By Jon Fosheim

Arriving at a consensus for the most useful performance measurement for REITs and other real estate companies is darn near impossible. GAAP-defined net income is uniform and simple enough to understand, but due to such factors as depreciation charges and gains from sales of depreciated assets, it is generally accorded about as much respect as Rodney Dangerfield. The NAREIT-endorsed definition of funds from operations (FFO), while more closely followed by REITs than it used to be, is still problematic due to the confusion caused by the numerous accounting pronouncements that only a bored CPA could love.

More importantly, FFO largely overstates true operating cash flow due to such items as capital expenditures, leasing commissions and tenant improvement costs that are capitalized and not deducted in the FFO calculation. Also, FFO does not include a decent mechanism for measuring value creation or destruction—gains on sales is sometimes used as a proxy, but it is a very flawed one. It is about as useful as measuring a car's speed with a thermometer. It follows that any derivative of FFO, such as adjusted funds from operations and cash available for distribution are similarly flawed, because they all start with FFO.

In many other countries, this problem is addressed by what is called current value accounting.

This short example should help clarify the definition of current value accounting. If we want to compare the performance of two REITs over any given time period, an appropriate question would be, “including dividends received, which one added more to my net worth?” If REIT A delivered superior per-share cash flow and dividends compared with REIT B, but did it by, say, leveraging up the balance sheet and buying high yielding (“junky”) properties (perhaps even overpaying for them), while REIT B had less cash flow and dividends, but added more to my net worth through such activities as value-added developments, shrewd asset purchases (including timely share buybacks), or other smart capital allocation decisions, current value accounting will correctly identify REIT B as the better performer.

The part of this formula that pertains to dividends received is easy—we can get that information from any number of sources. The tricky part, as you may have already surmised, is to calculate the change in the value of net worth. There is no easy way to do it.

In the above hypothetical comparison, investors must have an informed opinion as to the marked-to-market value of the two REITs' assets and liabilities at both the beginning and end of the period. Asset appraisals have to be made, at the mandate of management, and/or independently by analysts. Certainly, management would have an incentive to game this approach as well, and could pressure appraisal firms to manipulate value estimates to their liking.

Sure, reasonable minds can disagree about the current market value of a given REIT's assets, but by how much? Marking to market the assets of most public companies would be daunting—what value would you assign to drug patents or proprietary software programs? However, the presence of an active market for real estate affords an opportunity to take a reasonable stab at it. We are willing to wager that the range of potential errors in estimating market values for real estate assets is substantially smaller than the errors and gaming that are inherent in net income, FFO or AFFO.

REITs have an asset base that allows investors to do what they can't do in many other sectors—drill down and see how much a company is adding to or detracting from its net worth. Current value accounting is very appropriate for the REIT industry, and would help investors make more informed choices.