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investor clinic

Each time I see a column on real estate investment trusts I hope a mystery that has bedevilled me might be resolved, namely: How can a real estate investment trust pay out more in distributions than it makes in profit? - R.B.

Prior to the adoption of new accounting rules on Jan. 1, it was common for REITs to pay out more than they reported in profit. That's because they were required, under generally accepted accounting principles (GAAP), to gradually depreciate their property much as a manufacturer depreciates machinery and equipment.

The purpose of depreciating an asset under GAAP was to spread the cost over the item's useful life instead of taking the full hit all at once, but in the case of REITs, it ended up distorting their bottom lines – making it appear as if they earned less money than they actually did.

"If you think about real estate, it doesn't depreciate that way," said Michael Smith, real estate analyst at Macquarie Securities. "First of all, the land doesn't depreciate at all. If it's well located, it usually goes up. And the building doesn't really depreciate, in the manner that GAAP came up with, predictably over a certain period of time."

To get around the problem, REITs use alternative measures – namely, funds from operations (FFO) and adjusted funds from operations (AFFO) – to assess their financial performance. You can usually find these numbers in a REIT's financial statements.

The actual definitions are complex, but FFO is essentially operating profit excluding GAAP-style depreciation and any gains or losses on disposals of properties. AFFO is generally equivalent to FFO less an allowance for maintenance capital expenditures and leasing costs, to reflect the cash a REIT spends to maintain its buildings.

"AFFO is the real estate equivalent of profit, and it's a good metric to use in assessing a REIT's payout ratio," Mr. Smith said.

(Just to complicate matters further, the adoption of International Financial Reporting Standards on Jan. 1 introduced yet another definition of net income, but FFO and AFFO are still the preferred measures in the REIT industry.)

The upshot for investors? As long as a REIT isn't continually paying out more than its AFFO, there's usually no cause for concern. Let's look at a couple of examples.

Canadian Real Estate Investment Trust reported AFFO of $1.05 per unit in the six months ended June 30, and paid distributions of 71 cents per unit. This represents a conservative payout ratio of 67.6 per cent of AFFO.

RioCan REIT , on the other hand, reported AFFO of 63 cents per unit and paid distributions of 69 cents in the six months to June 30, for a payout ratio of about 110 per cent. This isn't an immediate problem for the company, because many investors elect to reinvest their distributions in additional shares, which means they don't have to be paid in cash.

Mr. Smith expects RioCan's payout ratio will fall below 100 per cent on an annualized basis by the end of this year or early next year thanks to the company's growing AFFO, which has been bolstered by acquisitions, developments and improving rents.

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