Winter 2000
	Cover Story REITs at the Millennium Industry veterans look into their crystal balls. Where are REITs headed? Company Spotlight Can Crescent Get Its Groove Back? John Goff is working to restore Crescent Real Estate Equities’ reputation as a REIT that "gets it." Property Fundamentals Lack of Correlation J.P. Morgan’s Michael Giliberto provides answers to the age-old question, "Are REITs really real estate?" Awards Spotlight Best & Brightest Realty Stock Review’s eighth annual awards presentation recognized the top vote getters in a number of categories, including outstanding analysts, CEOs, and CFOs. Voters also chose the industry’s man of the year and men of the decade. Investment Analysis Applying MPT to REIT Portfolios Careful portfolio construction can make or break the performance of a pool of assets. Investment Fundamentals The High Cost of Real Estate Ownership Swapping net income for FFO might not be such a bad idea after all. By The Numbers A Fund Manager’s Worst Nightmare If it’s true that what doesn’t kill you makes you stronger, real estate fund managers may be some of the strongest folks around. Point Of View REITs and Rights Plans Criticism of REITs that adopt rights plans is simply misplaced. Investment Spotlight Spooked What happens when more than a dozen REIT UITs start unwinding in the midst of the worst bear market in a quarter of a century? The New Economy When Worlds Collide The Internet will provide investment opportunities for innovative office and retail real estate companies that embrace the changing landcape. Investment Insight LBO Math The market is beginning to understand that LBO valuation does not equal net asset value. Parting Shot Coming of Age REITs have evolved from pools of properties to focused real estate operating companies. Newsline Captec Wants to Shed REIT Status Investor's Guide Questions Back Issues Feedback

by Mike Kirby, John Lutzius, Warner Griswold, and Jon Fosheim
Illustration by Arnold Roth

As the REIT sector continues its lengthy search for a performance measure to replace/repair its deeply flawed funds from operations (FFO) measure, the idea of scrapping FFO and merely reporting net income appears to be gaining acceptance. While this push seems to be more related to a high level of dissatisfaction with FFO rather than a feeling that net income is a good performance benchmark for a REIT, net income actually has merits that make it a decent performance measure. Net income’s treatment of depreciation is conceptually appealing, because the industry’s long-standing contention that "real estate doesn’t depreciate" just doesn’t fly. Buildings either depreciate or they require very sizable capital investments to stave off this depreciation, but the real estate industry (both public and private) has long been in denial about the magnitude of these costs. FFO ignores these costs entirely. Adjusted funds from operations/cash available for distribution (AFFO/CAD) likely understates the magnitude of these costs, and net income probably overstates them. It is far from clear that net income is any more or less flawed as a performance measure than any of its brethren. Net income is generally viewed by most members of the REIT community as a meaningless statistic that merely serves as a starting point to the greater end of calculating FFO. While REITs present this measure because they have to, it gets no attention on conference calls and is generally shunned as having no real meaning by the investment community. While we don’t believe net income is the Holy Grail of performance measures, there is an increasing likelihood that the industry will begin to focus more attention on it because it brings with it little of the confusion and skepticism accorded FFO.

What’s Good About Net Income?
Net income, as defined for real estate companies, has flaws. However, members of the real estate community oftentimes overstate these flaws. Net income, at least conceptually, is a far better performance measure than FFO. Contrary to the oft-heard refrain that "real estate doesn’t depreciate, therefore we should ignore depreciation by adding it back to net income," real estate does indeed depreciate. By adding back all real estate depreciation in the computation of FFO, the REIT industry is guilty of ignoring this very real, and very material, expense.

The "real estate doesn’t depreciate" fallacy arises from the simplistic observation that the value of most real property goes up over time. While true, what is really happening is the value of land (which, of course, does not incur depreciation expense) is going up disproportionately, while the value of a building only goes up if its owner plows large sums of capitalized expenditures into it to keep it competitive. Virtually every component of a building needs to be replaced at some point in the future, which is exactly what depreciation is designed to measure.

While FFO does a great job of recognizing the appreciation that is taking place by counting all of the higher revenues, it often ignores the large costs of keeping a building competitive since many of these costs are capitalized rather than expensed. Because of this, FFO fails the simple theoretical accounting test of matching revenues with expenses. Net income, on the other hand, has no such shortcoming. The depreciation of the buildings and the improvements that show up in net income are, conceptually, very close cousins to the capitalized expenditures or "cap ex" reserves applied by most analysts when they compute AFFO/CAD. Thus, from a theoretical context, FFO is a much more flawed performance measure than net income.

Even in practice in many instances, the concept of depreciation for real estate companies is reasonable and fair. This is particularly true for shorter-lived assets, such as carpets, paint, flooring, roofs, tenant improvements, leasing commissions, parking lots, and HVAC units. These items tend to have useful lives less than 40 years, and generally accepted accounting principles (GAAP) mandate that they be depreciated over their respective useful lives. On this front, net income works just fine (a qualifier is warranted, however, as our analysis suggests that depreciation expense is too low on short-lived assets), as most analysts otherwise try to estimate an appropriate "cap-ex" reserve to apply in computing AFFO/CAD to reflect these very same costs. Why not just use the depreciation expense? There are two reasons: (1) most REITs do not disclose the components of depreciation expense (despite guidelines to this effect from NAREIT’s 1995 FFO white paper), and (2) most REITs allocate virtually nothing to the short-life bucket on their recent acquisitions, which causes short-lived depreciation to be understated. While currently a big impediment toward making reported depreciation a useful figure, both problems can be fixed over time.

What’s Bad About Net Income?
The primary reason net income is viewed with disdain by REIT managers lies in its treatment of depreciation of longer-lived assets, such as building structures. By forcing property owners to depreciate building structures on a 40-year schedule, the expense is arguably too high for structures with a substantially longer life. The most serious flaws with the 40-year schedule likely fall in the office, industrial, and mall sectors, where many of the buildings have limestone, granite, marble, concrete, or steel framework, which may still be in good shape hundreds of years from now. While it is less clear that the GAAP rules are unfairly harsh with, say, a wood-frame, garden-style apartment, a 40-year life is probably still too short. Since these structural components generally comprise the vast majority (usually over 80 percent) of the construction cost for any building, the inflated depreciation expense here has the effect of depressing net income to a level that is substantially below the economic "truth." The depreciation of structural items is even more overstated by GAAP when the time value of money is factored in.

Net Income’s Other Flaws
In addition to recognizing depreciation expense that is arguably too high for structural items, net income has other shortcomings. First, depreciation expense is based on book value, and assets that have been owned a long time may have a much lower book value than identical, but recently acquired, assets. Older assets tend to have lower depreciation expenses than new ones. This is mitigated somewhat by the fact that lots of capitalized expenditures have typically been added to the book value of older properties since acquisition, and these have the effect of boosting the depreciation expense. Nevertheless, the presence of older asset values on the books of most companies has the effect of understating depreciation expense (at least relative to replacement cost) and overstating net income.

Second, as noted, real estate companies, especially those that have been active acquirers, have generally done a poor job of allocating appropriate costs to the components of their buildings. Based on our conversations with management teams, most acquisitive REITs appear to be guilty of lumping virtually the entire cost of their new acquisitions into the 40-year "real estate" bucket, as opposed to allocating some of the costs to components with shorter lives. This has the effect of understating depreciation expense and overstating net income. Developers, by contrast, are usually required to allocate their costs more realistically. Even here, however, sizable allocation issues arise. One example is the appropriate period for a mall developer to depreciate the very large tenant improvement dollars that are often given to anchor tenants. If reported depreciation becomes a figure analysts/ investors begin to rely on, a suitable role for NAREIT and the Financial Accounting Standards Board (FASB) will be to work toward guidelines to improve the haphazard allocation process that currently exists.

Third, net income shares certain flaws with FFO, such as the wrong-headed GAAP convention regarding the straightlining of rents. It also includes gains on sales and other items that people such as us would likely remove before deriving a valuation benchmark to use in a P/E computation. These shortcomings can be easily dealt with through good disclosure.

Just How Bad Is Net Income?
FFO overstates performance and net income understates performance. Which is worse? For the companies in our coverage universe, 1998 net income was only 56 percent as large as FFO (see graph above). Net income before extraordinary items was 59 percent of FFO, and net income before both extraordinary items and gains on sales was 52 percent of FFO. This latter benchmark seems to be the most meaningful. Therefore, a good rule of thumb appears to be that multiples of net income (before extraordinary items and gains on sales) are nearly twice as high as FFO multiples. Based on 1998 earnings for both REITs and the S&P, the market, as of the end of the third quarter, was ascribing the following multiples: S&P = 29.7x; REIT FFO = 9.4x; and REIT P/E (defining earnings as net income before extraordinary items and gains) = 19.9x. While the more-commonly cited leading earnings multiples are somewhat lower for each of these indices (e.g., S&P = 23.5x), the 1998 data highlight the differences between the pricing multiples.

Our preferred performance measure has long been AFFO, which equates to FFO less a reserve for "cap-ex," less straightlining of rents, less gains on sales. For the average company in our coverage universe, AFFO equates to 86 percent of FFO. Thus, if AFFO is the "correct" benchmark, FFO comes closer to being correct than net income, but they are both flawed. It is worth noting, however, that we are in the process of reviewing many of our "cap-ex" reserve assumptions, the likely outcome of which will be to increase the reserve and decrease AFFO. Thus, net income may come closer to AFFO than it does now.

The graph on page 44 shines a little more light on why net income varies so much from FFO and AFFO; not surprisingly, the difference is largely attributable to the large size of the depreciation expense. The graph includes a random sampling of companies from each of the three major property sectors (office, malls, and apartments) and serves to highlight the fact that depreciation expense is usually a much larger number than our "cap-ex" reserve. For the eight companies in the analysis, depreciation averaged 28 percent of NOI, while cap-ex averaged 9 percent of NOI.

As we continue to assess the true economics of operating real estate, we have a strong feeling that we’ll be increasing our "cap-ex" reserves to a number more in line with - but probably still much smaller than - the depreciation expense.

Is There a Leak in the IRR Bucket? REIT managers have some explaining to do. All of their 1994-98 acquisitions, like all acquisitions in the history of real estate, were underwritten to produce unleveraged internal rates of return of 11 percent to 13 percent. Assuming 40 percent leverage and a 7 percent cost of debt (reasonable assumptions for a typical REIT’s capital structure over the past few years), this implies a leveraged IRR expectation in the range of 15 percent. Isn’t it odd, then, that the average annual total returns of the NAREIT Equity Index - an index of leveraged real estate companies - over the past five- and 10-year periods have been only 8.8 percent and 9.2 percent, respectively (through August 1999 per NAREIT)? These returns are particularly disappointing since they have occurred during a rising portion of the real estate cycle. REIT-industry veterans may suspect that a large portion of the poor five-year average return can be explained by REITs falling from a big premium to NAV in mid-1994 to their August 1999 7 percent discount to NAV. Not so. REITs were trading about equal to NAV in August 1994 per Green Street’s estimate at the time. Thus, while the movement to a discount did bring down returns, it was only by a little more than 1 percent per year. Our NAV premium/discount data does not stretch back to 1989, but our best guess is that REITs were trading at a small premium or even a discount at that time. Not only have REIT returns not met the expectations of real estate investors, they are even worse when compared with the broader market. The wind has been at the back of all public companies over these time periods, yet REITs have produced disappointing results. If REITs were an industry segment of the Fortune 500, they would have placed No. 36 in a list of 39 industry segments based on total returns for the trailing 10 years. One plausible explanation for this poor performance is that REITs are currently underpriced in the public market. Once REITs recover from their bear market, their returns will fall in line. Partial evidence for this theory is the 20-year REIT track record, which shows a respectable 14 percent per year average total return. We have advanced the "REITs are cheap" argument ourselves and consider it a reasonable theory. That said, skeptical investors should consider alternative explanations. A problem with the 20-year NAREIT Equity Index data is that it predates the "modern REIT era," and it is based on a small sample size (e.g., the equity market cap of the REIT industry in 1984 was less than $2 billion). Also, the early index had very little representation from office, industrial, and regional mall assets - huge real estate sectors. The 20-year average total return using NCREIF (National Council of Real Estate Investment Fiduciaries) data, the most popular private market return series, is only about 9 percent per year. While the NCREIF data is appraisal based and, therefore, does not necessarily capture true market pricing, the unimpressive return figure is noteworthy. Given our lack of confidence in both of these return measures and their conflicting indications, we categorize the long-term track record of real estate investment as "indeterminate" at this time. If REITs aren’t cheap (i.e., if the public market is getting the valuation right today or if the NCREIF return data is accurate), we need to know where those IRR models went wrong. While investors rightly worry about the potential effect of overbuilding or a recession on NOI, other candidates for scrutiny are cap-ex reserves and exit cap rates. With regard to capital expenditures, there is little doubt now that large portions of these expenditures are effectively current-period expenses. Exit cap rates employed in typical IRR calculations are often overly optimistic: Why would the cap rate remain the same when a property has aged by 10 years and all below-market rents have been repriced to market? In our discussions with real estate executives over the past several years, we have been struck by their lack of insight about the below-the-NOI-line costs of operating real estate over a full cycle. This, in turn, makes us wonder if these same executives are correctly estimating real estate residual values. These two areas deserve more attention as investors search for the leak in the real estate IRR bucket. If the long-term return potential of real estate truly is in the single digits, real estate pricing in the private market may be too high, and values may fall as investors lower their expectations for real estate cash flows and growth. Could it be that, as real estate markets achieve equilibrium for the first time in many years, these costs will become more apparent and return expectations will fall? We are not ready to offer a firm opinion, but we are increasingly interested in what is currently the minority view: The public market may know more about future real estate prices than most real estate professionals.

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