REIT Accounting It’s an Art REIT Accounting It’s an Art

Not a ScienceNot a Science

Carl T. BerquistCarl T. Berquist

Deputy Director of Arthur Andersen Deputy Director of Arthur Andersen (AA) Real Estate and Hospitality (AA) Real Estate and Hospitality Services Group (REHSG) WorldwideServices Group (REHSG) Worldwide

Head of AA Southeastern U.S. REHSG Head of AA Southeastern U.S. REHSG and Metropolitan Wash., D. C. REHSG and Metropolitan Wash., D. C. REHSG PracticePractice

National Association of Real Estate National Association of Real Estate Investment Trusts (NAREIT) - Associate Investment Trusts (NAREIT) - Associate Board MemberBoard Member

Carl T. BerquistCarl T. Berquist

ExperienceExperience• Initial and Secondary Public OfferingsInitial and Secondary Public Offerings• Assisting in various private real estate Assisting in various private real estate

capital raisescapital raises• Financial modeling, projections, Financial modeling, projections,

strategic planningstrategic planning

OverviewOverview

REITsREITs Market Performance IndicatorsMarket Performance Indicators

• FFOFFO• AFFOAFFO• FADFAD• EBITDAEBITDA• Debt to Market CapDebt to Market Cap

Performance AnalysisPerformance Analysis Application of Accounting PoliciesApplication of Accounting Policies

Real Estate Investment Real Estate Investment Trust (REIT)Trust (REIT)

Assets are primarily composed of Assets are primarily composed of real estate held for the long termreal estate held for the long term

Income mainly derived from real Income mainly derived from real estateestate

Pays out at least 95 percent of Pays out at least 95 percent of taxable income to shareholderstaxable income to shareholders

One level of taxationOne level of taxation Mutual fund for real estateMutual fund for real estate

Income TestsIncome Tests

Asset TestsAsset Tests

Widely HeldWidely Held

95% Distribution95% DistributionRequirementRequirement

REIT RulesREIT Rules

Over 300 U.S. REITs, 216 Publicly TradedOver 300 U.S. REITs, 216 Publicly Traded

168 33 15

How Many REITs Are How Many REITs Are There?There?

Annual Total REIT Security Annual Total REIT Security OfferingsOfferings

$ Billions$ Billions

010

20

30

4050

60

70

1990 1991 1992 1993 1994 1995 1996 1997 1998

Year-end Market Year-end Market CapitalizationCapitalization

$ Billions$ Billions

020406080

100120140160180

1990 1991 1992 1993 1994 1995 1996 1997 1998

REIT Advantages and REIT Advantages and DisadvantagesDisadvantages

AdvantagesAdvantages

No corporate income taxes No corporate income taxes paidpaid

Liquidity and access to capitalLiquidity and access to capital Public market pricingPublic market pricing Expert managementExpert management Strong institutional investor Strong institutional investor

interestinterest Growth opportunitiesGrowth opportunities Lower debt levelsLower debt levels Corporate governanceCorporate governance Independent analyst reviewIndependent analyst review Attractive returnsAttractive returns

DisadvantagesDisadvantages

Paying out 95%+ of net income Paying out 95%+ of net income reduces internal capital for growthreduces internal capital for growth

Pay-out requirements force Pay-out requirements force dependence on healthy capital dependence on healthy capital marketsmarkets

Operating businesses must be Operating businesses must be owned and operated outside of the owned and operated outside of the REITREIT

Being placed into “REIT Box” limits Being placed into “REIT Box” limits potential investor universepotential investor universe

Market expectations limit leverageMarket expectations limit leverage GAAP accounting issuesGAAP 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 XX

Dissecting the REIT Dissecting the REIT Income StatementIncome Statement

Funds From Operations Funds From Operations (FFO)(FFO)

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

Evolution of FFOEvolution of FFO

NAREIT white paper NAREIT white paper Net income not a satisfactory measureNet income not a satisfactory measure Conventional P/E multiples not Conventional P/E multiples not

meaningfulmeaningful FFO/Share equivalent to EPSFFO/Share equivalent to EPS Definition varied in practiceDefinition varied in practice Key benchmark statisticKey benchmark statistic Used to compare to peersUsed to compare to peers

Key FFO Measurement Key FFO Measurement BenchmarksBenchmarks

Growth RatesGrowth Rates Payout Ratios (Dividends/FFO)Payout Ratios (Dividends/FFO) FFO MultiplesFFO Multiples

Growth RatesGrowth Rates

Done on a Per Share BasisDone on a Per Share Basis Compared to PeersCompared to Peers Quality of EarningsQuality of Earnings

• Core vs. Accounting GimmicksCore vs. Accounting Gimmicks• Accretive AcquisitionsAccretive Acquisitions

Payout RatiosPayout Ratios

Safety of DividendSafety of Dividend Retained CaptialRetained Captial

FFO MultiplesFFO Multiples

Similar to PE RatioSimilar to PE Ratio Drives Share PriceDrives Share Price

• Share Price/FF0 per Share = MultipleShare Price/FF0 per Share = Multiple The Industry Average is 10 - 12 TimesThe Industry Average is 10 - 12 Times Several Subjective VariablesSeveral Subjective Variables

• ManagementManagement• Business StrategyBusiness Strategy• LeverageLeverage• Quality of EarningsQuality of Earnings• Dividend GrowthDividend Growth• Payout RatioPayout Ratio

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

Company A B C D E

FFO Multiple 10.7 x 10.2 x 9.6 x 9.1 x 6.9 x

Breakeven PurchasePrice $107 mill $102 mill $96.0 mill $91.0 mill $69.0 mill

Cap Rate 9.3% 9.8% 10.4% 11.0% 14.5%

Adjusted Funds From Adjusted Funds From Operations (AFFO)Operations (AFFO)

FFO adjusted for straight-lining of FFO adjusted for straight-lining of rents, as well as a reserve for rents, as well as a reserve for recurring capital expenditures recurring capital expenditures (including tenant improvements)(including tenant improvements)

Similar to FADSimilar to FAD

Funds Available for Funds Available for Distribution (FAD)Distribution (FAD)

Another Type of Payout RatioAnother Type of Payout Ratio• Dividend / FADDividend / FAD

Highlights Safety of DividendHighlights Safety of Dividend Shows Ability to Grow DividendShows Ability to Grow Dividend

• The Lower the %, the Greater the The Lower the %, the Greater the Ability to GrowAbility to Grow

• More than 100% Shows the Dividend More than 100% Shows the Dividend Cannot be SustainedCannot be Sustained

Earnings Before Interest, Taxes, Earnings Before Interest, Taxes, Depreciation and Amortization Depreciation and Amortization (EBITDA)(EBITDA)

EBITDA/Interest CoverageEBITDA/Interest Coverage Ignores capital structureIgnores capital structure The higher the ratio the greater The higher the ratio the greater

the ability to growthe ability to grow Can always purchase EBITDACan always purchase EBITDA

Debt to Market Debt to Market CapitalizationCapitalization

Total Debt / (Debt + Equity Total Debt / (Debt + Equity Capitalization)Capitalization)

The Lower the Ratio, the Greater The Lower the Ratio, the Greater the Ability to Growthe Ability to Grow• Acquisitions can be leveragedAcquisitions can be leveraged• Expansions can be financedExpansions can be financed• Reduced Refinancing RiskReduced Refinancing Risk

Stock PriceStock Price

Quality EarningsQuality Earnings Growing FFOGrowing FFO Strong ManagementStrong Management Well Defined Growth Strategy Well Defined Growth Strategy Low Debt to Market CapLow Debt to Market Cap Ability to ExecuteAbility to Execute

Accounting “Gimmicks”Accounting “Gimmicks”

Capitalization vs. expense Capitalization vs. expense Straight-lining of rental revenueStraight-lining of rental revenue Tenant improvement costs vs. rental ratesTenant improvement costs vs. rental rates Off balance sheet financingOff balance sheet financing Off balance sheet venturesOff balance sheet ventures One time transactionsOne time transactions FFO adjustmentsFFO adjustments

• deferred finance feesdeferred finance fees• percentage rentpercentage rent• preferred returnspreferred returns• unusual itemsunusual items

ClarksonClarkson

Acquisition reservesAcquisition reserves Leverage (Mark-to-Market)Leverage (Mark-to-Market) FAD pay out ratioFAD pay out ratio

ClarksonClarkson

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

StatesStates

Tenant improvementsTenant improvements Income from joint venturesIncome from joint ventures Internal development costsInternal development costs Straight-lining of rentsStraight-lining of rents

AmericanAmerican

ReservesReserves Other adjustmentOther adjustment

Original PER SHAREFFO FAD Payout EBITDA

Company 1998 1997 % Inc. 1998 1997 1998 1997 % Inc. Debt-To-Mkt-Cap

Clarkson 0.79 0.60 32% 102 96 1.56 1.09 43% 60%

States 0.48 0.42 14% 91 90 0.80 0.62 29% 48%

American 0.38 0.32 19% 91 96 0.45 0.40 13% 19%

Performance IndicatorsPerformance Indicators

Adjusted PER SHAREFFO FAD Payout EBITDA

Company 1998 1997 % Inc. 1998 1997 1998 1997 % Inc. Debt-To-Mkt-Cap

Clarkson 0.69 0.60 15% 120 96 1.56 1.09 43% 60%

States 0.44 0.42 5% 98 90 0.80 0.62 29% 48%

American 0.34 0.32 6% 116 96 0.45 0.40 13% 19%

AmericanAmerican

As Reported As Adjusted

1998 1998

Funds From Operations 15,386 15,386

Deduct "Other" Adj. (1,456)

Adjusted FFO 13,930

Mortgage Principal Pay-downs (1,023) (1,023)

Normalized FF&E Replacement (822) (1,919)

Normalized Capital Expenditures (546) (546)

Funds Available for Distribution 12,995 10,442

FFO Per Share 0.38 0.34

FAD Payout 91 116

StatesStates

As Reported As Adjusted

1998 1998

Funds From Operations 6,155 6,155

Tenant Improvements Adj. (100)

Internal Leasing Costs (380)

Adjusted FFO 5,675

Mortgage Principal Pay-downs (407) (407)

Capital Expenditures and TI (106) (31)

Funds Available for Distribution 5,642 5,237

FFO Per Share 0.48 0.44

FAD Payout 91 98

ClarksonClarkson

As Reported As Adjusted

1998 1998

Funds From Operations 23,080 23,080

Mark-to-Market (2,100)

Acquisition Reserves Adj. (805)

Adjusted FFO 20,175

Mortgage Principal Pay-downs (2,457) (2,457)

Capital Expenditures and Ten. Imp. (2,802) (2,802)

Funds Available for Distribution 17,821 14,916

FFO Per Share 0.79 0.69

FAD Payout 102 120

REIT Accounting Its an ArtREIT Accounting Its an ArtNot a ScienceNot a Science

SummarySummary• There is no easy answerThere is no easy answer• Understand the numbersUnderstand the numbers• Research is criticalResearch is critical