Accounting & Tax

Debate Over Real-Estate Earnings Puts Analysts at Odds

Funds from operation, earnings per share, or operating earnings? The debate heats up as S&P considers letting REITs into the S&P 500.
CFO.com StaffAugust 29, 2001

The debate over real-estate earnings continues, according to a Wall Street Journal report.

For the past 10 years, the real-estate investment trust industry has focused on an earnings recipe called funds from operations, or FFO, rather than net income. Public real-estate firms say FFO — which generates higher earnings than net — is the best way to evaluate operating performance.

Then last month, three major Wall Street firms — Merrill Lynch & Co., Morgan Stanley and Citigroup Inc.’s Salomon Smith Barney — broke ranks with fellow analysts and the real-estate industry and said they would start forecasting earnings for real-estate investment trusts, or REITs, based on earnings per share, which conforms with generally accepted accounting principles (GAAP).

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Now, a second group of analysts, miffed that they were excluded by the big three firms, has been secretly meeting to come up with its own definition of earnings for the sector, says the Journal. The problem is that the splinter group is itself split, with various members proposing different earnings formulas, such as operating earnings per share, which excludes gains or losses from sales. The definition that Merrill, Morgan Stanley, and Salomon Smith Barney adhere to includes gains and losses on sales.

The debate over real-estate companies’ earnings shines a light on the contentious issue of so-called pro forma results. Proponents of pro forma measures argue that certain sectors, like real estate or insurance or technology, need a different formula than net income to give investors a clearer financial picture.

Critics argue that pro forma earnings allow companies to play down items that would reduce reported earnings. Companies and industry analysts, in turn, often use pro forma earnings to justify higher stock valuations.

But real-estate industry executives argue that net income can give a deceptive picture of performance for a real-estate firm, because GAAP require real-estate companies to depreciate the value of its properties each quarter, taking a hit to earnings. This is misleading since the actual value of the properties usually rises from year to year in most markets.

In 1991, the National Association of Real Estate Investment Trusts, the main trade group for the REIT industry, created a supplemental standard called funds from operations. It allowed REITs to add back real-estate depreciation. In addition, REITs, which derive their main earnings from rents on the buildings they own, were able to ignore gains on sales of properties. FFO became the standard performance measure as the REIT industry ballooned to a current total equity market capitalization of $148.4 billion from $8.7 billion at the end of 1990.

But the measure became controversial as REITs became increasingly aggressive in what they excluded from or included in FFO. Some began excluding technology-investment losses or foreign-currency losses; others included gains from sales of property that had been depreciated. Indeed, many analysts soon began publishing “adjusted” funds from operations to add back expenses that they felt had been improperly excluded.

How much difference can FFO make in a company’s results? Consider the second-quarter results of Equity Office Properties Trust, the nation’s largest office owner. For the latest second quarter, Chicago- based Equity Office reported FFO of 78 cents a share, but it reported earnings per share of just 40 cents. The difference: Equity Office added back in depreciation and amortization of 38 cents a share when it calculated FFO, says the Journal.

Some REITs are placing more emphasis on earnings per share. AMB Property Corp., a big San Francisco owner of industrial properties, has led its earnings announcements with earnings-per-share figures since the third quarter of 1999 and is believed to be the first REIT to do so, says the Journal. Since then, a few more REITs have directed attention to net. “We like earnings per share because the rules are very clear and those rules are policed by the accounting profession,” AMB CEO Hamid R. Moghadam told the newspaper.

The flap over FFO comes as the index committee at McGraw-Hill Cos. that oversees the Standard & Poor’s 500-stock index is considering allowing REITs into its stock index, says the Journal. Inclusion in the index could broaden the base for REITs, which have failed to whip up widespread interest among investors. “Earnings per share is what is tracked most widely by the investor universe,” Joseph Gyourko, director of the Zell/Lurie Real Estate Center at the Wharton School of the University of Pennsylvania, told the Journal. He continued that if REITs want to access that universe for capital, it would behoove them to adopt the measure.

In the end, REIT analysts may agree to use an earnings-per-share figure, with each making his own ad-hoc adjustments to calculate financial results — the same exercise they do with funds from operations, says the Journal.

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