choosing REITs and Watching Them Grow P A R T C H A P T E R REITs: HOW THEY GROW S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 I ncreases in the value of a company are, of course, the driv- ing force behind increases in its stock price over time. There are a number of ways to measure increases in company value, but measuring and valuing streams of income and cash flows is perhaps the most commonly used metric in the world of equi - ties. And it is the only metric presently sanctioned by today’s accounting rules, as a company’s assets must be carried on its books at historical cost, less depreciation, not at current fair market value. As a result, rising earnings are a key driving force for a company’s share price. Steadily rising earnings normally indicate not only that a REIT is generating higher income from its properties, but may also suggest that it is making favorable acquisitions or completing profitable developments. Furthermore, higher income is generally a precursor of dividend growth. In short, a growing stream of cash flow means, over time, higher share prices, increased dividends, and higher asset values. Value can be created in a REIT by invest - ment activities that don’t show up in current income or cash flow, but these latter metrics are most easily quantifiable. T H E S I G N I F I C A N C E O F F F O A N D A F F O Investors in common stock use net income as a key measure of profitability, but the custom in REIT world is to use funds from operations (FFO). The historical preference for FFO rather than net income relates to the concept of depreciation. The Securities and Exchange Commission (SEC), under federal securities laws, requires that all publicly traded companies file audited financial statements. On a financial statement, the term net income has a meaning clearly defined under generally accepted accounting prin - ciples (GAAP). Since most REITs are publicly traded companies, net income and net income per share can therefore always be found on a REIT’s audited financial statement. For a REIT, however, these net income figures are less meaningful as a measure of operating success than they are for other types of companies. The reason is that, in accounting, real estate depreciation is always treated as an expense, but in the real world, not only have most well-maintained quality properties retained their value over the years, but many have appreciated substantially. This is generally due to a combination 142 I N V E S T I N G I N R E I T S 143 R E I T S : H O W T H E Y G R O W S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 of increasing land values (on which the structure is built), steadily rising rental and operating income, property upgrades, and higher costs of construction for new competing properties. Thus a REIT’s net income under GAAP, reflecting a large depreciation expense, has been determined by most REIT investors to be less meaningful a measure of REIT cash flows than FFO, which adds back real estate depreciation to net income. Using FFO enables both REITs and their investors to partially cor- rect the depreciation distortion, either by looking at net income before the deduction of the depreciation expense or adding back depreciation expense to reported net income. When using FFO, there are other adjustments that should be made as well, such as subtracting from net income any income recorded from the sale of properties. The reason for this is that the REIT can’t have it both ways: In figuring FFO, it cannot ignore depreciation, which reduces the property cost on the balance sheet, and then include the capital gain from selling the prop - erty above the price at which it has been carried. Furthermore, GAAP net income is normally determined after “straight-lining,” or smoothing out contractual rental income over the term of the lease. This is another accounting convention, but, in real life, rental income on a multiyear property lease is not smoothed out, and it F U N D S F R O M O P E R A T I O N S ( F F O ) HISTORICALLY, FFO HAS been defined in different ways by different REITs, which has only exacerbated the confusion. To address this prob - lem, NAREIT (National Association of Real Estate Investment Trusts) has attempted to standardize the definition of FFO. In 1999, NAREIT refined its definition of FFO as used by REITs to mean net income com - puted in accordance with GAAP, excluding gains (or losses) from sales of property, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. Adjustments for unconsolidated partnerships and joint ventures should be calculated to reflect funds from operations on the same basis. 144 I N V E S T I N G I N R E I T S S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 often starts low but rises from year to year. For this reason, many investors, when examining FFO, adjust reported rent revenue to reflect current contractual rent revenue. Although most REITs and their investors believe the concept of FFO is more useful as a device to measure profitability than net income, it is nevertheless flawed. For one thing, most commercial property will slowly decline in value year after year, due to wear and obsolescence, and structural improvements are generally necessary if that property value is to be retained (e.g., a new roof, or better lighting). Merely adding back depreciation, then, to net income, when determining FFO, can provide a distorted and overly rosy picture of operating results and cash flows. The very term depreciation allows yet another opportunity for distortion when it comes to items that might be considered part of general maintenance, such as, for example, an apartment building’s carpeting or curtains, even dishwashers. The costs of such items often might not be expensed for accounting purposes; instead, they might be capitalized and depreciated over their useful lives. But, because the depreciation of such items is a real expense, when such “real estate” depreciation is added back to arrive at FFO, the FFO will be artificially inflated and thus give a misleading picture of a REIT’s cash flow. Practically speaking, carpeting and related items, to use our example, really do depreciate over time, and their replacement in a building does not significantly increase the prop - erty’s value. These are real and recurring expenses. Additionally, leasing commissions paid to leasing agents when renting offices or other properties are usually capitalized, then amortized over the term of the lease. These commission amortiza - tions, when added to net income as a means of deriving FFO, will similarly inflate that figure. The same can also be said about tenant improvement allowances, such as those provided to office and mall tenants. Usually, these are so specific to the needs of a particular ten - ant that they do not increase the long-term value of the property. Short-term capital expenditures cannot be considered property- enhancing capital improvements, no matter how they are accounted for, and they should be subtracted from FFO to give an accurate picture of a REIT’s operating performance. 145 R E I T S : H O W T H E Y G R O W S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 Unfortunately, not all REITs capitalize and expense similar items in similar ways when announcing their FFOs each quarter. Also, some include investment write-offs and gains from property sales in FFO, while others do not. With only FFO as a gauge, investors and analysts are still lacking consistency in terms of the way adjustments to net income are reflected. Furthermore, there is no uniform standard to account for recurring capital expenditures that do not improve a property or extend its life, such as expenditures for carpeting and drapes, leasing commissions, and tenant improvements. The term born of this need is adjusted funds from operations (AFFO), which was coined by Green Street Advisors, Inc., a leading REIT research firm. Although FFO as a valuation tool is more useful to REIT investors than net income under GAAP, NAREIT maintains that “FFO was never intended to be used as a measure of the cash generated by a REIT, nor of its dividend-paying capacity.” Adjusted funds from operations, on the other hand, is a much better measure of a REIT’s operating performance and is a more effective tool to measure free cash generation and the ability to pay dividends. Unfortunately, AFFO is normally not specifically reported by a REIT, and the inves - tor or analyst must calculate it on his or her own by reviewing the financial statements and related footnotes and schedules. And, even when AFFO is disclosed, different REITs define it differently. The following is an oversimplified, but perhaps useful, way of looking at this methodology. Revenues, including capital gains, minus: ◆ Operating expenses and write-offs ◆ Depreciation and amortization ◆ Interest expense ◆ General and administrative expense = NET INCOME A D J U S T E D F U N D S F R O M O P E R A T I O N S ( A F F O ) AFFO IS THE FFO as used by the REIT, adjusted for expenditures that, though capitalized, do not really enhance the value of a property, and is adjusted further by eliminating straight-lining of rents. 146 I N V E S T I N G I N R E I T S S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 Net Income minus: ◆ Capital gain from real estate sales plus: ◆ Real estate depreciation = FFO FFO minus: ◆ Recurring capital expenditures ◆ Amortization of tenant improvements ◆ Amortization of leasing commissions ◆ Adjustment for rent straight-lining = AFFO The problem encountered by investors in using FFO and its deriv- atives was discussed by George L. Yungmann and David M. Taube, vice president, financial standards, and director, financial standards, respectively, of NAREIT, in an article appearing in the May/June 2001 issue of Real Estate Portfolio. They note, “A single metric may not appropriately satisfy the need for both a supplemental earnings measure and a cash flow measure.” They suggest using a term such as adjusted net income (which is GAAP net income prior to extraordinary items, effects of accounting changes, results of discontinued opera - tions, and other unusual nonrecurring items) as a supplemental earn - ings measurement. Each REIT would then be free to supplement this “ANI” figure by reporting a cash flow measure such as FFO, AFFO, or other terms sometimes used by REITs and analysts such as cash avail - able for distribution (CAD) or funds available for distribution (FAD). Of course, when comparing the earnings and FFO figures reported by two different REIT organizations, it’s important to compare apples to apples, in other words, we don’t want to com - pare the P/FFO ratio of one REIT to the P/AFFO ratio of another, and we should try to apply similar FFO or AFFO definitions to the REITs being compared. In valuing a REIT, although net income should not be ignored, AFFO (when properly calculated) is the most accurate means for deter - mining a REIT’s free cash flow. Thus, some analysts and investors, when determining AFFO, look at the actual capital expenditures incurred by a REIT during a 147 R E I T S : H O W T H E Y G R O W S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 reporting period, while others apply a long-term average to smooth periods of unusually high or low capital expenditures. There is no “right” or “wrong” approach but, again, it’s important for the inves - tor to compare apples to apples. Now that we have established the differences between these important terms, we will use, in the balance of this chapter, either FFO (funds from operations) or AFFO (adjusted funds from opera - tions), keeping in mind that virtually all REITs report the former, although it is less meaningful to investors. When we discuss the price/earnings ratio of a REIT’s common stock, we will use either the P/FFO ratio or the P/AFFO ratio, with the understanding that, although we are trying to be as consistent as possible, sometimes true consistency is not attainable, and we must therefore be aware of how these supplements to net income reporting under GAAP are calculated by or for each REIT. T H E D Y N A M I C S O F F F O G R O W T H What makes REIT shares so attractive, compared with other high- yield investments like bonds and preferred stocks (and, to a less - er extent, utility stocks), is their significant capital appreciation potential and steadily increasing dividends. If a REIT didn’t have the ability to increase its FFO and its dividend, its shares would be viewed as not much different from a bond, and they would be bought only for their yield. Because of the greater risk, of course, the yields on the stocks of growth-challenged REITs would nor - mally be higher than those of most bonds and preferreds, and their prices would correlate with the fluctuations of long-term interest rates and investors’ perceptions of these REITs’ ability to continue paying dividends. FFO should not be looked upon as a static figure, and it is up to management to continue to seek methods of increasing it. We can sometimes find REITs that do trade as bond surrogates because of investor perception that they have very little growth potential. Some of these pseudo-bonds can be of high quality because of the stability of their stream of rental income, while oth - ers can be compared to junk bonds because of their high yields but [...]... new construction and stoked demand for single-family housing, put renters in control Apartment occupancy rates and net operating income declined, but started to grow again beginning in the latter part of 2004 Investors in this sector should expect longterm internal growth roughly in line with inflation Office rents suffered during the period of massive overbuilding in the late 1980s and early 1990s,... reputation for maintaining and even upgrading shopping centers to make them continually attractive to shoppers This concept has been carried over into the health care sector, where REITs have structured most of their leases (and even their mortgages when the REIT provides mortgage financing) so that the owner shares in same-store revenue growth above certain minimum levels In some cases, the rent increases... competencies in real estate acquisition, development, and management, including the acquisition of rights to restructure leases of bankrupt retailers, providing financing for certain retailers and dispensing of their surplus space, as well as developing properties for them Indeed, a number of developmentoriented REITs, particularly in the office and industrial sectors, such as Duke Realty, ProLogis, and Catellus,... operating income and internal rate of return, as they help us to understand how REITs can create—or destroy—value when making acquisitions or doing developments ◆ External growth can be generated through attractive property acquisitions, development and expansion, and developing fee-related and investment businesses ◆ The importance of attractive investment and development opportunities to a REIT’s FFO growth... upgrading and refurbishing them with new window treatments and upgraded kitchens Alexandria Real Estate, which focuses on the office/laboratory niche of the office market and provides space for pharmaceutical and biotech companies, has been expanding its redevelopment strategy and is believed to be earning returns in excess of 12 percent on such projects The lesson here for investors is that REITs with innovative... concepts in real estate, net operating income and internal rate of return The term net operating income (NOI) is normally used to measure the net cash generated by an income-producing property Thus, NOI can be defined as recurring rental and other income from a property, less all operating expenses attributable to that property Operating expenses will include, for example, real estate taxes, insurance,... factors related to supply and demand for specific properties in specific locations, as well as property quality and location Management’s leasing capabilities are also very important Trying to determine which REITs and their properties have better than average potential rental revenue and NOI growth is one of the challenges and some of the fun—of REIT investing HOW TO BUILD RISING FFO INTO THE LEASE Many... seek methods of increasing it ◆ AFFO is the most useful means for estimating REITs recurring free cash flows, but there is no uniform standard by which it is calculated ◆ FFO and AFFO can grow two ways: externally, by acquisition, developments, and engaging in related joint ventures and other businesses, and internally, through a REIT’s ability to improve profitability of its existing assets SOURCE:... that at one time were borne by the landlord, and have included “cost-sharing” or common area maintenance (CAM) recovery clauses in their leases to offset rising property maintenance, and even improvement, expenses In the case of office buildings, the lessees might pay their pro rata portion of the increased operating expenses, including higher insurance, property taxes, and on-site management costs Similarly,... and redevelopments in the office and industrial sectors Apartment development returns have declined in recent years along with the cap rates, but Avalon Bay and some of its peers are still developing up to 200 basis-point spreads over cap rates Finally, a few REITs, including AMB Property, ProLogis, and Simon, are even developing properties overseas, including Europe and Japan Although a REIT can contract . operating income declined, but started to grow again beginning in the latter part of 2004. Investors in this sector should expect long- term internal growth. choosing REITs and Watching Them Grow P A R T C H A P T E R REITs: HOW THEY GROW S O U R C E : B P T H E S A N