REIT Accounting Its 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

Disadvantages

Paying out 95%+ of net income

reduces internal capital for growth

Pay-out requirements force

dependence on healthy capital
markets

Public market pricing

Expert management

Strong institutional investor

interest

Operating businesses must be owned

and operated outside of the REIT

Growth opportunities

Lower debt levels

Being placed into REIT Box limits

potential investor universe

Corporate governance

Market expectations limit leverage

GAAP accounting issues

Independent analyst review

Attractive returns

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

10.7 x

$107 mill
9.3%

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