REITs - Real Estate Investment Trusts - Info & Discussion

This archived discussion is "read only".
For the corresponding "live" discussions, post in the active topic forum here.

Top 160. Aug 28, 2001 8:58 PM

» JenL_2 - REIT Earnings Debate

Jeepers talk about REITs maybe being over-hyped - 8/29 WSJ is a REIT 3-banger...

Debate Over Earnings Puts Wall Street Analysts at Odds

By RAY A. SMITH

In real estate, everyone agrees that location is everything. But when it comes to real-estate earnings, it seems no one can agree on anything.

For the past 10 years, the real-estate investment trust industry has focused on an earnings recipe called funds from operations, or FFO, rather than net income. Public real-estate firms say FFO -- which generates higher earnings than net -- is the best way to evaluate operating performance.

Then last month, three major Wall Street firms -- Merrill Lynch & Co., Morgan Stanley and Citigroup Inc.'s Salomon Smith Barney -- broke ranks with fellow analysts and the real-estate industry and said they would start forecasting earnings for real-estate investment trusts, or REITs, based on per-share net income that conforms with generally accepted accounting principles.

Now, a splinter group of analysts, miffed that they were excluded by the big three firms, has been secretly meeting to come up with its own definition of earnings for the sector. The problem is that the splinter group is itself split, with various members proposing different earnings formulas.

"This only adds to confusion in a marketplace that is already confused over how

REITs report earnings," says analyst Jonathan Litt of Salomon Smith Barney, one of the three firms that broke ranks with the industry.

The debate over real-estate companies' earnings shines a light on the contentious issue of so-called pro forma results. Proponents of pro forma measures argue that certain sectors, like real estate or insurance or technology, need a different formula than net income to give investors a clearer financial picture.

Critics argue that pro forma earnings allow companies to play down items that would reduce reported earnings. Companies and industry analysts, in turn, often use pro forma earnings to justify higher stock valuations.

First, a quick primer on FFO. Real-estate industry executives say net income can give a deceptive picture of performance for a real-estate firm. That is because, under generally accepted accounting principles, a real-estate firm must depreciate the value of its properties each quarter, taking a hit to its earnings. By contrast, the actual value of the properties usually rises from year to year in most markets.

In 1991, the National Association of Real Estate Investment Trusts, the main trade group for the REIT industry, created a supplemental standard called funds from operations. It allowed REITs to add back real-estate depreciation. In addition, REITs, which derive their main earnings from rents on the buildings they own, were able to ignore gains on sales of properties. FFO became the standard performance measure as the REIT industry ballooned to a current total equity market capitalization of $148.4 billion from $8.7 billion at the end of 1990.

Why the controversy? Over time, REITs became more aggressive in what they excluded from or included in FFO. Some began excluding technology-investment losses or foreign-currency losses; others included gains from sales of property that had been depreciated. Indeed, many analysts soon began publishing "adjusted" funds from operations to add back expenses that they felt had been improperly excluded.

The REIT industry's debate over FFO came to a head earlier this summer when the Merrill Lynch, Morgan Stanley and Salomon Smith Barney analysts got together and decided to start sending estimates for per-share net income to Thomson Financial/First Call, which tracks analysts' earnings estimates. Until then, the three firms, along with nearly every other Wall Street analyst, had been providing estimates based on FFO.

The group's decision to summarily de-emphasize FFO didn't sit well with some analysts, especially Lawrence Raiman at Credit Suisse Group's Credit Suisse First Boston. He and a few other analysts decided to round up analysts from other firms to participate in an "open-forum" dialogue. "We all thought the industry would be better served by having a broad constituency agree [on a definition], vs. having a few people going out," Mr. Raiman says.

Mr. Raiman called and e-mailed about 20 analysts, inviting them to participate in a conference call that was held less than a week after the other group's July announcement. The call was kept hush-hush. Representatives from the industry trade group and real-estate companies weren't on the guest list. Of course, neither were analysts from the group of three. Participants agreed not to share anything discussed during the call with anyone, including their clients and companies.

"That was to make sure that it wouldn't be publicized in a way that says there's one camp vs. another," Mr. Raiman says.

According to some people familiar with the call, the group didn't make a lot of headway. The participants decided to hold another call about a week later, but this time fewer analysts participated.

David Kostin of Goldman Sachs Group Inc. was among those who chose not to call in a second time. "We do not need a dictum from a group of analysts when the [GAAP] definition of earnings per share is so clear," says Mr. Kostin, who had dropped out of discussions with the major three firms before falling out with the dissident group. He described the first conference call as "disjointed" and says he has no plans to attend any follow-up meetings. Mr. Kostin's firm uses operating earnings per share, which excludes gains or losses from sales. The definition that Merrill, Morgan Stanley and Salomon Smith Barney adhere to includes gains and losses on sales.

How much difference can FFO make in a company's results? Consider the second-quarter results of Equity Office Properties Trust, the nation's largest office owner. For the latest second quarter, Chicago-based Equity Office reported FFO of 78 cents a share, but it reported earnings per share of just 40 cents. The difference: Equity Office added back in depreciation and amortization of 38 cents a share when it calculated FFO.

Some REITs are placing more emphasis on net income. AMB Property Corp., a big San Francisco owner of industrial properties, has led its earnings announcements with earnings-per-share figures since the third quarter of 1999 and is believed to be the first REIT to do so. Since then, a few more REITs have directed attention to net. "We like earnings per share because the rules are very clear and those rules are policed by the accounting profession," says Hamid R. Moghadam, chief executive of AMB.

The flap over FFO comes as the index committee at McGraw-Hill Cos. that oversees the Standard & Poor's 500-stock index is considering allowing REITs into its stock index. Inclusion in the index could broaden the base for REITs, which have failed to whip up widespread interest among investors. "Earnings per share is what is tracked most widely by the investor universe," says Joseph Gyourko, director of the Zell/Lurie Real Estate Center at the Wharton School of the University of Pennsylvania. "One would think if REITs want to access that universe for capital, it's a good idea to use earnings per share."

In the end, REIT analysts may agree to use an earnings-per-share figure, with each making his own adjustments to calculate financial results -- the same exercise they do with funds from operations. "We may end up agreeing on a standard but leave the specifics to be determined on an ad hoc basis," Mr. Raiman of Credit Suisse says.

Buffett's Sale of Stock Puts Focus on REIT

By JONATHAN WEIL

Warren Buffett, the billionaire investor who says the best time to sell a stock is never, has sold his stake in First Industrial Realty Trust. So should investors follow him out of the stock his wallet made famous?

For most of the past two years, First Industrial, a Chicago real-estate investment trust, has basked in being the stock recommended by Mr. Buffett as part of a December 1999 charity event. The name of the REIT was tucked inside the 20-year-old wallet auctioned by Mr. Buffett, raising $210,000 for Girls Inc. of Omaha, Neb. But First Industrial's days as a Buffett holding are over. "He owns no shares of the stock," a spokeswoman for Mr. Buffett says.

The spokeswoman declines to say when or why Mr. Buffett sold the stake, which he held personally. But the disclosure comes just as First Industrial is receiving scrutiny over the way it calculates the profit measure most widely followed by Wall Street analysts. Michael Brennan, First Industrial's chief executive, Tuesday declined to comment on Mr. Buffett's departure. "I don't comment on specific activity of specific shareholders," says Mr. Brennan, who also adamantly defends the company's financial-reporting practices.

As reported last year, Mr. Buffett bought 1.8 million shares of First Industrial at about $24 each, a 4% stake, for a total of $43 million. As of 4 p.m. in New York Stock Exchange composite trading Tuesday, First Industrial shares closed at $33.23, up eight cents.

Mr. Buffett recommended First Industrial when the tech-stock rally was near its peak. When share prices dropped, many investors fled the sector's red ink -- and reliance on "pro forma" accounting practices to make their results look better -- by rushing into supposedly safe stocks like REITs, which had real assets, steady dividends and healthy-looking profits. What investors may not have realized, however, is that the REIT industry's widely cited earnings benchmark -- "funds from operations," or FFO -- is just as fuzzy as the dot-coms' pro forma metrics.

"For investors that have moved into real-estate stocks for safety, it may not be as safe as it seems," says Lee Schalop, a REIT analyst at Banc of America Securities, who rates First Industrial a "market-performer" and says he isn't recommending it. "Of the 32 companies we cover, First Industrial is the most aggressive" in calculating FFO.

The National Association of Real Estate Investment Trusts defines FFO as net income plus depreciation and amortization expenses. The association excludes, among other things, gains or losses on sales of any properties that previously have been depreciated. The reason depreciation is added back is that real estate generally gains value over time. Gains and losses on sales of depreciated properties are excluded because their owners have declared, by depreciating them, that they are holding them for investment purposes rather than as inventory for resale.

Most REITs follow the guidelines set by the association, to which First Industrial belongs. But the guidelines aren't binding, leading to inconsistent pro forma accounting practices throughout the industry.

Unlike the trade group, First Industrial defines FFO to include net gains from sales of previously depreciated properties. The company doesn't disclose that in its quarterly-earnings news releases -- which have given more prominence to FFO than the REIT's lower net income. But the company does reveal how it computes FFO in separate "supplemental information" booklets for investors and analysts. Michael Havala, First Industrial's chief financial officer, says the company's disclosure practices have been evolving and are "as good as, if not the best in, the industry."

<img src="/files/mysites/jen2/reitbuffet.gif" width=220 height=300 align="left"> First Industrial first reported gains from depreciated-property sales in the first quarter of 2000, and the company began including them in FFO under a line item called "Integrated Industrial Solutions customer sales gain/fees." (First Industrial says gains represent almost the entire line item.) The company recorded $1.2 million in such gains in the first quarter of 2000, or just 3% of its $40.4 million of FFO, according to its supplemental information.

For the six months ended June 30, gains on depreciated-property sales totaled $11.7 million, or 13% of the company's $92.6 million of FFO. Based on the company's guidance, Banc of America's Mr. Schalop notes that analysts project First Industrial will report 2001 FFO of about $190 million, or $4.06 a share. Of that amount, Mr. Schalop estimates 59 cents a share, or nearly 15%, will come from the line item for depreciated-property sales. First Industrial's top executives also benefit from high FFO because FFO is a "primary component" of their bonus and incentive awards, according to the company's proxy.

Messrs. Brennan and Havala say they are aware the company's FFO definition doesn't follow the trade group's guidelines and that gains on sales of investment properties are considered nonoperating items under both generally accepted accounting principles and the association's FFO definition. They say First Industrial includes such gains because it considers them, in effect, recurring inflows of cash. As for the reason the gains on property sales have increased so much this year, they say corporate customers are taking advantage of low interest rates to buy their own buildings rather than lease them.

"Those activities are integral to the company's operations," Mr. Brennan says. For instance, First Industrial frequently contracts to develop custom-built facilities for customers who lease for the first few years and buy later. In those cases, he says, First Industrial is acting more as a developer than a passive investor, even if it is depreciating the property until it is sold.

Another area of investor scrutiny is the way the company has allocated purchase prices within newly acquired real-estate portfolios. For the second quarter of 2000, for instance, its biggest acquisition was a portfolio of 18 properties around Dallas for $44.3 million, or $34 a square foot, which it bought for investment purposes. About nine months later, it sold three of the properties for $12.1 million, or $38.39 a square foot. That produced an unusually large gain. The sale included the two properties in the portfolio with the lowest purchase-price allocations, at $20.17 and $21.55, respectively. That raises questions about whether those outsize FFO gains are sustainable; the average purchase price assigned to the 15 remaining properties is more than $36 a square foot.

The company says they are sustainable. Mr. Havala, the finance chief, says he had hoped to sell the three properties quickly when the company bought them. Mr. Havala says First Industrial didn't have those Dallas-area properties independently appraised, but that the purchase-price allocations were appropriate. He explains that company executives wouldn't intentionally boost FFO at the expense of higher taxes and, thus, reduced cash flow.

Rise in Common-Stock Offerings Shows Sector Still Looks Safe

By RAY A. SMITH

Equity offerings have slowed in most industries due to the weakened stock market. But not in the REIT world.

The increase in common-stock offerings by real-estate investment trusts shows that investors believe the industry is a haven in a down economy, says Jacques Brand, global head of real-estate investment banking with Deutsche Banc Alex. Brown in New York.

REITs, excluding those specializing in mortgages, conducted 15 secondary offerings of common stock so far this year as of last Wednesday, raising about $1 billion, compared with seven a year earlier, which raised $389 million, according to the National Association of Real Estate Investment Trusts. There haven't been any initial public offerings of REITs since 1999.

Meanwhile, the overall year-to-date number of common-stock offerings in the U.S., including initial and secondary offerings, was 351, with proceeds of $84.47 billion. That's down from 588 offerings, with proceeds of $127.72 billion, a year earlier, according to Thomson Financial, a Newark, N.J., data provider.

REITs hardly sold equity back in 1998 and 1999, as the sector suffered a bear market. But their stocks rallied in early 2000 as technology-related stocks fell out of favor. And they've continued to do well, allowing REIT executives to feel comfortable dipping into the equity pool.

"We anticipate a number of offerings after Labor Day," says Mark R. Patterson, global head of real estate and lodging at Salomon Smith Barney in New York. It's "not a torrent of deals like we saw in the past, but for companies that have good uses of the capital, [it's] prudent issuance after a period when there's really been very little."

REIT stocks are up in part because REITs are looking attractive to Wall Street, compared with other sectors. Investors have seen an average return of 15% so far this year as of last Wednesday, according to Morgan Stanley's REIT index. Total return from the Standard & Poor's 500-stock index, meanwhile, has fallen 11%.

Moreover, REITs, which are required to pay out 90% of their taxable income in the form of dividends, have attractive yields: an average of 7% at the end of July. The average yield for utility stocks was about half that.

<img src="/files/mysites/jen2/reit3.gif" width=187 height=229 align="left"> Analysts at Green Street Advisors of Newport Beach, Calif., have long maintained that a REIT's ability to issue shares should depend on where the company's stock is trading relative to the underlying value of its assets. As of last Wednesday, REITs on average were trading at a 5% premium to net-asset value, according to Green Street. A year earlier, REITs on average were trading at a 9% discount.

Trading at a premium "is a major condition for having the right environment for share offerings," says Green Street analyst John Lutzius.

Some REITs, like Weingarten Realty Investors, a Houston-based owner and developer of shopping centers, have already conducted more than one offering this year. And the company hasn't ruled out conducting more by the end of the year.

Others are doing so for the first time in years. Capital Automotive REIT's recent offering of about 3.4 million shares was its first since its IPO in 1998. The McLean, Va., company specializes in real-estate properties for car dealerships.

So just what do the companies intend to do with all their money? SL Green Realty Corp., which acquires older buildings in prime locations in midtown Manhattan, upgrades them, and markets them with the amenities of modern office buildings, says it raised equity to position itself for more acquisition opportunities.

Subscribe to WSJ Online @ http://www.wsj.com

......Jen

-- posted by JenL_2

Permalink

Print Discussion

Join the latest discussions