When you analyze the recent result of most companies, you’ll probably look at metrics such as net income or earnings per share (EPS). And there’s a good reason for this.
In most cases, a company’s earnings tell you how fast its profits are growing. Earnings also affect how much money is available to pay dividends, buy back shares, or reinvest in the business.
But traditional methods of calculating earnings don’t translate well to real estate investment trusts (REITs). A far better metric to use is funds from operations (FFO). Let's look at
- why EPS and net income aren’t accurate for real estate businesses,
- why FFO does the job better, and
- a real-world example of how it works.
Why net income and EPS are misleading metrics for REIT investors
Traditional ways of expressing "earnings" don’t translate well to REITs. The same is true of other businesses with substantial real estate assets. It's because of a simple tax deduction known as depreciation.
Here’s depreciation in a nutshell: If you buy an investment property, you can deduct the cost of the building (but not the land) over a certain number of years. 27.5 years for residential properties and 39 years for nonresidential properties.
In other words, if you spend $200,000 to acquire a rental condo, you can deduct $7,273 every year for the next 27.5 years. If your rental income after expenses for the property in a given year is $12,000, you can use a $7,273 depreciation expense to lower your rental income to just $4,727 for tax purposes.
This is a big advantage of investing in real estate. Wouldn’t everyone rather pay taxes on less than $5,000 of income as opposed to $12,000? The depreciation deduction allows real estate investors to keep more of their profits.
However, it makes your stated profit misleading. In this case, you didn’t really earn $4,727 for the year. Your profit was $12,000 and the depreciation deduction made your profits look deceptively low.
The same concept applies to REITs, only on a larger scale. REITs generally have massive depreciation "expenses" that reduce their net income. The problem is that depreciation is reflected in a REIT’s net income as an expense -- even though it doesn't cost anything. So a REIT's net income and earnings per share don’t give an accurate picture of the company’s profits.
Also, it’s worth mentioning that all companies that own real estate for business purposes can use the depreciation deduction. But a REIT’s primary business is owning real estate. That's why depreciation meaningfully distorts REIT earnings.
How funds from operations (FFO) is determined
The biggest adjustment FFO makes to a company’s net income is adding back the depreciation expense. After all, this isn’t an actual business expense, so it shouldn’t be reflected in any useful profitability metric. FFO also makes a few smaller adjustments, such as subtracting preferred dividends and distributions. But depreciation is typically the largest change by far.
To give you an idea of how this works, here’s the first-quarter 2019 FFO calculation for leading residential REIT Equity Residential (NYSE: EQR).