Real estate investment trusts (REITs) are one of the few publicly traded sectors that use an alternative form of performance measurement. With REITs, financial performance is universally determined by funds from operations, or FFO, which adds back depreciation when calculating cash flow. The obvious difficulty when using an alternative financial measurement is that it is hard to compare REIT stocks with those of other companies. For that reason, there has been a push in the REIT industry to do something about FFO, and the REIT trade association, National Association of Real Estate Investment Trusts, has been attempting to address the problem.
One company, Archstone Communities Trust, an Englewood, Colo.-based apartment REIT, decided to take the bull by the horns. In issuing its second-quarter earnings report, Archstone disclosed a new measure that it calls earnings before structural depreciation, or EBSD--an attempt to get closer to generally accepted accounting principles reporting. The company's EBSD provides for a single adjustment to GAAP net earnings, an add-back of depreciation for building components--concrete, lumber, drywall- -with initial useful lives of 30 years or longer. Depreciation on all other building components--carpets, appliances, roofs--that have shorter depreciable lives, are not added back. The perishable items are treated as expenses. "The big reason why GAAP net earnings are not adequate to fully understand the value of a real estate company relates to depreciation," explains Chaz Mueller, Archstone's CFO. "But, this is also the biggest issue with FFO. It is not close to GAAP."
A secondary issue with FFO can be attributed to the fact that REITs have had the ability to make adjustments to FFO for nonrecurring items, and that has been "fairly subjective." Individual companies make that decision differently from other REITs, which is also not consistent with GAAP. "The differences between GAAP and FFO create problems with investors who are not as familiar with real estate or REITs," Mueller says.