by Jonathan Litt
The latest pronouncement on FFO-related matters from the National Association of Real Estate Investment Trusts recommends that REITs report rent on a straightline basis, in accordance with generally accepted accounting principles, or GAAP.
Straightline rent is the average rental revenue received over the life of the lease, not the actual rent received in a particular year. This often results in the rental revenue being overstated during the initial years of a lease, and growth in contractual rental increases being lost in the reported results. Our adjusted funds from operations, or AFFO, estimates adjust FFO for the impact of straightlined rents to reflect the cash rent. For example, if a tenant has a 15-year lease, and the rent for the first five years is $10 per square foot (psf), $20 psf for the second five years, and $30 psf for the third five years, FFO would require the REIT to report $20 psf for every year of the lease as opposed to the actual rent paid.
Some companies recognize the shortcomings of the straightline rent adjustment (straightline rent does not apply to multifamily, manufactured homes, self-storage, or hotels). Those companies do not follow NAREIT’s recommendation, and instead report the actual rent received rather than the straightline amount.
Boston Properties is a great example of a company that uses straightline rent to its advantage. Consider the following: Boston Properties and Vornado both bid on New York’s Rockefeller Center. Rockefeller Center sold to a private buyer for $1.85 billion, at an 8 percent cap rate on cash rents. Cash net operating income (NOI) then is $148 million. We estimate the GAAP NOI, which is calculated using straightline rents, at $170 million.1 If Vornado had acquired the property, it would have stated the cap rate at 8 percent, and it would likely have been dilutive in the first year. If Boston Properties had acquired the property, it would have stated the cap rate was 9.2 percent, and it would likely have been accretive.
Compounding the effect of straightline rent adjustments is the fact that when a property is acquired or a merger is completed using purchase accounting, the start date of the lease is reset to the day the acquisition closes. Using the prior example, if the property is acquired with 10 years remaining on the lease, the straightline rent would equal $25 psf, or $5 more than the prior straightline rent.
Straightlining rents is a bonanza for a company that actively develops and reports results on a straightline basis. To best illustrate this point, let us review the differences in how Boston Properties and Vornado would report the results of the 2-million-square-foot Times Square ($1 billion) developments. Boston Properties has stated that the yield on the developments will be in excess of 11 percent. An 11 percent yield would generate a GAAP NOI of $110 million and, we estimate,2 cash NOI at $90 million. Thus, Vornado would report a 9 percent first-year yield.
But straightline rents is a slippery slope. Consider the example we used previously with rents of $10 psf, $20 psf, and $30 psf, which yields a straightline rent of $20 psf. If a developer was keen on exploiting the benefits of straightline rents, then he/she might offer the tenant a deal like this: $5 psf for the first five years, $10 psf for the second five years, and $60 psf for the third five years. The tenant would be eager to take this deal, as it perceives the present value of the income stream as more favorable. The developer is also eager to make this deal, because the straightline rent adjustment would equal $25 psf.
Using the Times Square example, Boston Properties believes it will earn in excess of 11 percent or $110 million in GAAP NOI on a $1 billion investment. However, if the lease were structured as outlined above, cash NOI would be $83 million, or a first-year cash yield of 8.3 percent, like Vornado would report. In the case of Boston Properties, whose roughly $4.5 billion development pipeline is more than 50 percent of its approximately $8 billion market cap, the implications of straightline rents are meaningful.
1 It is anticipated that most leases should be tied to CPI increases. If we assume CPI increases at 3 percent per year, that suggests rents will increase 30 percent over a 10-year lease. GAAP requires that the average lease rate over the term of the lease be reported, which is calculated by dividing the 30 percent increase in half. So, the reported rents will be 15 percent greater than the first-year rents. To arrive at GAAP NOI for Rockefeller Center, we increased the cash NOI by 15 percent.
2 Boston Properties does not disclose the lease terms on new developments.