REITs and the Fallacy of FFO

While most stocks are evaluated according to their earnings, Real Estate Investment Trusts (REITs) are evaluated according to Funds From Operations (FFO). Analysts believe that FFO provides for the best measure of value for REITs like ProLogis (PLD), Simon Property Group (SPG) and HCP, Inc. (HCP). I argue the opposite is true under current market conditions. In a declining real estate market FFO grossly overstates the value of a REIT’s earnings, particularly when acquisitions were made at the height of the market.

What is FFO?

In their online glossary, the National Association of Real Estate Investment Trusts [NAREIT], a REIT trade and lobbying group, defines FFO as follows:

Funds From Operations (FFO) The most commonly accepted and reported measure of REIT operating performance. Equal to a REIT's net income, excluding gains or losses from sales of property, and adding back real estate depreciation.

Basically, you get FFO by taking Net Income per Generally Accepted Accounting Principles (GAAP) and reversing gains or losses from sales and depreciation expense. It is the latter that will greatly distort the value of a REIT in difficult times.

What is the Rationale for the Use of FFO?

Analysts believe that FFO is a better measure of a REIT's health than net income because of the belief that real estate consistently appreciates in value. According to the NAREIT's white paper on Funds From Operations (2002):

Historical cost accounting for real estate assets implicitly assumes that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen or fallen with market conditions, many industry investors have considered presentations of operating results for real estate companies that use historical cost accounting to be insufficient by themselves.

The term Funds From Operations was created to address this problem. It was intended to be a standard supplemental measure of REIT operating performance that excluded historical cost depreciation from — or "added it back" to — GAAP net income.

Thus, Depreciation is reversed because, in theory, real estate values increase over time so it is unfair to subtract depreciation from income because such assets would likely be sold for a profit at a later date and would not depreciate to zero like equipment. I believe it is a fallacy to reverse depreciation expense in a down real estate market. Particularly when it is known fact that a real estate asset has decreased in value, depreciation should be accelerated and included in FFO.

Consider the hypothetical case of a REIT A that owns one asset: a residential home that is leased for income. REIT A purchased the home on January 1, 2005 for $375,000 (assume $100k is attributable to land & $275K is attributable to building). The home rents for $3,000 per month or $36,000 per year for 2005 and 2006 (assume constant rents for 2005 & 2006 (for simplicity)). Interest, taxes and insurance are $500 per month or $6,000 per year. Here is the 2005 & 2006 Income Statement for REIT A:

REIT A has 10,000 outstanding shares of common stock. Thus, earnings per share (EPS) is $6k / 10,000 or $0.60. However, REIT A would also report an FFO calculation by reversing the depreciation expense. Thus, FFO for REIT A would be:

* = Assume 27.5 year straight line depreciation ($275,000 ÷ 27.5 = $10,000)

Per share FFO will be $1.60 per share ($16K ÷ 10,000 shares = $1.60). You can see that the majority of the FFO number is a result of the reversal of depreciation. Indeed, this might be fair in a rising or stable real estate market.

However, assume that the rental home was purchased in 2005 in Stockton, California where home prices have dropped 50%-60%. Also, assume that the excess in inventory has also hurt rent pricing and the home can only be rented for $2,750 per month ($33,000 per year). Here is the Net Income for 2007 in that case:

You can see that Net Income has been cut in half from $6k to $3k. Now, let’s take a look at FFO for 2007:

You can see that FFO decreases very little in comparison with Net Income. FFO only drops 18.75% as compared to a 50% decrease in Net Income.

Is it really fair to continue accepting NAREIT's FFO metric when we actually know for a fact that that an asset has significantly depreciated in value much faster than the 27.5 year straight line depreciation schedule? FFO's continued use does not make any common sense, yet analysts continue to rely on it as dogma and refuse to challenge its validity.

Conclusion

Analyst’s continued emphasis on FFO has incented REITs to continue to acquire assets without regard to long-term cash profitability because a REIT will get more depreciation reversal if it grows its balance sheet. This motivation combined with the availability of credit over the past few years has resulted in irresponsible acquisitions from a sustainable business standpoint. Unfortunately, credit is not as easy to obtain now, so many REITs will suffer from real cash problems regardless of the FFO games.

Disclosure: Short PLD & HCP, No Position in SPG or AMB

Comments

[you're nuts:]

so you're talking the game to justify your short position? hope you get burned...

2008 Oct 10 02:39 PM

[William Eic...:]

The current and future income, plus the interest rates environment will determine the value of a property. The income from a medical office building, laboratory, or senior housing facility is the foundation for Health Care Properties as an investment. I forsee no slack in demand for their properties and therefore no decline in future income. Perhaps Mr.Woon should re-work his dissatisfaction with FFO & depreciation.

2008 Oct 10 04:30 PM

[E-rock:]

The author has absolutely no idea what he is talking about. There's plenty to argue with in the NAREIT definition but this is utterly non-sensical. REITs don't invest in single family residential dwellings and FFO is an earnings measure, NOT a value measure. This article should be removed. Who's this guy's editor?

2008 Oct 10 08:48 PM

[Fabrice:]

NAREIT communicates about FFO, but you can also found REIT's Net Asset Value from independant research companies.
In France, all REITs communicates NAV (= Actif Net Réévalué) and Free Cash Flow (which is near FFO).
NAV, FFO, Loan To Value, and 10 years bund / dividend spread are valuable tools to give an idea about an REIT. FFO alone is a nosense.

2008 Oct 11 01:33 AM

[CWest:]

FFO is a measure of free cash available for distribution or investment. As long as one understands FFO - the measure is useful.

2008 Oct 11 08:36 PM

[Richard Woon:]

The use of a single family residence as an example is for simplification only. While the assets differ, the principles are the same. I agree that FFO is an earnings measure and not a value measure - but it is an earnings measure that is dependent on an asset value assumption. Thus, when value is adjusted downward, FFO should be adjusted downward as well.

You may not believe that commercial real estate values were overinflated. If so, my article is useless to you. However, I believe over time I will be proven correct. I also predict the stock market will fall more. If you think it has bottomed - buy.

2008 Oct 12 02:06 PM

[User 161244:]

Don't take above comments to heart. I haven't yet digested the analysis. But definately a view point that I want to review,

2008 Oct 20 04:25 PM

[Main Street...:]

E-rock put it very well. FFO is an earnings measure, not a value measure. This article seems to be creative and somewhat well thought through, but as much as I love it when down to earth investors put the out of touch analysts in their place, this is a little too out of the box, so much that it doesn't make any sense at all. The author is dead wrong that FFO is based on an assumption of value. Earnings include depreciation, which is as the author put it "dependent on an asset value assumption". That is why FFO is adjusted from earnings by adding back in depreciation: as though it never happened so that FFO is NOT based on an "asset value assumption"! FFO should NEVER be adjusted due to changes in asset value and never, NEVER is.

Anyone who knows REITs or private market real estate knows that the depreciation shown on the books is not consistent with what reality; even the IRS knows that which is why the cost segregation proponents won in the courts. Further, buying when real estate is inflated helps lock in a high depreciation schedule which is GOOD for tax purposes. Even if real estate does fall in the short term, you have better depreciation and no downside if real estate falls in value in the short term. It should be noted that REITs may not purchase property for the purpose of selling it which also reduces the likelihood that short term drops in value will have any effect. The problem with buying inflated real estate is simply that you're paying too much for low returns and getting a low ROI. It's that simple, let's not over-complicate it.

2008 Oct 31 03:36 PM

[bgxlin:]

Mr. Woon, can you find me a 50 years old apartment in California for sale with $0, as it should have been depreciated to ZERO DOLLAR after so many years regardless where it's located or how it's maintained!

Apr 30 10:39 AM

[H.J. Huneycutt:]

This article totally misses the point. Real estate does not depreciate to $0. FFOs are earnings estimates, not value estimates.

However, this does bring up an interesting discussion --- the accounting treatment of REITs needs to be dramatically altered. Depreciation shouldn't be used except when we're talking about certain property additions that might have a well-defined lifecycle. REITs should claim their surveyed property values for their RE assets on the balance sheet --- those values can be written down if they are indeed "impaired", as many RE assets in the current environment have been.

May 17 04:36 PM

[Fred55:]

I'm not an accountant, but my take on this issue is as follows:

Depreciation assumes that the depreciated asset has to be replaced at the end of the depreciation period. It was believed (probably correctly) that with proper maintenance, buildings could last much longer than their GAAP depreciation periods. If that's true, then it makes sense to add back the non-cash depreciation expense. But if you add back depreciation, you have to make sure to account for the expense of maintaining the building in its current state forever, which is probably a significant expense.

I think what Richard Woon may be talking about is the possibility that the asset value of the building will be impaired because market prices of buildings will fall. You're on the right track, Richard, it's a valid concern. But depreciation has to do with erosion of value from "wear and tear" (fairly regular and predictable) and not repricing of assets by the market (less regular and predictable).

May 17 07:55 PM