CFA Level IAlternative InvestmentsMedium
A REIT reports net income of $5,000,000 for the year, which includes $2,000,000 of depreciation expense and a $500,000 gain on the sale of a property. Using the standard NAREIT definition, what is the REIT's Funds From Operations (FFO)?
- A$7,500,000
- B$5,500,000
- C$6,500,000
- D$7,000,000
Show answer & explanationAnswer & explanation
Correct answer: C. $6,500,000
FFO = Net income + Depreciation and amortization − Gains on sale of property (+ Losses on sale). FFO = $5,000,000 + $2,000,000 − $500,000 = $6,500,000. This adjustment removes non-cash depreciation (which understates real estate's economic value) and excludes one-time gains from property sales to better reflect recurring operating performance.
Why the other options are wrong
- A. Adds back depreciation but fails to subtract the gain on sale of property.
- B. Subtracts depreciation instead of adding it back, reversing the correct adjustment.
- D. Subtracts the gain incorrectly as a smaller amount or omits part of the depreciation add-back.
Funds From Operations (FFO)
FFO is a REIT performance measure calculated as net income plus depreciation and amortization, minus gains (plus losses) on sales of property, designed to better reflect a REIT's recurring cash-generating operating performance than GAAP net income.
- Depreciation is added back because real estate often appreciates rather than depreciates economically
- Gains/losses on property sales are excluded as non-recurring items
- FFO is a standard REIT industry metric defined by NAREIT
Memory trick: Add back the depreciation myth, strip out the one-time sale gain.