The way that REITs calculate their results can vary across the sector, making them difficult to analyze.
In fact, investors will generally ignore a REIT’s net income because of complications created by IFRS accounting rules. Instead, they’ll focus on measuring cash flows, including how cash flows compare to distributions.
It requires effort to transform the IFRS numbers into something usable for investment purposes. While REITs don’t grow their distributions as much as telcos, banks and pipelines, they also don’t suffer as much from dividend cuts, like those seen in the energy sector of late. Of course, cuts are not unheard of for REITs, so advisors must focus on the margin of safety in the distribution. This is best seen through a payout ratio, where the denominator focuses on cash flows.
Choosing a cash flow measure
Using the reported “cash from operations” figure in the financial statements is not wise. That’s because cash from operations (taken straight from the cash flow statement) can vary widely in its composition among companies.
Some REITs choose to exclude interest expenses from the calculations of cash from operations, which inflates their results relative to peers who choose more traditional reporting conventions. Under IFRS rules, companies have the option to count interest expenses as either part of investing or financing cash flows. They never had that choice under the old Canadian GAAP accounting rules.
This variance makes it better to focus on Funds from Operations (FFO), which is a non-IFRS number, so its oversight falls outside the purview of financial statement auditors. There’s some industry guidance that companies can follow when calculating FFO. The Real Property Association of Canada (REALpac) has filled part of the void by recommending a standardized calculation of FFO.
Here’s how it works. Start with the IFRS-calculated net income. Then, REALpac outlines 20 different adjustments to net income, focusing on adding back non-cash accruals. These cover depreciation and amortization, non-cash taxes, realized and unrealized gains and losses, and adjustments for non-controlling interests. Not every REIT needs to make every adjustment (see the tablet edition for an example calculation).
Advisors should keep in mind that these types of accounting cash flows still might differ from actual cash flows, and they’re only a proxy for investment purposes.
With this in mind, REALpac advises against using its FFO measure to assess dividend sustainability, but realizes a defined starting point is helpful to both issuers and investors.
When you remove so many accounting expenses from FFO, you could miss relevant cash outflows. Investors try to compensate for this by focusing on adjusted FFO (AFFO). It represents a better proxy for cash flows and is more akin to the free cash flow measure used in analyzing other industries. It’s also sometimes referred to as “funds available for distribution.”
One of the major adjustments that must be made to FFO to arrive at AFFO is to deduct an amount for maintenance capital expenditures. Since management only estimates what portion of total capital expenditures are needed for maintenance, investors have to assess the reasonableness of the figure for themselves. It’s likely that different management teams have different approaches to measure maintenance capex.
For instance, measuring the cash flows needed to maintain the revenue stream of current assets might differ from what is needed to maintain the overall quality of those assets, especially in a rising rental rate environment or when vacancies are low. Companies can spend less on maintenance when vacancies are low, and still generate the same revenue on assets that are slowing deteriorating.
REALpac stops short of recommending a calculation for AFFO, stating “there is not adequate consensus among preparers and users of reporting issuers’ financial statements to allow agreement on a single definition of AFFO.”
The securities commissions monitor and approve the presentation of AFFO only, and not the actual composition of the calculation. This leaves the discretion of AFFO up to individual company management, which creates comparability problems for investors.
Little external oversight
According to the OSC, 24 of 30 Ontario-based REITs use AFFO, as well as FFO, to present their payout ratios. The remaining 20% use FFO only, use distributable cash or use nothing at all.
Unfortunately, the OSC requires that REITs reconcile their AFFO calculations to cash from operations, instead of FFO or net income, which reintroduces the lack of consistency that exists for cash flow reporting under IFRS.
So, advisors need to monitor both FFO and AFFO in assessing payout ratios. In addition to monitoring for potential distribution cuts, investors also scrutinize and compare payout ratios to estimate which REITs have the most room to increase their distributions.
Given that REITs are supposed to distribute the majority of their cash flows to comply with tax rules, it’s not unusual for REITs to report AFFO payout ratios in the 90% and higher range. This leaves little room for error in comparing which REITs are better. It also casts more attention on the amount of discretion that management has in determining the adjustments that are made to base FFO in order to calculate AFFO.
Occasionally, REITs will report payout ratios higher than 100%, but this should only occur on a temporary basis if rents are stabilizing due to an acquisition. If the overage is a result of a dividend reinvestment program, advisors need to keep an eye on the trend in AFFO per share. If it’s declining, the DRIP is diluting the value to existing shareholders.