The terms funds from operations (FFO) and cash flow are related but describe somewhat different concepts. Cash flow is a measurement of the net amount of cash and equivalents moving in and out of a business. FFO is a specific method of expressing the cash generated by real estate investment trusts (REITs) and is close to, but not the same as, a certain type of cash flow. Here's what you need to know about cash flow, and why we need a different metric to show the cash generation of companies that own large amounts of real estate.

What is cash flow?
As the name implies, cash flow is the amount of cash and equivalents moving in and out of a business. If a business' cash flow is positive, that means that after paying all of its business expenses, there is still money left over to distribute to shareholders, reinvest in the business, and add to its bank accounts. A negative cash flow implies that money is moving out of a business faster than it is moving in, and could be a sign of trouble.

On a company's cash flow statement, there are three different categories of cash flow:

  • Operating cash flow: the cash generated by the company's day-to-day business.
  • Investing cash flow: cash generated by investment activity, including the acquisition of assets and securities.
  • Financing cash flow: the cash flow related to a company's investors and creditors.

Adding all three categories together gives you the company's overall cash flow for the time period.

Why do we use FFO for REITs?
For equity REITs, that is, REITs that own properties, FFO is used because it gives investors an accurate picture of the company's cash flow, since it compensates for one accounting figure that distorts these companies' income figures -- depreciation.

When businesses own long-term assets such as equipment, computers, and buildings, the IRS allows the assets to be depreciated over a long period of time. With the traditional calculation for income, these are deducted to reflect the declining value of these assets over time as business expenses.

However, when it comes to real estate, this really isn't an expense at all. In other words, real estate doesn't have a "shelf life" -- an apartment building, for example, will be just as much of an asset to a REIT in 10 years as it is today. In fact, it will probably increase in value over that time. This is in direct contrast to the depreciation "expense" reflected in REITs' income calculations.

The purpose of FFO is to convey a more accurate measure of a REIT's cash flow, and therefore its ability to keep up with its dividend payments to investors. FFO adds the depreciation expense (which doesn't actually cost anything) back in and makes a few other adjustments.

To illustrate, consider this FFO calculation from popular retail REIT Realty Income's most recent quarterly report.

Item

Amount

Net Income available to common stockholders

$60.71 million

Depreciation

$104.34 million

Depreciation (furniture, fixtures, and equipment)

($0.18 million)

Provisions for impairment

$3.86 million

Gain/loss on sale of properties

($6.22 million)

Other FFO adjustments

($0.34 million)

Funds from operations

$162.16 million

The Foolish bottom line
It's important to keep in mind that although operating cash flow and FFO are similar metrics, they're not quite the same thing. Cash flow can be a great way to evaluate the financial well-being of a business, but for the purposes of assessing whether a REIT is earning enough to cover its dividends, FFO is the way to go.

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