Tuesday, March 22, 2011

MFFO - It's Not You, It's Me
Modified Funds From Operations (MFFO) is a performance metric used to measure a real estate investment trust's financial health.  I do not like the metric and discount it when looking at a REIT's financial performance.  To me, MFFO adds back too many one-time items to make it useful for analyzing the long-term financial status of a REIT.  Non-traded REIT sponsors like to use MFFO when discussing a REIT's ability to cover its distribution because MFFO is going to be a higher number than operating cash flow or Fund From Operations, making the REIT's performance appear better.  When analyzing a REIT's ability to fund its distribution from cash flow I prefer the old fashioned method of comparing actual operating cash flow and Funds From Operations to a REIT's distributions, because I believe MFFO may inflate a REIT's coverage ratio. 

Funds from Operations (FFO) takes a REIT's net operating income and adds back non-cash accounting entries like depreciation.  It also includes an adjustment for property sales.  This leaves you with a pretty good estimation of a REIT's cash available for distribution.  Modified Funds From Operations takes FFO and then adds or subtracts other one time items, in particular acquisition expenses.  A REIT in its capital raising stage will have significant acquisition expense additions, skewing MFFO upward.  Neither FFO or MFFO are GAAP (Generally Accepted Accounting Principals) figures, only operating cash flow is a GAAP figure.  Because MFFO is a non-GAAP calculation, I always check the footnotes to see what items were added back to MFFO.

If a REIT purchases a significant number of properites late in the year the MFFO to actual cash will be even greater, as all acquisition expenses are added to MFFO while actual cash received is small.  Here is a simple example of a property acquired for $50 million.  I assumed the acquisition expenses are 3.50%, and a cap rate of 7%, which all goes to cash flow.  If the purchase closed on December 1, here is what the flow of funds would be:

Purchase Price  $50,000,000
Acq Cost % 3.50%
Acq Cost  $1,750,000
Addition to MFFO  $1,750,000
Cap Rate 7%
Annualized NOI  $3,500,000
One Month NOI  $291,667
Actual Cash  $291,667

The REIT would receive $291,667 in cash from the property, but would be able to add an additional $1,750,000 to its MFFO.  Even though the MFFO looks great, only the $291,667 is available for distribution.  Bear this in mind as non-traded REITs release their 2010 results in the coming weeks and tout their levels of MFFO. 

If you must look at MFFO, beware of the above and look for an improving trend, i.e. more MFFO covered by actual cash over multiple periods.  The disparity between operating cash flow, FFO and MFFO should narrow over time.  Wide differences in an established REITs operating cash flow, FFO and MFFO, when compared to the REIT's distribution, may signify that the current distribution is not sustainable.  For REITs early in their life cycle the divergence is going to be large but watching the trend is vital.  Chronic overpayment of distributions, while good for marketing, is bad and untenable long-term.  A trend where FFO and operating cash are getting closer to MFFO is positive. 

I have looked at enough financial statements over the years to know that it is not a good sign when distributions exceed operating cash flow for extended periods.  Many people in the broker / dealer and real estate industries have worked hard to make MFFO a more consistent and relevant figure, and I applaud them.  But for me, I will stick to my old fashioned method of comparing operating cash flow and FFO to distributions, it has rarely steered me wrong.


Clarity Finance said...

FFO is an excellent metric for evaluating REITs and comparing valuations. FFO also makes comparing REIT valuation to direct real estate holdings more meaningful, as FFO is closer to NOI than any GAAP measure.

With the change in GAAP, about ten years ago, calling for the immediate expensing of acquisition fees, the common FFO derivative (Net Income less Depreciation and Amortization)penalizes REITs that are making significant acquisitions. In the example given, the REIT would report a Net Loss of $1,458,000. The acquisition expenses must be added back to approximate NOI.

MFFO is not a panacea, and is subject to more manipulation than FFO, to be sure. (Handling of unconsolidated entities comes immediately to mind.) However, any cash flow measure must recognize the GAAP expensing of acquisition fees and not unduly penalize a REIT that is acquiring properties.

Anonymous said...

Acquistion fees should be expensed immediately to give the advisor and/or investor a clear picture of whether or not the properties are covering their distribution from FFO. MFFO is an accounting maneuver to make the numbers look better than they really are. With a avg. 13% up front load to overcome, if a NT REIT is not covering their ditribution, they are only digging a deeper hole and misleading their investors. Without a strategy to build significant asset appreciation, the load and delusion of MFFO coverage is absorded on the backend by the investor by lower share price and or dividend to make up the difference. By then investors can not redeem because of their limited liquidity. Use more conservative FFO ratio for analysis, with a REIT that has ability to build asset value, and track record of liquidity.

Anonymous said...

Thank you so much for posting this article. It has proven to be very helpful on a project I'm working (refinancing transaction).