A real estate investment trust, or REIT, is a company that buys, develops, manages and sells real estate assets. There are three types of REITs; they are equity REITs, mortgage REITs, and hybrid REITs. An equity REIT is a corporation that purchases, owns and manages real estate properties; it does not own or originate real estate loans. It may also develop properties. A mortgage REIT is a corporation that purchases, owns and manages real estate loans; it does not own real estate properties. It may or may not originate commercial and/or residential loans.
A hybrid REIT is a corporation that purchases, owns and manages both real estate loans and real estate properties. It has the qualities of both an equity and mortgage REIT which is why it is referred to as a hybrid. One of the most distinguishing characteristics of a REIT is that they are required to distribute at least 95% of taxable income to shareholders. REITs allow participants to invest in a professionally-managed portfolio of real estate assets. This is important because prior to Congress’s creation of REITs only extremely rich individuals were able to benefit from ventures in the real estate market.
By pooling assets together in a manner similar to that of a mutual fund, REITs allow the everyday investor the chance to invest in real estate properties. The main benefit of a REIT is that it is exempt from double taxation. The normal corporation is taxed on earnings, and then when dividends are paid, the individual receiving the dividend is taxed. REITs can deduct dividends distributed from taxable income. This results in only one level of taxation. The main disadvantage of a REIT is that since nearly all earnings are distributed as dividends, the trust must find capital to reinvest into the business from other areas.
These funds are usually raised by investments in the market, and through the capital gains realized from the sale of the REITs assets. The second method by which REITs procure capital to reinvest into the business raises an accounting issue regarding the classification of assets. Currently, the buildings and property that REITs utilize to raise income are classified as property, plant, and equipment. However, it can be argued that these assets should be classified as inventory. The accounting definition of property, plant, and equipment specifies those properties of a durable nature used in the regular operations of the business.
These assets consist of physical property such as land, buildings, machinery, furniture, tools and wasting resources. With the exception of land, most assets are either depreciable (such as buildings) or consumable (such as timberlands). These properties do reasonably fall into this category, especially in the cases where the REIT is involved in managing the property and receives revenue from rents. The definition for inventory relates to asset items held for sale in the ordinary course of business or goods that will be used or consumed in the production of goods to be sold.
It can also be reasonably justified that these assets fall into this category, this is the nature of REITs, to buy and sell real estate. This is a gray area in which reasonable people can disagree. It is my opinion that these assets should be classified according the company’s honest intent for its use. Many REITs own and operate apartment complexes and have no intent to sell the property, but are content to manage the units and collect rent. In these types of cases the property is not being sold but leased. Therefore, PP&E would be the appropriate classification, similar to the method that car rental agencies use.
But, if the company intends to improve and sell the property then the property should be inventory. This method would be similar to method by which securities investments are accounted for. Depending on the company’s intent, securities can be classified as held-to-maturity, available for sale, or marketable securities. Since all these properties are currently classified as property, plant, and equipment, the issue of depreciation becomes important. If these properties were classified as inventory, then all maintenance and repairs would expensed as incurred, and no depreciation would be recognized.
However, as property, plant, and equipment, maintenance and repairs would be capitalized and depreciation would be recognized over the life of the asset. This has a dramatic effect on the balance sheet, and the bottom line. Another issue is the fair representation of the financial situation of the company. If these assets are depreciated, then it implies that their value is going down over time. This is not case with these properties, the market value fluctuates and many times goes up rather than down. Therefore, a lot of value is lost from the balance sheet and investors cannot make an informed decision about where to invest.
To combat all of these issues, a number referred to as funds from operations, or FFO, has been derived to better value REITs. FFO is calculated by starting with net income and adding back the appropriate depreciation and amortization figures. It would not be correct to add back depreciation and amortization that is not applicable to the specific assets in question. Next the effect of non-recurring items is added back, this does not include extraordinary items, accounting changes, or discontinued operations. These calculations constitute FFO.
Although, many trusts report both FFO and net income, it is commonly FFO that that is used in EPS calculation. This is advantageous for the REIT because FFO is higher than net income. Therefore, EPS is higher, and in turn more attractive to investors. Those within the industry believe that these figures are a much better indicator of company performance than traditional EPS. Like EPS, P/E ratios are also calculated using FFO. Since earnings are reported higher, then the P/E multiple comes out to be lower. This also makes the company more attractive because it seems undervalued.
Accounting consists of a complex set of rules and guidelines that do an exceptional job of fairly representing the vast majority of corporations in the marketplace. However, there are some types of companies that are hurt by traditional accounting methods due to the unique nature of their business. It is fair to make an exception for these companies sometimes because of the broad purpose of accounting. This is to deliver timely, and accurate information to investors so that they may make informed decisions about how to allocate resources.