Funds From Operations

Funds from Operations Definition

The accepted funds from operations definition is the measurement of cash flow derived from certain types of real estate investment trusts. These real estate investment funds, or REITs, are generally exempt from corporate income taxes; consequently, they are required to distribute 90% percent of profits to investors. REITs share the same general investment structure as mutual funds, but are composed of real estate investments rather than stock market shares.

Funds from Operations Calculation

In order to determine the potential for earnings of a REIT, it’s necessary to calculate its likely funds from operations figure. This is accomplished by determining its net income including depreciation and amortization but excluding gains on real estate sold during the period. The typical formula for funds from operations calculation is as follows:

• Funds from operations = (Net income + depreciation + amortization) – gains on sales of real estate

The funds from operations figure offers a more accurate picture of the performance of REITs than typical accounting methods, since it takes into consideration the depreciation (or appreciation) of real estate investments and excludes one-time gains on sales that generally do not have a long-term effect on earnings potential.

Adjusted Funds from Operations

For an even more accurate depiction of the current financial performance of a REIT, analysts use a number of formulas to calculate the adjusted funds from operations figure. Simply put, the adjusted funds from operations for a REIT is derived by adding rent increases and subtracting capital expenditures and routine maintenance expenses from the funds from operations figure. The resultant figure provides shareholders and analysts with a more accurate basis for assessment of the probable earnings potential of the REIT and a better measure of its financial security.

Other Financial Indicators

Other important figures to consider when investing in REITs include net asset value and cash available for distribution. Net asset value is, as its name indicates, the total value of assets less any outstanding liabilities, and is usually divided by the number of outstanding shares in order to derive the net asset value per share. Because 90% of all profits are distributed to investors, the cash available for distribution figure is used to derive the likely short-term return on investment for REIT investors. Combined with the figures for funds from operations or adjusted funds from operations, these are the primary indicators of financial condition for REITs.

REITs have suffered hits to both their funds from operations and adjusted funds from operations figures in recent years due to recent housing industry downturns. Some REITs have lost as much as 60% of their previous value; prospects are uncertain for full recovery, although some recent indicators offer hope for the future. In order to ensure a reasonable return on investment, potential investors are advised to carefully examine management policies and historic data for any REIT they are considering; conservatively managed REITs typically have performed better in recent years than more risk-oriented investment offerings.