Why REIT FFO Differs from Net Income

The difference between REIT FFO (funds from operations) and net income is fundamental to real estate investing. FFO strips out depreciation—a non-cash charge that depresses GAAP net income—and excludes one-time gains on property sales, revealing the recurring cash the REIT can distribute to shareholders. For this reason, FFO is the standard metric investors use to value and compare REITs, not the headline net income figure.

The Depreciation Problem in Real Estate Accounting

Under generally accepted accounting principles, most assets are depreciated over a fixed useful life. A manufacturing facility, a truck, or office equipment loses value predictably and is expensed over years. The depreciation deduction is real from a tax standpoint—it reduces taxable income.

But commercial real estate does not behave like equipment. Buildings often appreciate over time, especially in tight markets. Yet the accountant must record depreciation because GAAP rules require it. A REIT that owns a $100 million office building, depreciating it over 40 years, records a $2.5 million annual non-cash charge that crushes reported net income—even if the building’s market value rose by $5 million that year.

This mismatch between accounting depreciation and economic reality led the industry to develop FFO.

Funds From Operations: The Add-Back Formula

FFO is calculated as:

FFO = Net Income + Depreciation & Amortization – Gains on Property Sales ± Other Adjustments

Start with the GAAP bottom line. Add back all non-cash charges related to real property (building depreciation, intangible asset amortization). Subtract one-time gains from selling a property at a profit. The result is a closer approximation of cash thrown off by the core real estate portfolio and available for distributions.

This formula acknowledges a simple truth: depreciation as recorded is a phantom expense. Cash left the building decades ago (when it was purchased or constructed), not this year. The depreciation charge is an accounting allocation, not a cash outflow.

Example: The Paradox of Rising Value and Falling Net Income

Consider a REIT with:

• 100 apartment buildings, each worth $1 million
• Purchased 20 years ago at $1 million each; 40-year lives, $25,000 annual depreciation per building
• Total depreciation per year: $2.5 million

Now assume rents rise 3% across the portfolio, generating $3 million in new rental income (net of expenses), and two buildings are sold at $1.2 million each (a $200,000 gain per building).

GAAP net income looks bad:

• Operating profit (rents minus operating costs): +$3 million
• Depreciation: –$2.5 million
• Gains on sale: +$400,000 (two properties × $200,000 each)
• Reported net income: roughly $900,000

But FFO looks much better:

• Operating profit: $3 million
• Add back depreciation: +$2.5 million
• Subtract gains on sale: –$400,000
• FFO: $5.1 million

The REIT generated $5.1 million in recurring cash from the portfolio (rents plus the reversal of a non-cash charge), yet GAAP net income shows under $1 million. A naive P/E valuation would severely undervalue the REIT.

Why Gains on Sales Are Excluded

When a REIT sells a property, it often books a large gain. This gain is real economically—the asset sold for more than its cost basis—but it is not recurring. If the REIT is shrinking or in harvest mode, high gains are expected; if the REIT is growing, gains may signal a one-time disposition to fund acquisitions.

By excluding gains from FFO, the metric isolates the repeatable cash from holding and operating the real estate portfolio. FFO is meant to answer: “What can I distribute to shareholders quarter after quarter from my core portfolio?” Gain or loss on a sale is a separate question—one-time capital redeployment, not a rent-paying machine.

AFFO: Further Refinement

Some investors and analysts use AFFO (adjusted funds from operations), which goes further:

AFFO = FFO – Maintenance Capital Expenditures + Other Adjustments

Maintenance CapEx is the cash the REIT must spend to keep properties in operating condition (roof repairs, parking lot resurfacing, HVAC replacement). Unlike growth CapEx (buying new properties or major renovations), maintenance CapEx is mandatory and ongoing.

AFFO subtracts this required maintenance spending, showing the cash truly available for distributions or growth. A REIT with high maintenance costs will have lower AFFO than FFO; one with newer, lower-maintenance properties will show the two metrics closer together.

How Valuation Differs: Dividend Yield on FFO

Investors value REITs using FFO per share and the FFO dividend yield (annual distribution divided by stock price), not traditional P/E multiples. A REIT trading at $50 per share with FFO per share of $5 has an FFO yield of 10%. If it distributes 80% of FFO as dividends, the cash dividend yield is 8%.

This focus on FFO reflects the economic reality of real estate: the business is essentially cash collection from rent-paying tenants, with depreciation an accounting artifact. FFO restores clarity.

Taxable Income and REIT Distributions

From a tax perspective, REITs often have lower taxable income than FFO because depreciation and other deductions shield income. The REIT can distribute FFO (or even more) while reporting little or no taxable income. This is why REIT distributions are often partly a return of capital (not subject to immediate tax) and partly ordinary income or capital gains.

Shareholders must track the composition of their distributions to understand their tax liability, a detail FFO reporting helps illuminate but does not resolve.

The Industry Standard

Today, all major REITs report FFO and AFFO in their earnings releases and investor presentations. The National Association of Real Estate Investment Trusts (NAREIT) publishes standardized definitions to ensure consistency.

Using net income alone to compare REITs would produce nonsensical results. FFO is not optional; it is the language of the REIT market.

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