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Mack-Cali Realty Corp.(NYSE:CLI) reported results a fortnight ago. While revenues managed to grow by 4.7%, the operating profits and net profits have taken a beating.



Source: Gridstone Research

The primary reasons for this (common for most commercial REITS and you can also read the article discussing these issues on HRPT here) are (1) impairment charges and (2) lower same-store property-level operating income. The lower same-store income is primarily due to decline in occupancies and roll-down in rent realizations.

Rent Revenues Have Increased, But Rent Realizations Are Down...

(Click to view enlarged image)

Source: Gridstone Research

Occupancies have declined from 91.3% as of Dec 31,08 to 90.1% on Dec 31,09. The ~100 bps decline in occupancies is not a major cause for concern as long as the occupancy levels don't' decline further. In fact, on a sequential basis from Sep09 to Dec09, occupancies have increased marginally from 90 % to 90.1%. Though marginal, this is a welcome sign in a weak CRE market where tenants have the advantage.

But this robust occupancy is not without its disadvantage. See the CEO comments from the 4Q09 earnings call (Read full transcript):

"..These transactions enabled us to end the year at 90.1% lease up in fact slightly from the last quarters 90%. Rents did roll down in quarter by approximately 10.5% or 6.8% on a GAAP basis .."

Unfortunately due to the straight-line rent accounting methods, only the 6.8% decline is reflected in the P&L statement, though the rent decline is far worse at 10.5%. To get a true picture it's best to adjust these 'unbilled rents' that the company anyway discloses.

Straight-Line Rents Mask The Actual Declines

(Click to view enlarged image)

Source: Gridstone Research

As seen from the graphic above, straight-line accounting added ~7M of 'non-cash' rent revenues to the Fiscal 2009 number. If this is excluded, the rent revenue increase is from $593 M to $609M. If this exercise is repeated for previous fiscals, it shows that the rent revenue increase even in 2004-2006 (the peak) has not been that much. However, since most leases were for at least 5-7 years and had step-up clauses, the rental income increase in those periods were exaggerated due to straight-line rent accounting.

As the new leases and lease renewals come in at lower rent realizations, the 'adjusted' FFO declines even more than FFO reported on a GAAP basis.

Adjusted FFO Will Show A Sharper Decline

(Click to view enlarged image)


Source: Gridstone Research

As seen from the data above, adjusted FFO( FFO-unbilled rent adj.) declined from $286M in 2007 to $274M in 2008 to $268 M in 2009. On a per share basis, the impact is at least 8-10 cents per share. Though the impact is minor in Mack-Cali's case, it could be significant for many other REITS which had a sharp increase in rent revenues in 2005-08 and rent realizations declined in 2009. What it conveys is that REIT financial reporting needs another layer of analysis and normalization before a true picture emerges.

Both in terms of FFO and rent revenue increases reported, investors need to carefully look at the causes and see if there is any 'organic' increase or if other factors are masking the actual increase / decrease in rents. Clearly a 10% rent realization decline (cash rent declines in Mack-Cali's case, which reflects actual market asking prices) is more stark than a 6% decline as per GAAP reporting. Another concern is that if occupancies continue to remain below 93-95%, all commercial REITS will find that the cash rents roll-down of 8-10% for new leases and lease renewals will continue in 2010. While this will not immediately impact rent revenues reported as per GAAP due to the long-term nature of such leases, the 'adjusted' FFO numbers decline.

The broader question is : Should GAAP do away with straight-line rent accounting? I think so, as it distorts the true picture in a cyclical industry like CRE. Another option is that straight-line accounting should be allowed for short-time frames of only, say, 3-4 year leases and not for all leases as that tenure could represent a typical boom-bust cycle in CRE.

Disclosure: No Positions

Source: Mack-Cali: Examining the Decline in Cash Rent Realizations