Understanding Funds Available for Distribution (FAD) in REITs

Funds available for distribution (FAD), also known as cash available for distribution, is used in reference to REIT investing. It shows the amount of net earnings of a REIT that will be distributed to stockholders and unitholders as dividendsDividendA dividend is a share of profits and retained earnings that a company pays out to its shareholders. When a company generates a profit and accumulates retained earnings, those earnings can be either reinvested in the business or paid out to shareholders as a dividend..

REITs own and manage a portfolio of real estate investments, ranging from residential apartmentsResidential Properties REITsResidential properties REITs are REITs that own and manage residential units for renting out to tenants. They may be either single-family or multi-family structures, shopping malls, office parks, luxury hotels, and hospitals, and they allow investors to buy and sell shares of the company in the public exchange. The investments generate a steady income in the form of leases, rents, and revenues from the sale of appreciated properties.

In order to maintain their REIT status, REITs are required to distribute at least 90% of their income to shareholders in the form of dividends. The dividend payments assure shareholders a steady cash flow over time, in addition to benefiting from share appreciation.

Quick Summary

• Funds available for distribution (FAD) is the amount of cash retained by a real estate investment trust for distribution to common shareholders.
• The FAD is obtained by deducting normalized recurring capital expenditures from the FFO of the REIT.
• Investors use the FAD tool as an indicator of the strength of a REIT.

Funds Available for Distribution Explained

The amount of funds available for distribution acts as a key assessment tool for determining the strength of a REIT. Investors are specifically attracted to REITs due to their ability to provide a consistent income stream throughout the investment period. Also, unlike other investments like stocks and bondsBondsBonds are fixed-income securities that are issued by corporations and governments to raise capital. The bond issuer borrows capital from the bondholder and makes fixed payments to them at a fixed (or variable) interest rate for a specified period., REITs show a relatively low correlation to the returns of other investments, such as fixed-income investments and equities.

REITs with consistently higher funds available for distribution attract income-focused investors more than REITs that have shown inconsistencies in the dividends they distribute to investors. There are no specific guidelines on how FAD should be calculated, but most REITs adjust the FFO for recurring capital expenditures, straight-lined rents, and non-cash items.

REITs can increase the amount of funds available for distribution in the following two ways:

1. Organic growth

Organic growth strategies seek to boost the FAD by maximizing growth from within the company on a quarterly or yearly basis. Some of the measures that companies pursue to grow organically include improving service delivery, generating new income streams, or undertaking promotions to increase property occupancy rates.

For example, an office REITOffice REITsOffice REITs are REITs that build, manage, and maintain office buildings, and they lease the offices to companies that need space to accommodate their staff can increase their revenues by offering incentives to corporations when they lease office spaces in their managed properties. They can also manage the common areas, such as conference halls, which they can rent out on a need-basis.

Investors use the organic growth performance to determine if the company is capable of earning more income each year through its internal sources, which translates to a higher stock price and higher dividend payouts.

2. Acquisitions and property developments

Another method of increasing the FAD is through inorganic growth, which arises from mergers and acquisitions of other businesses in the same industry. Most companies pursue inorganic growth as a faster method to grow revenues and expand operations to newer markets.

For example, a warehouse REIT can acquire other warehouses to increase its portfolio and profit from the increasing demand for warehouse space due to the growth of e-commerce. The REIT will benefit from higher rental income, greater number of assets, as well as larger warehousing space.

How to Calculate FAD

The value of FAD is obtained by calculating the funds from operations and deducting the recurring capital expenditures of the REIT. The FAD formula is given as follows:

FAD = FFO – RCE

Where:

• FFO is the Funds From Operations
• RCE is the Recurring Capital Expenditure

The two items are explained in detail below:

1. Funds From Operations (FFO)

Funds from operations (FFO)FFO - Funds From OperationsFFO or Funds From Operations is a measure of cash flow generated from business operations that is often used by Real Estate Investment Trusts - REITS. Funds from operations (FFO) is the actual amount of cash flow generated from core business operations. Guide to FFO is a measure of revenues generated by REITs, and it is used to define the cash flows that REITs generate from their operations. It is calculated by adding the depreciation and amortization to the net income and then deducting any gains on the sale of properties.

However, real estate properties appreciate in value over time, and deducting the depreciation can distort the actual value of a property. Therefore, the depreciation and amortization values of a property are added back to the net income to balance the values.

All the factors in the FFO formula are found in the balance sheet of the company, and investors can use them when evaluating a REIT as an investment opportunity.

2. Recurring Capital Expenditures (RCE)

Recurring capital expenditures are expenses that are necessary to maintain the REIT’s portfolio of properties, as well as the rental and lease incomes generated by the properties. The costs may include new carpeting, drapes in residential units, leasing expenses, tenant improvement allowances, and other normal, ongoing expenses necessary for operating the portfolio of properties.

The expenses are initially capitalized, and then gradually expensed through amortization. The allotted cash is spent upfront, which reduces the money available for distribution to shareholders. Deducting the capitalized expenses from the funds from operations allows investors to get a clear picture of the cash available for distribution to shareholders.

Related Readings

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