The Canadian Securities Administrators (CSA) in April released updated findings on the financial reporting of 47 REITs and real estate operating companies (REOCs) in Canada. The review covered firms of sufficient market capitalization that also pay distributions and use non-GAAP reporting measures.

The regulators found wide divergence in reporting, including instances where companies were required to restate their disclosures. As a result, CSA recommended that issuers improve their overall communications to investors.

Such a narrow recommendation, however, does little to improve reporting clarity for investors.

Thus, though we brought attention to this issue three years ago in a previous article (Advisor’s Edge Report, May 2015), it’s time to do so again.

The numbers behind the numbers

For advisors looking at REITs, a primary consideration is income profile—what cash flow is provided from dividends or distributions. Dividend sustainability is key, as is the ability to grow that dividend over time.

A good measure of stability and growth is the payout ratio, which is ostensibly the proportion of earnings or cash flows paid out as distributions. But not all ratios are created equal. While the calculation’s numerator—distributed cash amounts—is indisputable, there’s significant variance across firms in the denominator.

A REIT payout ratio’s denominator is usually adjusted funds from operations (AFFO) or adjusted cash flow from operations (ACFO), and represents the company’s performance assessment in the recent reporting period.

In its review, CSA found that companies had differing opinions on what AFFO or ACFO means. For example, the administrators found that 35% of companies viewed AFFO as a measure of earnings, 21% used it as a cash flow measure and 44% saw it as both.

Such divergence serves to underscore that all income statement, cash flow statement and non-GAAP figures are accrual accounting constructs, and don’t represent actual cash flows. Likewise, cash dividends can’t be accurately compared against, or necessarily paid from, an accrual accounting number or an adjusted non-GAAP figure—likely one of CSA’s primary concerns.

Companies have latitude in deciding how to calculate AFFO (or any non-GAAP metric, for that matter). REALpac, an association for owners and managers of investment real estate, has issued guidance on calculating FFO to reconcile the potential 20 puts and takes in a company’s specific calculation. That’s before the additional adjustments made to arrive at non-GAAP measures—the focus of the CSA study.

AFFO can be easily manipulated, for example, through management’s estimate of maintenance capital expenditures (capex), which is an assumption of how much cash spent on total capex should be counted toward the current period’s FFO. The split between maintenance capex and growth capex isn’t audited and is rarely scrutinized by an independent third party.

Advisors as first line of defence

CSA generally steers clear of commenting on what constitutes acceptable calculations. Instead, it encourages companies to adequately disclose the makeup and intended purpose of non-GAAP measures, and how they deviate from GAAP measures mandated by accounting standard-setters. Another major CSA focus is that standardized GAAP measures be disclosed in equal or greater prominence to hand-picked non-GAAP metrics.

This leaves investors exposed to the risk that a company’s chosen AFFO calculation is aggressive, potentially leading to an improved payout ratio or the appearance of higher growth. That means advisors must monitor trend lines and payout ratios—especially relative to other companies—to identify offside financial reporting.

This monitoring will be further required because advisors face shifts in REIT investing fundamentals: rising bond yields put pressure on unit prices and the decline of bricks-and-mortar sales increases execution risk for retail REITs. And this says nothing of the economic challenges in recent years to, for example, Alberta real estate.

Shifting investment strategies, continued economic uncertainty and reallocated capex funds mean there’s heightened risk that REIT financial reporting could become less transparent and comparable. Despite regulators’ efforts to encourage issuers to do better, there’s a growing gap between what companies provide and what investors need.

Al and Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, is MBA, CFA, CFE.

Originally published in Advisor's Edge

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