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FFO vs. Net Income

Why GAAP net income and FFO diverge for REITs, and why real estate depreciation is the reason the two numbers tell different stories

Two Different Questions

Net income and FFO aren't rival calculations of the same thing - they answer two different questions. Net income, computed under GAAP, asks: "after every accounting expense, including depreciation, what's left?" FFO asks a narrower question: "how did the properties actually perform this period, before the effects of a non-cash accounting charge and one-time property sales?" For most industries the two questions produce similar answers. For real estate, they routinely diverge by a wide margin, and understanding why is the starting point for reading any REIT's financials. See FFO explained for the full formula.

A Side-by-Side Example

Suppose a REIT owns a portfolio of apartment communities generating $120 million a year in property-level net operating income. After corporate overhead and interest expense, and after $40 million of real estate depreciation, GAAP net income comes out to $15 million for the year. That's a net margin so thin it might look like a company barely staying afloat.

Now add back the $40 million of depreciation (a bookkeeping charge, not a cash outflow) and assume no property sales that year. FFO comes out to $55 million, more than three times the net income figure, and a far more useful signal of how the business actually performed.

Both numbers are "correct" under their own rules. Net income follows GAAP to the letter. FFO simply removes the one line item, depreciation, that behaves differently for real estate than it does for most other asset classes.

Why Depreciation Behaves Differently for Real Estate

GAAP depreciation assumes an asset's value declines steadily over a fixed useful life, the same logic applied to a delivery van or a piece of factory equipment. Buildings, however, are often maintained, renovated, and re-leased for decades, and well-located land underneath them can appreciate. That doesn't mean real estate never loses value - it certainly can, particularly with deferred maintenance, obsolescence, or a weak local market - but the fixed, straight-line depreciation schedule GAAP requires rarely matches the actual pattern of a property's economic value over time. FFO's add-back is the industry's way of correcting for that mismatch.

Gains on Sale: The Other Adjustment

The second FFO adjustment, excluding gains (and adding back losses) from property sales, addresses a different issue: timing. Selling a building can produce a large, one-time gain that has nothing to do with how the remaining portfolio is performing this quarter. Leaving it in would make a REIT's operating results look artificially strong (or, after a loss-making sale, artificially weak) in the period the sale happens to close. Removing it keeps the focus on recurring operations.

Why This Matters for Valuation

Because net income is depressed by depreciation, ratios built on it, like the price-to-earnings ratio used across the rest of the stock market, tend to make REITs look expensive even when they aren't. That's the reason the sector uses Price-to-FFO instead of P/E as its primary valuation shorthand. See REITs vs. stocks for more on how REIT analysis diverges from typical equity analysis.

Where Net Income Still Matters

None of this means net income is irrelevant. It's still the audited, GAAP-governed figure that appears on the income statement, and a close cousin of it, REIT taxable income, is what actually determines the minimum dividend a REIT must pay out under the tax rules. See the 90% distribution rule and how REIT dividends are taxed for how that works. FFO and AFFO are supplemental, non-GAAP measures used for operating and valuation analysis - net income remains the official scorecard.

A Case Where FFO Can Fall Below Net Income

The relationship isn't always one-directional. In a quarter where a REIT sells a large, highly appreciated property, the gain on that sale can push net income above FFO, since FFO excludes that gain entirely while net income includes it in full. Take the REIT from the earlier example - $15 million of net income, built from $120 million of NOI less overhead, interest, and $40 million of depreciation - and suppose it also books a one-time $60 million gain on the sale of a flagship property that same quarter. Net income of $15 million already reflects that $60 million gain. FFO, after adding back the $40 million of depreciation and then subtracting the full $60 million gain, would actually come out lower: $15M + $40M - $60M, a negative number. This is exactly why relying on a single quarter of either figure in isolation can be misleading - large one-time transactions can cut in either direction.

None of this means GAAP accounting is "wrong." Net income still matters for measuring a company's total return on invested capital over the long run, including the eventual gain or loss realized when a property is sold. FFO simply isolates the recurring, ongoing-operations piece of that picture for a single quarter or year, which is why the two are best read together rather than as substitutes for one another. And it's also why a REIT reporting an unusually low, or even negative, P/E ratio after a large gain-on-sale quarter isn't necessarily signaling distress - the swing often says more about one-time transaction accounting than about the health of its ongoing rental operations.

See it in the data: Compare reported FFO across REITs → See a REIT profile →

Research and education only — nothing here is investment advice. Figures such as the 90% distribution rule are general and can change; always confirm against a company's filings.