Over the past year, NAREIT members have re-evaluated the effectiveness of the real estate investment trust industry's supplemental performance measure—Funds From Operations (FFO). Many industry participants believe that FFO is an appropriate indicator of the operating performance of investment property portfolios. They suggest that GAAP net income alone does not reflect this operating performance, especially in terms of cash generating capability. They further believe that GAAP net income is not a valid basis for valuing companies that own and operate portfolios of investment properties. In fact, many of these companies may not even refer to GAAP net income in substantive discussions of operating results.

Others believe that the industry's unique reporting is an impediment to REITs and other publicly traded real estate companies competing effectively in the broader capital markets. They suggest that these companies should eliminate this hurdle by reporting operating performance consistent with the rest of corporate America.

RMA Impact

Gaining greater acceptance of the industry by capital markets and the broader investment marketplace is likely to become increasingly important and relevant. The industry achieved a significant milestone in 1999 with the passage of the REIT Modernization Act (permitting the formation of taxable REIT subsidiaries), creating a valuable opportunity to expand a small part of their enterprise into other lines of business. These new lines of business will not only compete with other companies in providing services, but will also compete for capital. As the industry increasingly moves from the business of "passive" landlord/rent collector to becoming a broader service provider to real estate customers, many believe it will be more important than ever for real estate company performance reporting to provide for valid comparisons with the rest of corporate America.

Corporate America

Just how does corporate America report operating performance? After discussing this question with a number of investment analysts and representatives of earnings tracking services, we have concluded that our industry's performance reporting issues are not so different than those faced by the rest of corporate America.

Two things are clear. First, the great majority of companies do not rely solely on bottom-line GAAP net income (i.e., the "bottom line" on GAAP income statements) to communicate their operating performance or to value their equity position. In press releases and reports to earnings tracking services, most companies report GAAP earnings exclusive of what they consider to be "lumpy items" included in the bottom line. Many refer to this measure as "adjusted net income" (ANI). These lumpy items include those defined by GAAP (i.e., extraordinary items, cumulative effects of accounting changes and results of discontinued operations), as well as other types of unusual items (e.g., gains/losses on sales of assets or affiliates, unusual litigation gains/losses, unusual restructuring charges, etc.). Except for the adjustment of depreciation and amortization expense out of net income, FFO, prior to its 1999 clarification to include non-recurring items (except those defined by GAAP as extraordinary), was equivalent to ANI reported by many companies outside of the real estate industry.

Second, companies in many industries make a clear distinction between their earnings performance measure and their basis of valuation. The valuation bases may include earnings before interest, taxes, depreciation and amortization (EBITDA), revenues, cash flow, net asset value, and other measures. In fact, in its database First Call often maintains two tables for each company. The first table tracks earnings and the second table tracks the company's/industry's basis of valuation. In the case of REITs and other publicly traded real estate companies, the First Call database solely tracks FFO or earnings before depreciation and deferred taxes (EBDDT).

ANI Reporting by REITs and REOCs?

Is it possible for those REITs and other publicly traded real estate companies who want their operating performance reporting to mirror the model used by most of corporate America to report "adjusted net income" as their earnings measure and FFO, AFFO, CAD, FAD or EBITDA as their basis of valuation? In addition to ANI being consistent with how most of corporate America reports operating results, this measure would be based on GAAP and, therefore, subject to audit. The table on page 84 provides a framework that REITs and other publicly traded real estate companies could study to better understand the way ANI and a separate basis for evaluation might work.

George L. Yungmann is vice president, financial standards and David M. Taube is director, financial standards for NAREIT.

Earnings Measure vs. Valuation Base
	Earnings Measure		Valuation Base
	Calculated in accordance with GAAP		Not calculated in accordance with GAAP
	'Bottom-line' GAAP Net Income adjusted for:		Possible adjustments to ANI:
	Discontinued operations		Depreciation and amortization
	Extraordinary items		Straight-line rents
	Cumulative effect of accounting changes		Contingent rents
	Non-recurring items		Capital expenditures
	Gains (losses) on property sales		Principal payments Other?
	= Adjusted Net Income (ANI)		= FFO = EBITDA = FAD = CAD = Other?
	Covered by Auditor's Opinion		Not covered by Auditor's Opinion