How this instrument works
Funds from operations exists because GAAP net income is a poor stand-in for how much cash a real estate investment trust actually generates each period. Depreciation is the biggest culprit: accounting rules force a REIT to write down its buildings every year as if they were machinery wearing out, even though well-maintained real estate in decent markets usually holds or gains value. FFO adds that non-cash depreciation charge straight back onto net income, then strips out gains or losses from selling properties, because one-time sale profits do not repeatably measure how the portfolio performs quarter to quarter.
Nareit, the industry's trade association, formalized this add-back-and-strip-out approach in 1991 specifically so REITs could be compared to one another on a consistent basis, since GAAP earnings for two REITs with different depreciation schedules or sale activity in a given quarter can look wildly different despite near-identical underlying performance. Analysts, REIT chief financial officers, and dividend-focused investors use FFO instead of earnings per share to judge whether a trust's payout is actually covered by cash the business produced, rather than propped up by an accounting charge working in its favor.
FFO is not free cash flow. It excludes routine capital spending — leasing commissions, roof repairs, tenant improvements — that a property needs just to keep generating rent, which is why many REITs also disclose adjusted FFO that subtracts those recurring costs. Treat this figure as a cleaner earnings number for comparing REITs, not as a substitute for the full cash-flow statement.
- Enter Net income, $ — the GAAP figure straight off the REIT's income statement for that period.
- Add Depreciation & amortization, $ — the non-cash charge from the same period's cash flow statement.
- Enter Gains on property sales, $ — any one-time profit booked from selling real estate this period.
- Read Funds from operations — the instrument adds back D&A and removes sale gains automatically.
Worked example — one REIT's $5M quarter
One mid-size REIT closes its quarter with net income of $5,000,000 on its GAAP income statement. Depreciation and amortization for the same period comes to $3,000,000, the non-cash charge tied mostly to its office and retail buildings. During the quarter the trust also sold an aging strip mall for $500,000 over book value, unrelated to its ongoing operations.
Entering those three figures gives FFO = $5,000,000 + $3,000,000 − $500,000 = $7,500,000. That $7.5 million, not $5 million GAAP net income, is what a REIT's chief financial officer reports to analysts, and what a dividend investor checks against total quarterly distributions to judge whether payouts are actually covered by operating performance.
Questions
Why add depreciation back to net income?
Because GAAP depreciation assumes a building wears out like equipment, losing value every year on fixed schedules, while well-located real estate in normal markets typically holds or appreciates. That mismatch makes depreciation the single largest reason GAAP net income understates a REIT's real cash performance, so FFO reverses the charge to get closer to actual operating cash generated.
Why subtract gains on property sales?
One sale gain reflects one transaction, not the recurring rents and operations that make up a REIT's ongoing business. Leaving it in would let one profitable sale flatter that quarter's FFO and make it useless for comparing performance against a quarter with no sale activity. FFO strips it out, and would add back a sale loss, so the metric tracks repeatable, operating-driven cash flow only.
How is FFO different from AFFO?
FFO adds back depreciation and removes sale gains, full stop. Adjusted FFO starts from FFO and further subtracts recurring capital costs — leasing commissions, tenant improvements, routine building upkeep — that a property needs just to keep generating rent. AFFO sits closer to true free cash flow; FFO is the simpler, industry-standard comparison metric most REITs report first.
Is FFO the same as cash flow from operations?
No. Cash flow from operations comes straight off the cash flow statement and reflects actual cash movements, including changes in working capital. FFO starts from net income and makes two specific, standardized adjustments defined by Nareit. The two figures are related but rarely identical, and analysts track both rather than treating one as a substitute for the other.
Why do REITs report FFO instead of just EPS?
Because GAAP earnings per share is dragged down by depreciation charges that do not reflect any real decline in the properties' value, making EPS an unreliable way to compare REITs against each other or against their own dividend payouts. FFO per share, not EPS, is the figure most REIT dividend-coverage and valuation discussions actually use.
Can FFO be negative?
Yes, if net income is negative enough that adding back depreciation and subtracting any sale gains still leaves the total negative — typically during periods of heavy write-downs, high vacancy, or a struggling portfolio. Negative or sharply falling FFO relative to distributions paid is one of the clearest warning signs analysts watch for in a REIT's quarterly results.
References
- SEC Investor.gov — Real estate investment trusts (REITs)
- SEC — Real Estate Investment Trusts investor bulletin
Read this first: This instrument shows arithmetic, not advice. Real offers add fees, taxes and terms that vary by lender and place — verify the figures against your actual paperwork before deciding anything.