REIT Accounting Its an Art Not a Science

Carl T. BerquistDeputy Director of Arthur Andersen (AA) Real Estate and Hospitality Services Group (REHSG) WorldwideHead of AA Southeastern U.S. REHSG and Metropolitan Wash., D. C. REHSG PracticeNational Association of Real Estate Investment Trusts (NAREIT) - Associate Board Member

Carl T. BerquistExperienceInitial and Secondary Public OfferingsAssisting in various private real estate capital raisesFinancial modeling, projections, strategic planning

OverviewREITsMarket Performance IndicatorsFFOAFFOFADEBITDADebt to Market CapPerformance AnalysisApplication of Accounting Policies

Real Estate Investment Trust (REIT)Assets are primarily composed of real estate held for the long termIncome mainly derived from real estatePays out at least 95 percent of taxable income to shareholdersOne level of taxationMutual fund for real estate

Income TestsAsset TestsWidely Held95% Distribution RequirementREIT Rules

Over 300 U.S. REITs, 216 Publicly TradedHow Many REITs Are There?

Annual Total REIT Security Offerings$ Billions

Year-end Market Capitalization$ Billions

REIT Advantages and DisadvantagesAdvantages

No corporate income taxes paidLiquidity and access to capitalPublic market pricingExpert managementStrong institutional investor interestGrowth opportunitiesLower debt levelsCorporate governanceIndependent analyst reviewAttractive returnsDisadvantages

Paying out 95%+ of net income reduces internal capital for growthPay-out requirements force dependence on healthy capital marketsOperating businesses must be owned and operated outside of the REITBeing placed into REIT Box limits potential investor universeMarket expectations limit leverageGAAP accounting issues

Revenues XXXXOperating Expenses(XXX)EBITDA XXXInterest Expense (XX)Funds From Operations XXXDepreciation & Other(XXX)Net Income XXXDebt Principal Amortization (XX)Normalized Cap Exp (XX)Tenant Improvements (XX)Depreciation & Other XXXFunds Available for Distribution XXDissecting the REIT Income Statement

Funds From Operations (FFO)Net income (GAAP) excluding gains (or losses) from debt restructuring and sales of property, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures

Evolution of FFONAREIT white paper Net income not a satisfactory measureConventional P/E multiples not meaningfulFFO/Share equivalent to EPSDefinition varied in practiceKey benchmark statisticUsed to compare to peers

Key FFO Measurement BenchmarksGrowth RatesPayout Ratios (Dividends/FFO)FFO Multiples

Growth RatesDone on a Per Share BasisCompared to PeersQuality of EarningsCore vs. Accounting GimmicksAccretive Acquisitions

Payout RatiosSafety of DividendRetained Captial

FFO MultiplesSimilar to PE RatioDrives Share PriceShare Price/FF0 per Share = MultipleThe Industry Average is 10 - 12 TimesSeveral Subjective VariablesManagementBusiness StrategyLeverageQuality of EarningsDividend GrowthPayout Ratio

Maximum price a REIT can pay for $10 million in FFO and not be dilutive

Adjusted Funds From Operations (AFFO)FFO adjusted for straight-lining of rents, as well as a reserve for recurring capital expenditures (including tenant improvements)Similar to FAD

Funds Available for Distribution (FAD)Another Type of Payout RatioDividend / FADHighlights Safety of DividendShows Ability to Grow DividendThe Lower the %, the Greater the Ability to GrowMore than 100% Shows the Dividend Cannot be Sustained

Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)EBITDA/Interest CoverageIgnores capital structureThe higher the ratio the greater the ability to growCan always purchase EBITDA

Debt to Market CapitalizationTotal Debt / (Debt + Equity Capitalization)The Lower the Ratio, the Greater the Ability to GrowAcquisitions can be leveragedExpansions can be financedReduced Refinancing Risk

Stock PriceQuality EarningsGrowing FFOStrong ManagementWell Defined Growth Strategy Low Debt to Market CapAbility to Execute

Accounting GimmicksCapitalization vs. expense Straight-lining of rental revenueTenant improvement costs vs. rental ratesOff balance sheet financingOff balance sheet venturesOne time transactionsFFO adjustmentsdeferred finance feespercentage rentpreferred returnsunusual items

ClarksonAcquisition reservesLeverage (Mark-to-Market)FAD pay out ratio

ClarksonThe company continued its innovative policy of renovating apartments to fit specific tenant needs and notes that this is a growing source of revenue for the future.

StatesTenant improvementsIncome from joint venturesInternal development costsStraight-lining of rents

AmericanReservesOther adjustment

Performance Indicators

American

States

Clarkson

REIT Accounting Its an ArtNot a ScienceSummaryThere is no easy answerUnderstand the numbersResearch is critical