How a Big Mall REIT
Capitalizes on Costs

CBL & Associates Properties Inc., a real-estate investment trust that owns mall properties, is capitalizing on its capital expenditures.

CBL has promised to spend $220 million over four years to renovate a huge mall portfolio it bought last year. You would think that would reduce the company's earnings for the next few years. But as it turns out, it will actually help increase them.

Unlike most companies outside of real estate that make capital expenditures, the Chattanooga, Tenn.-based REIT doesn't book the costs of upgrading its malls as an expense against its funds from operations, a supplemental earnings measure used to gauge REITs' financial performance. But when CBL is reimbursed by tenants for many of the renovation costs it incurs, it includes them as revenue. Essentially, its funds from operations end up getting a boost from its mall-improvement costs.

"This game can go on for quite some time as long as capital-expenditure needs remain substantial," says Greg Andrews, an analyst at Green Street Advisors Inc. in Newport Beach, Calif. But not too long, he adds. Either capital-expenditure requirements have to decrease or tenants will seek lower rental rates to offset the high pass-through costs, Mr. Andrews says.

CBL isn't the only REIT that treats capital expenditures in this way. The method of not booking such costs as an expense but including the reimbursements as revenue is actually approved under generally accepted accounting principles. In net income, the cost of expenditures is reflected as depreciation. However, since funds from operations, a measure adopted by the National Association of Real Estate Investment Trusts in 1991, adds back depreciation, no expense shows up. This method has the effect of boosting CBL's funds from operations.

Discussions about the company's treatment of capital expenditures have been revived as the company takes on its largest capital-improvement project yet -- renovation of 21 malls it bought last January -- and as the Enron Corp. debacle has Wall Street's attention turned to broader accounting and quality-of-earnings issues.

John N. Foy, CBL's chief financial officer, says the company is in full compliance with GAAP and Nareit. Mr. Foy says the REIT fully discloses how it calculates capital expenditures in its financial statements and in filings with the Securities and Exchange Commission.

He adds that on a different accounting issue -- how it treats the selling of excess land that surrounds the company's properties -- the REIT is actually more conservative than others. Under Nareit guidelines, REITs can add gains from the sales of excess land to funds from operations. But CBL chooses not to include those gains citing the potential volatility and unpredictability of such sales.

Mall REITs have been handling capital expenditures this way for so long that the practice hardly bothers REIT analysts and big REIT investors. "When we analyze CBL," says David Fick, analyst at Legg Mason Wood Walker Inc. in Baltimore, "we recognize that there's apples-and-oranges issues in terms of quality of earnings."

What's more, CBL has been so widely praised by analysts and investors for creating shareholder value through its strategy of buying and improving "B" malls, that its treatment of capital expenditures is viewed as less important. "We're more concerned with asset valuation and this doesn't affect that at all," Mr. Fick says.

Yet Mr. Fick and other analysts acknowledge that smaller investors, and those who aren't dedicated longtime REIT investors, may not be aware of or understand that some REITs are getting a boost in earnings by doing this. "Without additional disclosure," says Green Street's Mr. Andrews, "investors will be unable to assess the magnitude and sustainability of this source of funds from operations."

Email your comments to rjeditor@dowjones.com.