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2017 FactRight Due Diligence Conference!

How One Little Accounting Change May Significantly Alter Non-traded REIT Financial Analysis

by Jacob Heidkamp

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The Financial Accounting Standards Board (FASB) recently updated the definition of a business, which has implications for financial statements and the analysis of REITs. Accounting Standard Update 2017-01, released in January 2017 and effective Q4 2017, creates a framework to evaluate whether a property acquisition is classified as a business combination or an asset acquisition. Companies may elect early adoption prior to Q4 2017, as Griffin Capital Essential Asset REIT II, and Steadfast Apartment REIT III (STAR III) have already done.

From Expensing to Capitalizing

The update establishes a screen that holds if substantially all of the fair value of a prospective acquisition is concentrated in a single asset or similar assets, the acquisition will not be classified as a business combination. This screen applies to the majority of transactions for the REITs that we follow (saving ourselves from the abstract insanity that is integrated sets, inputs, processes and outputs, contained in this 55 page gem to add to your leisure reading!). Practically speaking, the acquisition of an entity that is comprised almost entirely of real estate assets is now an asset acquisition as opposed to a business combination. The new treatment allows for the acquiring entity to capitalize acquisition expenses incurred with the transaction. This is in contrast to the previous accounting treatment, under which acquisition fees and expenses incurred were expensed and flowed through the income statement. Out with expensing and in with capitalizing.

Spread Between MFFO and FFO Shrinks

One implication of the update is the practical convergence of funds from operations (FFO) and modified funds from operations (MFFO). FFO is equal to GAAP net income, then adjusted for non-cash accounting entries such as depreciation, and gains or losses from property sales, among other lesser contributors. MFFO has historically been equal to FFO, further adjusted for acquisition expenses and fees (which were added back), and GAAP’s straight-lining of rent on leases that have rent growth over the lease term, among other adjustments, which vary from REIT to REIT, despite IPA Guidelines listing about a dozen items that may be included in MFFO. The bulk of the amount adjusted to arrive at MFFO from FFO, and especially for REITs that are raising capital and in the portfolio construction phase, is represented by the acquisition expenses. The change in accounting, allowing for the capitalization of acquisition expenses, effectively diminishes the spread between FFO and MFFO.

The example of STAR III highlights this effect. This following table highlights STAR III’s reported MFFO (post-adoption of the accounting standard) in its Form 10-Q for the first quarter of 2017, contrasted with the calculation of MFFO under the previous expense treatment. (Note that in the expense treatment example below, depreciation of real estate assets and amortization of lease-related costs are unchanged from the reported capitalization treatment, as if the acquisitions occurred on the final day of the quarter, and such adjustments to depreciation and amortization would have been de minimus.)

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Note that there are multiple footnotes to the acquisition fees and expenses included in MFFO (wait a minute—you just told me those expenses were to be capitalized! Things are not so simple. What would accounting be if not byzantine, exceptions and nuance for everything—how else would one explain 55 pages of a FASB update to determine what a business is!). These acquisition fees and expenses are related to expenses incurred on “dead deals” (prospective acquisitions that were vetted in the first quarter that were not pursued or closed) and thus their treatment is not altered by ASU 2017-01 (because they were not incurred for actual acquisitions, but in preparation for prospective acquisitions). But overall, there is still a significant reduction in the spread between FFO and MFFO, as the acquisition expense add back in MFFO, the most significant adjustment in MFFO, is now reflected in net income. Consequently, net income and FFO is boosted significantly during the capital deployment stage of the REIT.

While the FFO-MFFO debate rages, here, a little context here, and definitely here, the debate will become less meaningful in the face of the convergence of FFO and MFFO, as the largest adjustment is now incorporated into net income/loss. Note the primary metric for publicly-traded REITs and closed REITs is FFO, which is commonly utilized as a valuation metric for investors (Price/FFO, akin to Price/Earnings for non-REITs) as well as a distribution coverage metric. After ASU 2017-01, it likely will take greater prominence for non-traded REITs in the capital deployment stage as well.

Changes Coming to Balance Sheets and Customer Account Statements Near You

Other practical effects of the new methodology are a bump to the balance sheet. By not expensing out but capitalizing acquisition fees and expenses (which are substantial in the early stages of a REIT’s life cycle), this bumps net income (by reducing expenses) and in turn increases total assets. This will provide a boost to values on customer account statements as net assets will generally be higher under the new capitalization treatment than in the previous expense treatment.

In STAR III’s case highlighted above, increased net income was reported as ($2,322,391) in the first quarter, and would have been ($3,210,729) under the previous expensing regime. This also boosted total assets by 0.6% in the first quarter, a small amount in one specific quarter, but will invariably increase as further acquisitions are recorded. And it’s certainly not just STAR III—FactRight’s internal analysis of historical acquisition fees incurred between 2010 and 2016 by many non-traded REITs suggests that had the new accounting treatment applied to those programs during those years, net asset levels and NAV share implications would have varied from de minimus impact on some programs, to mid-teen percentage upward adjustments on other programs.

Changes to the balance sheet undoubtedly affect leverage ratios as well, and increased assets will reduce debt to total assets on programs, in the absence of any additional adjustments to leverage ratio calculations. One little accounting change may yield significant shifts in financial statements and financial analysis of REITs in the near future!

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Filed Under: REITs