Why Funds From Operations (FFOs) are the Key Metric for REIT Success
As real estate prices continue to rise, investing in property can be challenging for most investors. Fortunately, Real Estate Investment Trusts (REITs) have emerged as a popular alternative investment option, providing diversification into real estate at a nominal rate. REITs are tradable on the exchange and provide regular dividends to its investors.
However, using metrics such as Earnings Per Share (EPS) to measure the success of REITs may not be the most accurate approach, as EPS is a common metric used to analyze stocksSponsored Product. Instead, measuring the financial performance of REITs requires unique metrics such as Funds From Operations (FFOs).
What are REITs and FFOs?
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.
FFOs 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 calculate FFO, the formula is:
FFO = Net Income + Depreciation + Amortization – Gains or Losses from Sales
Depreciation and amortization expenses are added to the FFO formula because, according to accounting principles, depreciation and amortization are deducted. However, real estate assets often appreciate in value over time and don’t experience the same kind of depreciation as other assets. Hence, depreciation is added back.
For example, imagine a REIT operating in India that earned Rs 50 lakh in net income over the course of a year. During that time, the REIT sold one property for a profit of Rs 5 lakh and another for a loss of Rs 1 lakh, resulting in a net gain of Rs 4 lakh. Additionally, the REIT recorded a depreciation of Rs 1 lakh and an amortization 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 lakh (net income) + Rs 1 lakh (depreciation) + Rs 75,000 (amortization) – Rs 4 lakh (net gain from property sales), which comes to Rs 47.75 lakh.
Why FFOs are Important for REIT Success
When it comes to REITs, the value of their properties can fluctuate with changes in the country’s macroeconomic trends. Also, 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 analyze 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. Therefore, investors can use FFO as a reliable indicator to analyze a REIT’s financial performance accurately.
Investing in REITs can be lucrative, but 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 you make informed investment decisions. Therefore, investors looking to invest in REITs should keep FFO in mind as a reliable indicator to analyze a REIT’s financial performance.
(The author is Head of Research, TejiMandi)
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of Economic Times)