Instead of reporting earnings like other companies, REITs report FFO. Why is this?
REITs have high depreciation expenses because of how properties are accounted for. But the properties don’t fall in value to zero like, say a piece of equipment would. So, the high real estate depreciation charges—which are required accounting—can seem unrealistic given that real estate assets have historically appreciated and been sold for a gain. Besides, those depreciation expenses aren’t real cash being expensed anyway. It’s only a paper loss and not a cash loss. So FFO adds back the depreciation expenses—and makes other adjustments as well.
Keep in mind that FFO is a non-GAAP financial measure of REIT performance. GAAP stands for Generally Accepted Accounting Principles. Non-GAAP means that FFO is not an accounting standard.
The National Association of Real Estate Investment Trusts (NAREIT) has defined FFO as:
Net Income
+ Depreciation
-/+ Gains/Losses on Property Sales (removes one-time items)
-/+ Adjustments for unconsolidated joint ventures and partnerships
Unfortunately, the NAREIT definition isn’t uniform in practice. Not every REIT calculates FFO according to the NAREIT definition. Or they may interpret the NAREIT definition differently.
Blue Vault presents FFO in keeping with the NAREIT definition to the best of its ability, given the public information made available by each REIT in the quarterly filings. We may attempt to deduce FFO for nontraded REITs that are not forthcoming but cannot guarantee the accuracy.
FFO does have some limitations:
FFO is an accrual measure of profitability, not a cash measure of profitability. That is because FFO (and net income) records income and expenses, regardless of whether cash has actually changed hands.
The NAREIT definition of FFO also does not take into account one-time items—those gains or losses that aren nonrecurring.
FFO contains another weakness: it does not subtract out the capital expenditures required to maintain the existing portfolio of properties. Real estate holdings must be maintained, so FFO is not quite the true residual cash flow remaining after all expenses and expenditures.
FFO is an imperfect measure of REIT performance, but it is one we can use for the nontraded REIT industry at this time. Blue Vault is employing the NAREIT definition and adjusting company-reported FFO to comply with NAREIT whenever possible.
