investors often ignore or misunderstand real estate investment trusts (REITs), because the methods used to evaluate their performance are often very different from the more familiar ways that investors analyze retailing, manufacturing, and technology companies.

In reality, REITs such as Public Storage (NYSE:PSA), Kimco (NYSE:KIM), and Equity Office Properties Trust (NYSE:EOP) aren't much more difficult to evaluate financially than a retailer such as Target. One particular metric can provide investors with a good start toward gauging an REIT's performance. Funds from operations (FFO) allow investors a more accurate look at "earnings" for REITs.

Funds from operations and its limitations
Here's how the National Association of Real Estate Investment Trusts (NAREIT) defines FFO:

FUNDS FROM OPERATIONS means net income (computed in accordance with generally accepted accounting principles), excluding gains (or losses) from sales of property, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. Adjustments for unconsolidated partnerships and joint ventures will be calculated to reflect funds from operations on the same basis.

To make this definition easier to read, I have put it into a table:

For most REITs, the two most important parts for investors to consider when calculating FFO will be the reversal of the depreciation charge (the second item in the table above) and any gains or losses from sales of property (the third item above). Gains and losses from property sales are largely one-time in nature, and should obviously be factored out, but the reason for reversing the depreciation charge may not be as clear.

Here's why depreciation is reversed: To calculate net income, generally accepted accounting principles (GAAP) require that you calculate and expense depreciation for all assets except land, which is not depreciated. Real estate, such as buildings and land, generally retains its value -- and in some cases increases in value. But on the balance sheet, land sits at its historical cost, and the building is eventually depreciated down to zero. Since a REIT's primary business involves operating real estate, the depreciation charges are substantial, and they can negatively skew a company's true profitability.

There's another problem with FFO -- not every company defines it the same way NAREIT does. This makes it tricky to compare one REIT to another, and there's no easy way around this problem. I recommend you check how each of your selected REITs calculates FFO before you make any comparisons.

The other limitations of FFO are the same as those for net income and earnings per share. Both FFO and net income are accrual measures of profitability, not cash measures of profitability. Also, neither accounts for the cost of capital necessary to maintain the existing level of earnings. Sometimes, a company's cash and accrual profitability aren't very different -- but not always.

One important item missing in FFO: the maintenance (or recurring) capital expenditures required to keep buildings in good working order. These include light fixtures, flooring repairs, paint, and general repairs. Since depreciation is included in FFO, it's important to adjust for these expenditures.

AFFO, CAD, and FAD
To get to closer to cash profitability, many REITs also report an adjusted FFO (AFFO), cash available for distribution (CAD), or funds available for distribution (FAD) figure. None of these figures is standardized, and many REITs define them differently. It's important to consider the details each company provides and how closely those details mirror the company's costs of operating its business. Some of the more common items rolled into AFFO, CAD, and FAD include recurring capital expenditures, straight-line rental income, tenant improvements, and leasing commissions. All of these items are different under accrual accounting than cash accounting. If adjusted for, they'll decrease FFO in most cases.

Motley Fool Income Investor selection Healthcare REIT (NYSE:HCN) includes funds available for distribution (FAD) in its earnings press releases. In its calculation of FAD, Healthcare REIT adjusts for straight-line rent and compares its funds available for distribution to its dividend payout. This is a helpful metric, but since it's missing recurring capital expenditures, it still doesn't get investors all the information they need to calculate cash profitability.

A Foolish FFO finale
To calculate a true adjusted FFO number, investors must often read a company's 10-Q -- and, if available, the supplemental disclosures that many REITs such as Weingarten Realty Investors (NYSE:WRI) post on their websites. This may sound like a lot of work on the surface, but it's not much different from a Sears Holdings (NASDAQ:SHLD) shareholder having to adjust operating cash flow and capital expenditures to calculate free cash flow.

Like any earnings measure, FFO and the variants I've mentioned above have their limitations. Even a well-thought-out analysis of a company's AFFO doesn't tell you anything about its balance-sheet strength, its strategy, or its management. However, the FFO and AFFO of a REIT give you an important tool that for gauging a company's ability to fund its dividend, and a baseline from which you can jump into other forms of analysis.

Learn more about FFO and REITs in the pages of Mathew Emmert's Motley Fool Income Investor . Mathew's full Foolish list of top dividend-paying stocks is yours free with a 30-day guest pass.

At the time of publication, Nathan Parmelee owned shares in Healthcare REIT. He has no financial interest in any of the other companies mentioned. The Motley Fool has an ironclad disclosure policy.