Issues in Focus May 2003

In the post-Enron world, financial officers of REITs and other public real estate companies face increased scrutiny while taking on a larger role in operations.

By Maria Wood, Senior Editor, Real Estate
Forum Magazine

The Sarbanes-Oxley Act of 2002 certainly had a hand in that. Among the stipulations of the act are provisions mandating that companies adopt a formal code of ethics; report all information regarding off-balance-sheet transactions and prohibit audit partners from providing audit services for more than five years. Additionally, CEOs and CFOs must sign forms certifying company financials. The act also speaks extensively to auditing procedures, mandating that audit-committee members be independent and not receive any compensation from the company other than what is paid to the board of directors and committee members.

companies' operations and strategic direction. "The CFO is becoming more a part of the team that runs the business, on both the revenue-generating and cost-cutting sides," says Mike Havala, CFO at First Industrial Realty Trust in Chicago. "CFOs have input into matters ranging from operations and capital markets to overhead and other revenue-generating activities."

Even though the Sarbanes-Oxley act speaks only to public corporations, private firms have taken notice and are also shoring up their financial reporting. So says Bill Leiser, CFO at Dallas-based Staubach Co. "All CFOs are much more sensitive to the different aspects of the business that is going on around them," he finds, "and they are playing a bigger role than they did before. CEOs are now relying more on the CFO's opinion" on how a company's actions will be reflected in its financials.

The elevation of the chief financial officer is reflective of the importance companies now place on a strong financial foundation, says Lauralee Martin, global CFO at Jones Lang LaSalle in Chicago. "There has been a realization that financial performance creates value in a firm," she states.

However, some CFOs admit that the intense scrutiny brought about by the accounting scandals can be stressful at times. "It's never comfortable to be a CFO of a public company when there are things like Enron and WorldCom going on," says Chris Marr, CFO at Brandywine Realty Trust in Plymouth Meeting, PA. "As the situation matures, I would hope to get to a middle ground that's more conducive to an operating business."

challenging time to be a CFO," says Howard Sipzner, CFO of Equity One Inc., a shopping center REIT based in Miami Beach, FL. "There is obviously direct personal responsibility backed up by criminal penalties. Although 99% of the people are doing the right thing, they are being watched because the remaining 1% aren't."

Several CFOs actually welcome the spotlight, Steve Sterrett, CFO of the Simon Property Group in Indianapolis, among them. "Clearly, the post-Enron world has shined more scrutiny on the finance function, but I think that is a good thing," he states. "Ultimately, it means that the CFO is an integral part of the senior management and the strategic direction of the firm."

Impact of Sarbanes-Oxley

All chief financial officers, particularly those at REITs, confirm they had in place most of the mandates spelled out in Sarbanes-Oxley, either formally or informally. If they did not, they soon took steps to incorporate them. But with these new rules come additional documentation and paperwork that is sometimes burdensome.

"It's fair to say it has put a strain on the resources within the office of our general counsel, the legal department and the accounting

department," Marr says. "For the CFO and CEO certification process, we put various levels of additional reporting in place. The controls were always there, but now we are looking for individuals throughout the organization to sign very similar certifications saying that to the best of their knowledge everything we're saying and doing is accurate and complete."

Some in the industry point out that a code of ethics and more documentation are meaningless if the guidelines are not followed. "We've always had an ethics statement," JLL's Martin says. "Quite honestly, an ethics statement is only as valuable as the culture of the firm."

For a few public real estate companies, the price of staying in the public marketplace post-Enron may be too high, suggest some CFOs. "In the real estate arena, there are two types of companies: the asset-owning ones, which are basically the REITs, and the service providers," Staubach's Leiser says. "On the asset-owning side, it's fairly straightforward. They own their properties and they have debt on them. It's just a matter of beefing up the documentation. On the service side, it's going to be harder because traditionally those folks haven't had to disclose as much. They are going to have to figure out if the public arena is right for them."

Howard Sipzner says an indirect result of the Sarbanes-Oxley act might be more M&A activity. "For whatever reason, there are going to be companies that feel these requirements are too onerous," he suggests. "A corollary impact will be the cost of being a public company will go up somewhat. All of these steps take time, money and resources. And that will further the push toward consolidation."

Off-Balance-Sheet Transactions

Off-balance-sheet dealings opened the lid on the unsavory business practices at companies like Enron. And while in the REIT universe these structures are straightforward and explained at length in financial statements, CFOs are taking extra care when it comes to disclosing such arrangements. "We

there is an off-balance-sheet component. We're disclosing more information about the debt that is in place at the joint-venture level. On our conference calls, we speak to our risks as they relate to those ventures. Going forward, the level of vetting that we would do on any new transactions and the level of documentation will certainly be higher than what may have been done in the past."

Simon's Sterrett contends that off-balance sheet real estate deals are far removed from the deceptive tactics of an Enron. "These are straight-up ventures where we own half an asset and an institutional partner owns the other half," he says. "Because neither one of us has absolute control, the accounting rules require us to account for it off our balance sheet."

More Scrutiny From Investors, Analysts

And, indeed, investors and analysts are watching. But that is not necessarily a bad thing. JLL's Martin says that one possible outcome of Sarbanes-Oxley is that it will force investors to look at the long-term value of a company. "We're seeing investors

increased scrutiny from analysts as well. "We deal with equity analysts, and with credit analysts on our public bonds," he says. "The latter in particular have been among the earliest to identify corporate governance as a key part of the risk and credit evaluation."

Ultimately, the better a company articulates its story, the more investors it will attract, says Chris Marr. "Those companies that provide full disclosure and update their disclosure as needed, will be rewarded with more investor interest," he believes. "Those that don't do earnings calls or put out much information publicly are going to be penalized."

GAAP Versus FFO

The debate over how REITs should report their earnings has been raging for years and will probably continue, say the CFOs. The consensus seems to be that Generally Accepted Accounting Rules for reporting earnings per share and net income do not give a clear picture of real estate earnings because of the depreciation factor. Therefore, funds from operations is an equally valuable tool.

"FFO has been the primary performance measure for as long as we've been public because GAAP net income has a significant flaw for real estate companies and that's because it's got a huge depreciation expense component," Sterrett explains. "Our assets tend to appreciate because of their income-producing nature. We've always had the two performance measures side by side. I don't think that will change. But if you talk to the investing public or the analytical community, you'll see that while GAAP net income is useful, FFO is the primary measure."

Equity One's Sipzner agrees that the GAAP EPS number can distort REIT financial reporting because of asset depreciation. "If I bought a piece of real estate 10 years ago at a very low price, I'd have a very low basis for GAAP and very low depreciation and I'd generate a market rate of return," he explains. "If someone comes along and buys the same type of property today at a higher price, they will have higher depreciation.

distorts between a company that has owned its real estate for a long period of time versus one that has bought it more recently, while the earning power on both are really equivalent. FFO equalizes that kind of anomaly.

"I've always been in favor of FFO," Sipzner continues. "If you follow the industry-standard definition, you are going to be on safe ground."

Havala of First Industrial adds in more measurements. "In our industry, investors should look at three main items: GAAP EPS, FFO and net asset value," he recommends. "Those three together provide the vast majority of information people want as far as valuing these companies. Unfortunately, there is no one perfect measure. Investors need to look at a number of different measures."