||Add back all GAAP depreciation and amortization to GAAP net income.
Some believe that adding back all depreciation and amortization shown on the GAAP income statement provides the clearest, most transparent and credible earnings measurement. Their reasoning is that both the starting point, GAAP net income, and the add-back, GAAP depreciation and amortization, are GAAP numbers that come directly from the GAAP income statement. Therefore, each of these numbers and their combination (as the industry's potential supplemental performance benchmark) are auditable based on GAAP. This alternative produces a uniform, transparent and highly credible benchmark. At the same time, a significant shortcoming of this alternative is that the industry benchmark would include no capital maintenance charges - not even costs that are not "uniquely significant" to real estate operations or costs that relate directly to current and short-term revenue streams.
||Maintain the current NAREIT policy - add back to GAAP net income depreciation and amortization of assets "uniquely significant to the real estate industry."
Some believe that the industry's depreciation and amortization add-back should remain unchanged from the policy set forth in the 1995 "White Paper." They believe that tweaking this calculation before solving the GAAP depreciation problem would provide only nominal improvement in the industry's performance benchmark and is not worth the potential confusion of the change. The most significant criticism of this alternative is that it does not result in depreciation and amortization of expenditures that are incurred to maintain the current revenue stream (e.g., normal, on-going capital maintenance and leasing related costs).
||Same as Alternative B except that depreciation and amortization of all assets which clearly wear out over an identifiable, short period of time, or that clearly relate to identifiable, short-term revenue streams, would not be added back to GAAP net income.
Using this method to arrive at the industry's depreciation and amortization add-back would result in a charge to the supplemental benchmark for depreciation and amortization of expenditures required to maintain and possibly enhance the current- and near-term revenue stream. This would reduce the benchmark for the depreciation and amortization of expenditures, which most analysts deduct from current FFO in calculating Adjusted Funds From Operations (AFFO), Funds Available for Distribution (FAD) or Cash Available for Distribution (CAD). Some believe that this adjustment yields a more appropriate measurement of the economic profitability of operating real estate. Others would prefer to not exclude these depreciation and amortization charges from the benchmark and rely on disclosures about on-going capital maintenance expenditures to provide investors and analysts with information to make appropriate adjustments.
||Same as Alternative B except that depreciation and amortization of all assets with depreciable lives of less than "X" years would not be added back.
This alternative is similar to Alternative C, but rather than charging the industry benchmark with depreciation and amortization of certain types of assets, the charges are based on the depreciable lives of assets. The depreciation and amortization of assets with lives less than a specific number of years (e.g., 5, 10, or 20 years), would not be added back to GAAP net income. While an initial reaction to this method is that a "bright line" would result in uniformity, many believe that in practice depreciable lives would be arbitrarily biased toward lives exceeding the "bright line." Others believe that this method would yield inappropriately high depreciation charges for properties and/or operations with significant amounts of short-lived assets.
sinking fund depreciation
salvage value depreciation
Sinking fund depreciation is accepted under Canadian GAAP and is used by virtually all members of the Canadian Institute of Public Real Estate Companies to depreciate operating real estate. Under this method, the cost of a property is depreciated in a manner similar to a principal amortization schedule on a long-term, fixed-rate mortgage. This, of course, results in increasing periodic depreciation charges over the life of the property - a pattern compatible with a property's increasing revenue stream. There has been much written about the sinking fund depreciation method. In 1982, it was approved by the American Institute of Certified Public Accountants (AICPA). However, the FASB rejected the AICPA's position. The advantage of this method is that it is relatively simple and has been used for over 20 years by some NAREIT-member companies. The experience of these members would make implementation easier.
Salvage Value Depreciation is a method which NAREIT and the National Association of Real Estate Companies (NAREC) developed in 1996-1997. Generally, this method results in a charge to earnings for the cost of a property in excess of its current fair value. Properties are not written-up above cost under this method, but are not depreciated below fair value. Applying this method would require periodic valuations of property. These could be simple valuations of net operating income, without third party appraisers involved. Many believe that this method of depreciation most faithfully represents the economic reality of operating real estate depreciation. It is also a method which is generally supported by the most recent position of the International Accounting Standards Committee (IASC), a group that establishes accounting standards on an international basis. The IASC represents more than 100 member-countries and sets standards that influence U.S. accounting standards. The IASC is currently considering the issuance of an exposure draft that will require "investment real estate" to be carried on the balance sheet at fair value, not depreciated, and that changes in value be reported in the income statement. A final vote on the proposed standard is expected this fall. The U.S. will not be subject to this standard, but will certainly be influenced by it over time. In addition to this global support, some believe that using fair value in the determination of depreciation for income producing properties is supported by current thinking with respect to fair value accounting for financial instruments. Those that take this position rely on the similarities of certain economic characteristics between long-term bonds and income-producing real estate.
Regardless of which of the Alternatives A through E is selected, the Council believes that the industry supplemental performance measure should be defined in a manner that supports and encourages attestation by independent auditors.
Note on Presentation and Disclosure of Depreciation - Many analysts require a clear understanding of capital expenditures, tenant improvements, and leasing costs in order to calculate cash-based measurements of profitability. Regardless of the outcome of the Council's proposals with respect to the add back of depreciation and amortization, it will continue to be important for companies to provide information with respect to these types of on-going expenditures. In addition, the amounts of depreciation and amortization that would be eligible and ineligible to be added back to GAAP net income to calculate the industry supplemental performance measure should be presented separately either on the face of the GAAP income statement or disclosed in the notes to the financial statements. The Council believes that these disclosures are vitally important and would encourage disclosure of these expenditures regardless of the alternative implemented.
The Council believes that sufficient disclosure accompanying the REIT industry's supplemental performance benchmark is critically important. As a result, the Council is considering what supplemental disclosures should be appropriate to accompany the REIT industry's supplemental performance benchmark.
Consistent with current practice and the existing definition of FFO, the Council believes that any adjustments to net income for unconsolidated partnerships and joint ventures should be disclosed on the same basis and calculated consistently with any final modifications.
The Council also believes necessary, accompanying disclosures should include the other disclosures recommended in the existing definition and clarification of FFO. Specifically, companies should reconcile the REIT industry's supplemental performance benchmark to GAAP net income and include a line item breakdown of each of the adjustments used in the calculation. The reconciliation should be sufficiently detailed to provide investors with a material understanding of the differences between GAAP net income and the REIT industry's supplemental performance measure. Additional disclosures also should include material capital expenditures, including tenant allowances, tenant improvements, capitalized leasing costs, expansions and major renovations, floor coverings, appliances, and exterior preparation and painting. Depending on the circumstances surrounding an individual property, a disclosure should also be provided showing the non-cash effect of straight-line rents that affect periodic results. Further, as with the reporting of GAAP net income, companies should report the REIT industry's supplemental performance measure both before and after GAAP extraordinary items.
The Council also believes that computation and publication of an individual company's industry supplemental performance measure should always be consistent with NAREIT's stated definition and that deviations should not be reported. The industry's supplemental performance measure should never be "as adjusted" to accommodate adjustments, such as those that some companies now make to FFO with respect to straight-line rents. Although the adjustment usually has been disclosed, the practice substantially undermines uniform reporting and the fundamental shift to an industry measure that more closely tracks GAAP net income.
The Council also is mindful of the disclosures and practices that the SEC requires with respect to all non-GAAP financial measures (e.g., FFO, EBITDA, EBDT, etc.). These practices are described in SEC Accounting Series Release No. 142. They include: 1) that the measure not be given greater authority or prominence as GAAP net income in financial reports; 2) that a clear description or tabular presentation of the calculation be provided; 3) that an indication is provided that the measure is not a GAAP indicator of performance or of cash flows; 4) the reason why the measure is presented and how management uses the information; 5) that prior periods presented must be calculated consistently with the current period; and 6) that the measure not be reported on a per share basis in SEC filings.
Most real estate companies currently report FFO per share in earnings releases and disclosures that typically accompany the releases. The Council believes that the industry's supplemental performance measure on a per share basis should be calculated and disclosed consistent with FASB Statement No. 128 with the substitution of the industry's supplemental performance measure for net income.
Comments on these and other potential disclosures are encouraged.
In the event NAREIT leadership, after considering comments from industry participants, determines in the future that there should be changes made along the lines discussed in this paper, the Council is evaluating whether the industry's supplemental performance measure should be changed at one time or in a two-step approach providing for more extensive review of depreciation-related issues. The two approaches currently being considered are:
||Add back to GAAP net income the difference between: GAAP depreciation and amortization, and the amount of depreciation and amortization calculated using a method which results in what NAREIT and others believe is an appropriate depreciation and amortization charge to earnings (e.g., sinking fund depreciation or salvage value depreciation).
This alternative results in a depreciation charge to the industry supplemental benchmark that the industry agrees should be appropriate under GAAP. It produces a benchmark that the industry would hold out and promote as an appropriate GAAP net income number. Although neither of the two methods discussed below are GAAP today, the inclusion of one of these or another method in the industry supplemental performance measure may set the stage for its acceptance as GAAP in the future. The industry would work with the appropriate accounting standard setters toward having the depreciation and amortization method selected under this alternative accepted as GAAP. The two such methods which have been promoted by the industry at various times and which have official acceptance outside the United States are:
One-time - Adopt all Potential Modifications effective January 1, 2000 or some other date.
Two-step - First adopt Potential Modification No. 1, later adopt Potential Modifications No. 2 and 3 after further consultation with FASB, industry standard-setters, etc.
In either case, the Council also requests comment on the proposed effective date of any change, the timing of a name change, as well as whether companies should be encouraged or required to restate all years presented to reflect the new benchmark. The Council also seeks comment on alternative approaches to implementing any modification.
The definition of FFO is as follows:
FUNDS FROM OPERATIONS means net income (computed in accordance with generally accepted accounting principles), excluding gains (or losses) from debt restructuring and sales of property, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. Adjustments for unconsolidated partnerships and joint ventures will be calculated to reflect funds from operations on the same basis.
The 1995 NAREIT White Paper on Funds From Operations clarified the definition of FFO by specifying that the add back of depreciation or amortization to GAAP net income be related to those assets "uniquely significant to the real estate industry."
The potential redefinition of FFO, the REIT industry's supplemental performance measure, is as follows:
"FUNDS FROM OPERATIONS [OR THE CHANGED NAME OF THE REIT INDUSTRY'S SUPPLEMENTAL PERFORMANCE BENCHMARK] means net income (computed in accordance with generally accepted accounting principles) plus qualifying depreciation and amortization."
In keeping with the existing definition of FFO and the recommendations contained in "Accompanying Disclosures" above, any new definition would also be "after adjustments for unconsolidated partnerships and joint ventures" and "adjustments for unconsolidated partnerships and joint ventures will be calculated to reflect" the REIT industry's supplemental performance benchmark on the same basis.
A roster of the Best Financial Practices Council is attached. The Council looks forward to serious and thoughtful input from all REIT and publicly traded real estate company stakeholders. Your comments are strongly encouraged and your views will be considered fully before recommendations to the NAREIT Board of Governors are completed. Please send your comments to NAREIT c/o George Yungmann, Senior Advisor, Financial Standards, 1875 Eye Street, NW, Suite 600, Washington, DC, 20006-5413. George may be reached at (202) 739-9432 and via email at firstname.lastname@example.org. Additionally, you may contact David Taube, NAREIT's Financial Standards Analyst, at (202) 739-9442 and email@example.com. You may also want to contact all or any of the co-chairs of the NAREIT Accounting Committee: Steve Richter, Weingarten Realty Investors, firstname.lastname@example.org; Tim Peterson, American Real Estate Investment Corporation, email@example.com; and Barry Lefkowitz, Mack-Cali Realty Corporation, firstname.lastname@example.org. Please forward your comments no later than August 20, 1999.
June 22, 1999