By George Yungmann and David Taube

Most executives of REITs and other publicly traded real estate companies, as well as users of these companies' financial statements, agree that "bottom line" net income calculated using generally accepted accounting principles (GAAP) is not, by itself, a meaningful indicator of the profitability of these companies. In an Accounting Series Release, the Securities and Exchange Commission urged industries that want to use supplemental earnings measures to develop uniform definitions and terminology for such measures. In 1991, funds from operations (FFO) was defined by NAREIT and became widely used by the industry. Users of the industry's financial statements have accepted FFO as a starting point from which to analyze the historical, as well as prospective profitability and value of companies in the industry. The definition of FFO was reevaluated and modified in 1995 and again in 1999.

Inconsistencies Persist

Despite the industry's efforts to create a uniform supplemental operating performance benchmark, some companies and financial statement users do not calculate FFO in accordance with the NAREIT definition and guidance. Much of this inconsistency appears to be caused by the notion that FFO represents, or should represent, a measure of stabilized cash flow generated by operations rather than a supplemental measure of accrual, GAAP basis earnings. It is clear from both the 1995 and 1999 versions of NAREIT's FFO White Paper that FFO is intended to be a supplemental accrual basis earnings measure, not a measure of cash flow. The current White Paper, approved by the NAREIT Leadership in 1999 based on broad input from NAREIT's membership, defines FFO as (bold type is used for emphasis):

"FUNDS FROM OPERATIONS means net income (computed in accordance with generally accepted accounting principles), excluding gains (or losses) from sales of property, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. Adjustments for unconsolidated partnerships and joint ventures will be calculated to reflect funds from operations on the same basis."

Further, the Paper states:
". . .the underlying premise of the definition of FFO was not to sanction deviations from GAAP in the name of calculating Funds From Operations. In fact, the definition specifically refers to GAAP net income as the starting point in the calculation of FFO.

Importantly, FFO was also not intended to be used as a measure of cash generated by a REIT nor of its dividend paying capacity."

FFO is intended to provide financial statement users with a uniform GAAP-based benchmark to compare against earnings expectations. It represents a consistent starting point for analysis of a company's profitability and value—the same way GAAP net income is used in other industries.

Despite this definition and guidance with respect to FFO, some preparers and users of REIT financial statements treat FFO as if it is intended to report stabilized cash flow generated by operations. This practice may be the single most significant cause of the inconsistencies in calculating FFO among REITs and other publicly traded real estate companies.

Telltale Signs

Treating FFO as a cash flow measure is evidenced by certain of the adjustments made to the defined calculation of FFO.
These adjustments include:

• Translating rents from a straight-line, GAAP accrual basis to a cash basis
• Adding back to GAAP net income the non-cash amortization of deferred financing costs—a practice explicitly prohibited by the FFO White Paper
• Adding back deferred income taxes to GAAP net income to eliminate this non-cash GAAP expense
• Adding back to GAAP net income non-cash write-offs of investments in new ventures
• Adding back to GAAP net income the non-cash portion of compensation expense
• Adjusting GAAP basis contingent rental income to reflect the billing of contingent rents and
• Adjusting GAAP rental income/expense related to capital leases to a cash basis.

A number of preparers and users appropriately make the adjustments identified above for the purpose of translating FFO to cash flow measures, such as "Adjusted Funds From Operations" (AFFO) and "Cash or Funds Available for Distribution" (CAD or FAD). These measures are used as a basis for valuing companies.

One Measure May Not Fit All Needs

The inconsistencies in calculating FFO from the perspective of earnings and cash flow indicate that a single metric may not appropriately satisfy the need for both a supplemental earnings measure and a cash flow measure. The need for two, separate measures to satisfy these needs is common in other industries. In many industries, while earnings are measured based on GAAP (accrual based) principles, company valuations are based on a second measure. The possibility of the real estate industry utilizing separate measures for reporting earnings and cash flow was discussed in this column in the September/October 2000 issue of Real Estate Portfolio.

The earlier discussion suggested that a GAAP-based earnings measure, such as "adjusted net income" (ANI), could be reported uniformly by all companies. ANI would consist of GAAP net income before extraordinary items, cumulative effects of accounting changes, results of discontinued operations and unusual, non-recurring items. The amount of each of these adjustments to GAAP net income would be based on GAAP measurements.

As a supplement to ANI, each company would be free to calculate and report a cash flow measure, such as CAD or FAD, that best reflects the economics of its operations and provides an appropriate basis of valuation. In addition to enhancing the uniformity and transparency of the industry's supplemental earnings metric, using a reporting model that mirrors practices used by many industries may enhance the opportunities of REITs and other publicly traded real estate companies as they reach out for new sources of capital in the broader capital markets.

Going Forward

It seems clear that FFO alone cannot meet the need for both a uniform, transparent earnings measure and a cash flow/valuation metric. This is a universal condition that is recognized in the suite of GAAP financial statements that includes a Statement of Earnings and a separate Statement of Cash Flows. Based on the NAREIT White Paper, both the 1995 and 1999 versions, FFO is an accrual, GAAP based earnings measure. If, over time, NAREIT members continue to believe that FFO is not effectively satisfying the need for a supplemental operating performance measure, the industry could consider alternatives. This may be more appropriate than companies reporting FFO based on a variety of unique definitions.