REIT Earnings Receive
Some Added Attention

The earnings you've come to expect from a certain camp of real-estate investment trusts may not be all they're cracked up to be.

Some REITs, especially those developing industrial property, engage in a practice called merchant building, where the company develops and then quickly sells a building for a profit. What investors may not know is that some REITs add the one-time gains from those sales into their funds-from-operations figure, a commonly used measure of REITs' financial performance.

These gains from merchant building are treated as recurring income -- as consistent as, say, rental income. But that's hardly the case. As the economy slows, so does this type of building activity. The result is that, with a lower level of merchant building, funds from operations are expected to drop at some REITs, including First Industrial Realty Trust Inc. and ProLogis Trust.

Some analysts say merchant building is too volatile to be viewed as recurring, and they question the wisdom of including it in funds from operations. "It's clearly a risky strategy to layer merchant-building gains into funds from operations during a period of a slowing economy because the amount of new development that takes place during such periods is declining," says James W. Sullivan, an analyst at Prudential Securities in New York. He recently revised downward his 2001 and 2002 funds-from-operations estimates for ProLogis and First Industrial citing, in part, lower merchant-building gains.

As the Enron Corp. debacle focuses more attention on accounting and quality-of-earnings issues, the way REITs calculate and release their results is receiving new notice. Critics have faulted funds from operations -- a supplemental earnings measure that adds back depreciation on real-estate properties -- because it isn't audited, tends to overstate earnings and is subject to different interpretations by REITs. Boosting funds from operations by including gains from merchant building adds fuel to the fire, and critics cite the practice as yet another reason why the industry lacks some credibility in the investment community.

Officials at ProLogis and First Industrial say they view the development business as a normal course of their real-estate operations. Walt Rakowich, chief financial officer of ProLogis, says more than 50% of the REIT's merchant-building business is driven by its existing customer base, accounting for a lot of repeat business, thus making it "a business that is recurring." The Aurora, Colo., firm included gains on merchant building of $126.8 million in its $439.1 million of funds from operations for 2000.

Chicago-based First Industrial says it now makes potential users of buildings for which the company is developing sign contractual obligations to buy the property to reduce the chances of a property not being sold. In the past, the REIT sometimes developed property without a guaranteed buyer. First Industrial included merchant-building profits of $12.2 million in its 2000 funds from operations of $169.2 million.

The National Association of Real Estate Investment Trusts leaves it up to REITs to choose whether to include merchant-building profits in funds from operations. REITs that do include these gains indicate that they are doing so in separate line items in their supplemental earnings statements. But analysts say investors may not understand the language.

Tim Lucas, research director at the Financial Accounting Standards Board, says that while he couldn't comment on REITs specifically, "if you have a multiple set of standards and performance measures and one company uses one set and another company uses a different set, and [an investor] has to figure out which model a company used, you get an increasing number of questions and different sets of answers."

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