Funds from Operations versus Net Income: Examining the Dividend Relevance of REIT Performance Measures

By Ben-Shahar, Danny; Sulganik, Eyal et al. | The Journal of Real Estate Research, January 1, 2011 | Go to article overview

Funds from Operations versus Net Income: Examining the Dividend Relevance of REIT Performance Measures


Ben-Shahar, Danny, Sulganik, Eyal, Tsang, Desmond, The Journal of Real Estate Research


A b s t r a c t

This study compares Funds From Operations (FFO) and net income by examining how well these two performance measures explain the dividend policy of Real Estate Investment Trusts (REITs) beyond operating cash flows. The findings reveal that while the non-cash component that is common to both FFO and net income is significantly associated with the level of dividends distributed by REITs, the additional non-cash component in net income but not in FFO has no association with dividends. The findings also show that the non-cash component in net income becomes significantly associated with dividends only when measurement errors in depreciation are low (i.e., reporting quality in depreciation is high). By suggesting that the inclusion of depreciation distorts the dividend-relevance of REIT net income, this paper provides further support to the dominance of FFO over net income for financial reporting in the REIT industry.

The Real Estate Investment Trust (REIT) industry in the United States is traditionally viewed as a cash flow business. Essentially, REITs are investment vehicles that generally rent out properties and, in return, collect cash rents, thereby generating income to pay for operating expenses (that are also predominantly in cash). Studies in the finance and accounting literature show that, beyond a firm's operating cash flows, performance measures nonetheless contain incremental information (e.g., Beaver, Lambert and Morse, 1980; Kormendi and Lipe, 1987; and Lipe, 1986).

Specifically, in the REIT industry, firms commonly report two alternative performance measures: the conventional net income measure that is required by the Financial Accounting Standards Board (FASB) to be reported in all firms' financial statements under the Generally Accepted Accounting Principles (GAAP), and a summary performance measure known as Funds From Operations (FFO) that supplements net income in measuring firm profitability. Since the introduction of the FFO concept by the National Association of Real Estate Investment Trusts (NAREIT) in 1991, industry participants have been advocating the adoption of FFO as they perceive it to be a more informative performance measure than net income.

REIT managers generally claim that net income does not accurately reflect the performance of REITs due to the mandatory inclusion of some non-cash items such as depreciation, amortization, and several one-time, non-recurring, non-cash revenues and expenses that provide little incremental information for evaluating REIT performance. They argue that these income statement items, particularly depreciation, distort the true profitability of a REIT.1 By adding back the noncash expenses and subtracting the one-time, non-recurring, non-cash revenues from net income in the computation of FFO, the latter provides useful information about firms' operating performance. Theoretically, FFO can serve as a better measure than net income as it can better approximate cash flows by not deducting depreciation, amortization, and many one-time, non-recurring, non-cash revenues and expenses. Moreover, FFO has the potential to be a better measure than cash flows from operations, since it accounts for cash flows, as well as the recurring, non-cash revenues and expenses that are important in firm evaluation.2

However, government regulators, the Securities and Exchange Commission (SEC), and other standard-setters are concerned about the usefulness and reliability of the FFO measure as it is un-audited, voluntarily reported, and not prepared according to GAAP (e.g., Vincent, 1999). Accordingly, it is possible for REIT managers to ''cherry-pick'' financial items to include and exclude when they calculate FFO. Moreover, the recurring, non-cash revenues and expenses require REIT managers to make estimates based on various accounting assumptions. Measurement errors of these items would create noise to the FFO measure. Consequently, FFO would not be more useful than net income in providing incremental information beyond cash flows whenever both FFO and net income include these non-cash, recurring revenues and expenses (that are subject to measurement errors). …

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