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When evaluating the profitability of most companies, we can simply look at the net income, and derive metrics such as earnings per share (EPS) and the price-to-earnings ratio (P/E). However, when it comes to real estate investment trusts, or REITs, these metrics don't provide an accurate snapshot of how much money the company is really making.

In the case of equity REITs -- that is, REITs that own properties -- a better metric to use is funds from operations , or FFO . Here's what you need to know about FFO and how to use it.

Why can't we just look at a REIT's net income?

The biggest reason we can't just use net income, or earnings, is the way real estate investments are accounted for. Specifically, businesses are allowed to depreciate assets over time as a form of business expense, including real estate. This makes it appear that the REIT's properties are losing value over time, even though this "expense" isn't costing anything.

Not only is this not a real expense, but as we know, real estate tends to increase in value over time. Since net income takes a substantial amount of depreciation into account, it's not an accurate depiction of the cash flowing into a REIT.

How FFO is calculated

FFO starts with net income, and then adds the depreciation expense back in, and makes a few other adjustments in order to accurately show investors the REIT's cash flow.

To illustrate FFO, consider this example from Realty Income's most-recent quarterly report. As you can see, the depreciation "expense" is quite a large amount. As a result, net income and FFO are two completely different numbers.

Item Amount
Net Income $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 (FFO) $162.16 million

Using FFO to value REITs

When REITs issue their quarterly reports, FFO is usually divided by the number of outstanding shares to produce the FFO/share. This is the equivalent metric to earnings per share (EPS) when evaluating a REIT.

From the FFO/share, we can use the REIT's current share price to evaluate its Price-to-FFO ratio, which is the REIT version of a P/E ratio. This is useful for comparing the valuations of several REITs, and can also tell you whether or not REITs, in general, are trading for a high or low valuation.

Is there an even more accurate measurement of cash flow?

Finally, it's worth noting that many REITs use a modified version of FFO in their financial reports. This may be known as adjusted FFO (AFFO), or normalized FFO, and further compensates for certain company-specific capital expenditures.

While this is the most precise measurement of a REIT's cash flow and ability to pay its dividend, keep in mind that modified forms of FFO aren't standardized between companies. In other words, one REIT's method of computing AFFO may not be the same as that of its peers. For this reason, even though it is more indicative of cash flow, AFFO, or normalized FFO metrics, aren't ideal for comparing REITs to one another.

The Foolish bottom line

FFO is one of the most important metrics to use when evaluating equity REITs , and can give you a clearer picture of each company's profitability than simply looking at net income.

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