REIT Accounting It’s an Art
Not a Science
Carl T. Berquist
 Deputy Director of Arthur Andersen (AA)
Real Estate and Hospitality Services Group
(REHSG) Worldwide
 Head of AA Southeastern U.S. REHSG and
Metropolitan Wash., D. C. REHSG Practice
 National Association of Real Estate
Investment Trusts (NAREIT) - Associate
Board Member
Carl T. Berquist
 Experience
• Initial and Secondary Public Offerings
• Assisting in various private real estate capital
raises
• Financial modeling, projections, strategic
planning
Overview
 REITs
 Market Performance Indicators
•
•
•
•
•
FFO
AFFO
FAD
EBITDA
Debt to Market Cap
 Performance Analysis
 Application of Accounting Policies
Real Estate Investment Trust
(REIT)
 Assets are primarily composed of real
estate held for the long term
 Income mainly derived from real estate
 Pays out at least 95 percent of taxable
income to shareholders
 One level of taxation
 Mutual fund for real estate
REIT Rules
Income Tests
Asset Tests
Widely Held
95% Distribution
Requirement
How Many REITs Are There?
 Over 300 U.S. REITs, 216 Publicly Traded
168
33
15
Annual Total REIT Security
Offerings
$ Billions
70
60
50
40
30
20
10
0
1990 1991 1992 1993 1994 1995 1996 1997 1998
Year-end Market Capitalization
$ Billions
180
160
140
120
100
80
60
40
20
0
1990 1991 1992 1993 1994 1995 1996 1997 1998
REIT Advantages and
Disadvantages
Advantages

No corporate income taxes paid

Liquidity and access to capital

Public market pricing

Expert management

Strong institutional investor
interest

Growth opportunities

Lower debt levels

Corporate governance

Independent analyst review

Attractive returns
Disadvantages

Paying out 95%+ of net income
reduces internal capital for growth

Pay-out requirements force
dependence on healthy capital
markets

Operating businesses must be
owned and operated outside of the
REIT

Being placed into “REIT Box” limits
potential investor universe

Market expectations limit leverage

GAAP accounting issues
Dissecting the REIT Income
Statement
Revenues
Operating Expenses
EBITDA
Interest Expense
Funds From Operations
Depreciation & Other
Net Income
Debt Principal Amortization
Normalized Cap Exp
Tenant Improvements
Depreciation & Other
Funds Available for Distribution
XXXX
(XXX)
XXX
(XX)
XXX
(XXX)
XXX
(XX)
(XX)
(XX)
XXX
XX
Funds From Operations (FFO)
 Net income (GAAP) excluding gains (or
losses) from debt restructuring and sales
of property, plus depreciation and
amortization, and after adjustments for
unconsolidated partnerships and joint
ventures
Evolution of FFO
 NAREIT white paper
 Net income not a satisfactory measure
 Conventional P/E multiples not meaningful
 FFO/Share equivalent to EPS
 Definition varied in practice
 Key benchmark statistic
 Used to compare to peers
Key FFO Measurement
Benchmarks
 Growth Rates
 Payout Ratios (Dividends/FFO)
 FFO Multiples
Growth Rates
 Done on a Per Share Basis
 Compared to Peers
 Quality of Earnings
• Core vs. Accounting Gimmicks
• Accretive Acquisitions
Payout Ratios
 Safety of Dividend
 Retained Captial
FFO Multiples


Similar to PE Ratio
Drives Share Price
• Share Price/FF0 per Share = Multiple


The Industry Average is 10 - 12 Times
Several Subjective Variables
•
•
•
•
•
•
Management
Business Strategy
Leverage
Quality of Earnings
Dividend Growth
Payout Ratio
Maximum price a REIT can pay for
$10 million in FFO and not be dilutive
Company
FFO Multiple
Breakeven Purchase
Price
Cap Rate
A
B
10.7 x
$107 mill
9.3%
C
10.2 x
D
9.6 x
$102 mill $96.0 mill
9.8%
10.4%
E
9.1 x
6.9 x
$91.0 mill $69.0 mill
11.0%
14.5%
Adjusted Funds From Operations
(AFFO)
 FFO adjusted for straight-lining of rents, as
well as a reserve for recurring capital
expenditures (including tenant
improvements)
 Similar to FAD
Funds Available for Distribution
(FAD)
 Another Type of Payout Ratio
• Dividend / FAD
 Highlights Safety of Dividend
 Shows Ability to Grow Dividend
• The Lower the %, the Greater the Ability to Grow
• More than 100% Shows the Dividend Cannot be
Sustained
Earnings Before Interest, Taxes,
Depreciation and Amortization (EBITDA)
 EBITDA/Interest Coverage
 Ignores capital structure
 The higher the ratio the greater the ability
to grow
 Can always purchase EBITDA
Debt to Market Capitalization
 Total Debt / (Debt + Equity Capitalization)
 The Lower the Ratio, the Greater the Ability
to Grow
• Acquisitions can be leveraged
• Expansions can be financed
• Reduced Refinancing Risk
Stock Price
 Quality Earnings
 Growing FFO
 Strong Management
 Well Defined Growth Strategy
 Low Debt to Market Cap
 Ability to Execute
Accounting “Gimmicks”







Capitalization vs. expense
Straight-lining of rental revenue
Tenant improvement costs vs. rental rates
Off balance sheet financing
Off balance sheet ventures
One time transactions
FFO adjustments
•
•
•
•
deferred finance fees
percentage rent
preferred returns
unusual items
Clarkson
 Acquisition reserves
 Leverage (Mark-to-Market)
 FAD pay out ratio
Clarkson
 “The company continued its innovative
policy of renovating apartments to fit
specific tenant needs and notes that this is
a growing source of revenue for the future.”
States
 Tenant improvements
 Income from joint ventures
 Internal development costs
 Straight-lining of rents
American
 Reserves
 Other adjustment
Performance Indicators
Original
FFO
1997 % Inc.
PER SHARE
FAD Payout
1998 1997
1998
EBITDA
1997
Company
1998
Clarkson
0.79
0.60
32%
102
96
1.56
1.09
43%
60%
States
0.48
0.42
14%
91
90
0.80
0.62
29%
48%
American
0.38
0.32
19%
91
96
0.45
0.40
13%
19%
Adjusted
Company
PER SHARE
FFO
1998 1997 % Inc.
FAD Payout
1998 1997
1998
EBITDA
1997
% Inc.
% Inc.
Debt-To-Mkt-Cap
Debt-To-Mkt-Cap
Clarkson
0.69
0.60
15%
120
96
1.56
1.09
43%
60%
States
0.44
0.42
5%
98
90
0.80
0.62
29%
48%
American
0.34
0.32
6%
116
96
0.45
0.40
13%
19%
American
As Reported
1998
Funds From Operations
Deduct "Other" Adj.
Adjusted FFO
Mortgage Principal Pay-downs
Normalized FF&E Replacement
Normalized Capital Expenditures
Funds Available for Distribution
FFO Per Share
FAD Payout
15,386
As Adjusted
1998
(1,023)
(822)
(546)
12,995
15,386
(1,456)
13,930
(1,023)
(1,919)
(546)
10,442
0.38
91
0.34
116
States
As Reported
1998
Funds From Operations
Tenant Improvements Adj.
Internal Leasing Costs
Adjusted FFO
Mortgage Principal Pay-downs
Capital Expenditures and TI
Funds Available for Distribution
FFO Per Share
FAD Payout
6,155
As Adjusted
1998
(407)
(106)
5,642
6,155
(100)
(380)
5,675
(407)
(31)
5,237
0.48
91
0.44
98
Clarkson
As Reported
1998
Funds From Operations
Mark-to-Market
Acquisition Reserves Adj.
Adjusted FFO
Mortgage Principal Pay-downs
Capital Expenditures and Ten. Imp.
Funds Available for Distribution
FFO Per Share
FAD Payout
23,080
As Adjusted
1998
(2,457)
(2,802)
17,821
23,080
(2,100)
(805)
20,175
(2,457)
(2,802)
14,916
0.79
102
0.69
120
REIT Accounting Its an Art
Not a Science
 Summary
• There is no easy answer
• Understand the numbers
• Research is critical