FUNDS FROM OPERATIONS VERSUS NET INCOME:
EXAMINING THE DIVIDEND-RELEVANCE OF REITPERFORMANCE MEASURES

Danny Ben-Shahar
Faculty of Architecture and Town Planning
Technion – Israel Institute of Technology
Technion City
Haifa 32000, Israel
Email: dannyb@technion.ac.il
Eyal Sulganik
The Arison School of Business
The Interdisciplinary Center Herzliya
Herzliya 46150, Israel
Email: sulganik@idc.ac.ilandDesmond Tsang
Desautels Faculty of Management
McGill University
1001 Sherbrooke Street West, Montreal
Quebec, Canada H3A 1G5
Email: desmond.tsang@mcgill.ca

May 2010♦♦

This paper is developed based on the thesis of Desmond Tsang completed at the University of California
at Berkeley. We would like to thank the following people for their comments on earlier drafts of this paper:
Robert Edelstein, Xiao-Jun Zhang, Maria Nondorf, Thomas Linsmeier, Heather Wier, Steve Fortin,
Thomas Davidoff, Sunil Dutta, Qintao Fan, Dwight Jaffee, Nicole Johnson, Shai Levi, James Powell, Zvi
Singer, and the participants at the AREUEA International Meeting 2007, FARS Meeting 2007, AAA
Annual Meeting 2007, AAA Northeast Regional Meeting 2007, and the CAAA Annual Conference 2007,
and seminar participants at McGill University, University of California at Berkeley, University of Hawaii
at Manoa, Simon Fraser University, York University, University of Hong Kong, and Singapore
Management University. We acknowledge the able research assistance of Matthew Cote, Matthew Carozza
and Daniel Lasry.

FUNDS FROM OPERATIONS VERSUS NET INCOME:
EXAMINING THE DIVIDEND-RELEVANCE OF REITPERFORMANCE MEASURES

Abstract
We compare the Funds from Operations (FFO) and net income by examining how wellthese two performance measures explain dividend policy of Real Estate Investment Trust(REIT) firms beyond operating cash flows. Our investigation extends over the period of
2001-2008, subsequent to the provision of the new FFO definition by the National
Association of Real Estate Investment Trusts (NAREIT). Specifically, by decomposing
the performance measures into their cash and non-cash (accrual) components, we findthat, while the non-cash component that is common to both FFO and net income issignificantly associated with the level of dividends distributed by REITs, the additional
non-cash component contained in net income but not in FFO has no association withdividends. We further find that the non-cash component in net income becomessignificantly associated with dividends only when measurement errors in depreciation arelow (i.e., reporting quality in depreciation is high). By suggesting that the inclusion ofdepreciation distorts the dividend-relevance of REIT net income, this paper provides
further support to the dominance of FFO over net income for financial reporting in the
REIT industry.

Keywords: Funds from Operations; Net Income; Dividends; Real Estate Investment
Trusts; Performance Measure; Depreciation
JEL Classifications: M41; G38

1

1

Introduction

The Real Estate Investment Trust (REIT) industry in the U.S. regularly reports asummary performance measure known as Funds from Operations (FFO) to supplement
net income in measuring firm profitability. Since the introduction of the FFO concept by
the National Association of Real Estate Investment Trust (NAREIT) in 1991, industry
participants have been advocating the adoption of FFO as they perceive it to be a more
informative performance measure than net income.
REIT managers generally claim that by excluding depreciation, amortization, andseveral one-time, non-recurring revenue and expenses, FFO provides useful information
about firms’ operating performances. They argue that several income statement items,
particularly depreciation, distort the true profitability of REIT.1 However, government
regulators, the Securities and Exchange Commission (SEC), and other standard-setters
are concerned about the usefulness and reliability of the FFO measure as it is un-audited,voluntarily reported, and not prepared according to Generally Accepted Accounting
Principles (GAAP) (see, for example, Baik, Billings, and Morton, 2008).
Previous research that examines the usefulness of the FFO measure (compared to
net income) generally finds mixed evidence. For example, Fields, Rangan, andThiagarajan (1998) focus on a sample of REITs during the period 1991-1995 and findthat, while FFO is better in predicting one-year-ahead FFO and cash flows from
1

Among the rationales underlying this argument is the conventional adoption of the straight-line method
for accounting depreciation allocation on the assumption that the value of real estate assets diminishes
predictably over time. Yet, managers using this assumption tend to underestimate the period of time overwhich depreciation occurs (for recent studies that estimate depreciation for real estate assets, see, forexample, Fisher, Smith, Stem, and Webb, 2005 and Harding, Rosenthal, and Sirmans, 2007). Also, given
the complexity of the real estate portfolios owned by a REIT, it is frequently difficult to categorize realestate properties/capital improvements into the right asset classes such that the correct depreciation
schedule can be applied. As a result, the adjustments for depreciation could contain large measurement
errors. Finally, net income includes unusual and extraordinary items that are deemed to have little relation
with a firm’s future operating performance (see NAREIT National Accounting Bulletin, 2002).

2

operations (CFO), net income is better in predicting contemporaneous stock prices andone-year-ahead net income. Gore and Stott (1998) examine a slightly longer sample
period (1991-1996) and use a different empirical design; they find that FFO is, in fact,
more closely associated with stock returns than net income. They also find that dividend
forecast ability tends to be higher for net income than for FFO. Vincent (1999) examines
the relative as well as the incremental information content of FFO compared to earningsper-share (EPS), CFO, and earnings-before-interest-tax-depreciation-and-amortization(EBITDA) and finds that all four measures are related to stock returns, but their statisticalsignificance is highly dependent on the econometric specification. Graham and Knight(2000) find that FFO has higher and incremental information content over net income.
Stunda and Typpo (2004) extend the study of Graham and Knight (2000) and find that
REIT investors use both earnings and FFO information in making investment decisions,
but FFO gains importance in valuation as earnings become more transitory. Hayunga andStephens (2009) examine dividend smoothing in REITs and find that both FFO and net
income are contemporaneously related to dividends.2
By running a horserace comparison of the two measures, these aforementioned
studies suggest that the real estate industry seems to perceive FFO as being more usefulthan (or at least as useful as) net income in valuation. However, only a handful of studies
have attempted to provide a rationale for this conclusion.3 Moreover, prior research on

2Some recent studies also examine the relative quality of FFO and net income from the perspective ofanalysts. For example, Downs and Güner (2006) compare analysts’ forecast errors of FFO for a sample of
REIT and analyst forecast errors of EPS for a sample of non-REIT firms. They find that analyst forecast
errors are lower for the FFO measure. Examining analyst forecast accuracy of FFO and EPS under thesame REIT firm construct, Fortin and Tsang (2008) find that analyst forecast accuracy is substantiallyhigher for FFO than for EPS.
3
Ben-Shahar, Margalioth, and Sulganik (2009), for example, develop a theoretical framework in which
they examine the usefulness of reported depreciation and find that none of the commonly used depreciation3

the comparison of FFO and net income is also particularly scarce following the provisionof the new FFO definition in 2000 that accompanied the improved industry efforts tostandardize the FFO measure.4 Our study fills these voids by empirically decomposing
and examining the components that are common to net income and FFO and those in net
income but not in FFO over the period of 2001-2008.5
Given that dividend-payout represents an important source of income to REIT
investors, we particularly focus on the FFO and net income measures from the dividendrelevance perspective. Despite the fact that REITs are required by Federal law to
distribute 90% of their taxable income as dividends to shareholders, prior studies (e.g.,Wang, Erickson, and Gau, 1993 and Bradley, Capozza, and Sequin, 1998) have shownthat REITs tend to distribute more dividends than the statutory requirement and that theirdividend policy is more dependent on firm fundamentals such as cash flows, leverage,
and firm size rather than on the statutory dividend distribution threshold.
As FFO contains the same cash and accrual components as net income except thatit excludes depreciation and several one-time, non-cash, non-recurring items, we

methods ex-ante conforms to the accounting matching principle. They attribute their findings as a
resolution to the dominance of FFO over net income in the REIT industry.
4
Responding to the noted concerns that its member firms may report FFO opportunistically to mislead
investors, NAREIT has exerted continued efforts to provide guidance in the preparation of FFO (in 1995
and 1999) and it has subsequently devised a “standard” definition of FFO as of January 1, 2000. The white
paper on FFO published by NAREIT currently defines FFO as follows: “Funds from Operations means net
income (computed in accordance with GAAP), excluding gains (or losses) from sale of property, plus
depreciation and amortization, and after adjustment for unconsolidated partnerships and joint ventures.”
REIT firms are encouraged to follow the “standard” definition of FFO as defined by NAREIT. However,
the guidance of NAREIT remains advisory in nature, and managers have the flexibility to make further
adjustments on items to include and exclude as they deem appropriate. In practice, we find that REIT
managers also exclude from FFO certain other unusual and infrequent accounting items (e.g., impairment,
extraordinary items, and early extinguishments of debt). For studies that focus on the market impact of theregulatory efforts on FFO reporting in 2000, see Higgins, Ott, and Van Ness (2006) amd Baik, Billings, andMorton (2008).
5
To our best knowledge, the only study that examines the differences between FFO and net income in asimilar context is Fortin, Liu, and Tsang (2009), where they examine the imposition of Regulation G in2003 on the usefulness of FFO. However, they do not examine the relative usefulness of the FFO versus net
income.

4decompose the performance measures into three components: (1) a cash component thatis common to both FFO and net income; (2) an accrual component that is common toboth FFO and net income; and (3) an accrual component in net income but not in FFO.
We test the dividend-relevance of these components and find that the non-cash
component common to both FFO and net income is significantly associated with the levelof dividends distributed by REITs, indicating accrual adjustments in the performancemeasures provide investors with incremental information on a firm’s dividend policy
beyond cash flows. However, we also find that the additional accrual component in net
income but not in FFO has no association with dividends.
We next examine whether it is specifically the reported depreciation, typically thelargest expense item on the financial statement of REITs, which distorts the measurementof net income (as depreciation is required by GAAP to be included in net income but is
excluded from FFO). Following Healy and Wahlen (1999) and Marquardt and Wiedman(2004), we thus decompose the depreciation expense into its normal and abnormal
portions, with the abnormal component as a proxy for the measurement errors in
depreciation (due to unintentional mistakes and/or intentional earnings management). We
find that only when measurement errors in depreciation are low, the non-cash component
in net income, but not in FFO, nonetheless contains dividend-relevant information.
Further investigating the non-cash component in net income, but not in FFO, we
decompose it into two sub-components, depreciation and other items. We find that, whenmeasurement errors in depreciation are low, while depreciation remains mostly
insignificant, the other items that are excluded from FFO but affect revenue and expenses(and thus net income) maintain significant correlation with dividends.

5

Overall, our findings suggest that while cash flows predictably affect the amountof dividends declared by a REIT, accrued revenue and expenses in FFO that are to berealized into future cash flows are also correlated with current REIT’s dividend policy. In
contrast, the accrual component in net income but not in FFO has little association withdividends. Furthermore, the evidence reinforces the industry’s claim that reported
depreciation in REIT tends to contain serious measurement errors; therefore, by
excluding depreciation from net income in the calculation of the FFO measure, NAREIT,
in effect, provides an alternative performance measure that better reflects REIT’s
dividend policy.
The remainder of the paper is organized as follows. In the next section, we present
the hypotheses and outline the research design. Section 3 explains the sample selection
process and describes sample statistics. Section 4 presents the main empirical results. We
discuss robustness checks in Section 5 and provide concluding remarks in the last section.

2

Hypotheses and Research Design

Dividend Relevance of FFO and Net Income
As noted earlier, proponents of FFO claim that FFO is a better performance measure thannet income as it allows more of the managers’ discretion on which financial items toinclude or exclude, so as to eliminate measurement problems (in depreciation and otheritems) and, thereby, better reflect firm’s cash flows and fundamentals over time. Hence,
FFO should further serve as a better measure of a firm’s dividend-paying ability.
Opponents of FFO, however, argue that the flexibility of the measure does not ensure that
FFO has higher quality: By undoing some particular accounting expenses such as6

depreciation, FFO merely increases net income by the amount of these adjustments.
Moreover, REIT managers have more flexibility in manipulating FFO by selectively
excluding certain expenses from net income as FFO is not governed by GAAP. If theseexcluded expenses require future cash disbursements, managers would undoubtedly
consider these future obligations when they determine their dividend policy for thecurrent period. Because these expenses are excluded, FFO would exhibit lower
correlation with a firm’s dividends than net income.
Our first hypothesis investigates which of the two performance measures, FFO or
net income, is more dividend-relevant. Presented in alternative form,

H1: FFO is more dividend-relevant than net income.

We test this hypothesis by first decomposing the performance measures into
different components: (1) a cash component that is common to both FFO and net income;(2) an accrual component that is common to both FFO and net income; and (3) an accrualcomponent in net income but not in FFO. While FFO contains the same cash and accrualcomponents as net income, unlike net income, it excludes depreciation and several onetime, non-cash, non-recurring items. Prior research shows a firm’s cash flows are an
important determinant for REIT dividend policy (e.g., Hayunga and Stephens, 2009).
Yet, the non-cash (accrual) components of the performance measures (i.e., revenue andexpenses that are recognized when earned and incurred, respectively, regardless of when
the cash is received or paid) can potentially provide incremental information to a REIT’s
dividend-paying ability as the accruals may affect future cash collection and7

disbursement. A rational manager may anticipate these future cash implications from
accrued revenues and expenses and determine the current dividend policy accordingly.
Thus, we hypothesize that the non-cash component of the performance measures also
provides investors with relevant information regarding the dividend policy of REITs.
The fundamental model for evaluating dividend-relevance of net income and FFO
is presented in the following regression framework:(1)

DIVj,t= α1 + β1CFOj,t + β2FFO_ACCj,t + β3NI_ACCj,t + β4Controlsj,t + εj,t,where DIVjt, is the annual dividend per share declared by REIT j in year t, and CFO,
FFO_ACC, and NI_ACC denote the cash component that is common to both FFO and net
income, the accrual component that is common to both FFO and net income, and theaccrual component in net income but not in FFO, respectively. We follow Collins andHribar (2002) and use the direct method to compute total accruals in net income and in
FFO, respectively, such that6(2)

TACCNIj,t = Net Incomej,t – CFOj,t

and
(3)

TACCFFOj,t = FFOj,t – CFOj,t.

FFO contains the same accruals as net income except for depreciation and certain onetime non-recurring items, so the accrual component in net income (denoted by TACCNI)
contains the accrual component of FFO (denoted by TACCFFO) and an additional accrualcomponent. Hence, the accrual component common to both FFO and net income,6

Collins and Hribar (2002) argue that although previous literature uses both indirect and direct methods tocalculate total accruals, the direct method provides a more accurate measurement of total accruals. The
indirect method calculates total accruals using information from both the balance sheet and the income
statement. The direct method calculates total accruals directly from the statement of cash flows.

8

FFO_ACC [see equation (1)] is simply TACCFFO, while the additional accrual component
in net income but not in FFO, [NI_ACC in equation (1)], is obtained by(4)

NI_ACCj,t = TACCNIj,t – TACCFFOj,t.
We also include in equation (1) a set of control variables (denoted by Controls)

documented in prior studies to affect REIT dividend policy. These include firm size
(measured as the natural logarithm of the REIT’s market capitalization and denoted by
SIZE); leverage (measured as the ratio of total debt to total assets and denoted by
LEVERAGE), return-on-assets (denoted by ROA), and future growth opportunity (proxiedby the market-to-book ratio and denoted by MTB). 7 Finally, all financial statement
variables in equation (1) are scaled by the firm’s average total assets to control for theeffect of heteroskedasticity.
Should both FFO and net income be dividend-relevant, we expect the cash (CFO)
and the non-cash (accrual) components (including both FFO_ACC and NI_ACC) to
maintain significantly positive coefficients. However, if FFO is more dividend-relevant
than net income, then we would observe significantly positive coefficients only for CFO
and FFO_ACC.

The Impact of Depreciation on Reported Performance of REIT
7

Bradley, Capozza, and Seguin (1998) argue that larger firms are more diversified and have less volatile
cash flows, and firms with volatile cash flows tend to pay less dividends. Thus, a positive relation is
expected. Hardin and Hill (2008) argue that a larger firm may need to conserve more cash to expand its
asset base, and hence size can be negatively related to dividends. Therefore, we do not offer directional
prediction of the SIZE variable. Bradley, Capozza, and Seguin (1998) and Hardin and Hill (2008) both
document a negative relationship between leverage and dividend payout. We follow these prior studies andexpect a negative coefficient for LEVERAGE. As better performing REITs are less motivated to use
dividends to signal performance, many studies document a negative relationship between ROA anddividends (e.g., Bradley, Capozza, and Seguin, 1998; Wang, Erickson, and Gau, 1993; Ghosh and Sirmans,
2006; and Hardin and Hill, 2008). To proxy for future growth opportunity, we include market-to-book ratio,
MTB. We expect a negative relationship of MTB and dividends because REITs with relatively high MTB
may seek to conserve more cash for future growth opportunities and thus pay smaller dividends (Devos,
Spieler, and Tsang, 2010).

9

Several studies (e.g., Barth, Cram, and Nelson, 2001 and Cheng and Liu, 2007) haveargued that depreciation expenses are, in fact, proxies for expenditure on long-term
investments and should be related to cash flows (and thus dividends). Hence, absent
measurement errors, depreciation expenses should help explain a firm’s dividend
distribution. Similarly, the other non-cash non-recurring items included in net income but
excluded from FFO should also have cash flow implications and should affect thedividend-payout.8
Yet, the determination of depreciation expenses requires managers to form
various assumptions on the estimated useful lives, asset classes, and depreciation
methods for real estate properties. Hence, depreciation reported by REITs may be more
subject to substantial (unintentional) errors when managers have large real estate
portfolios consisting of vastly different real properties. As prior research shows, however,errors in depreciation can also be caused by intentional earnings management. Given that
depreciation often represents the largest expense item for a REIT, managers might, forexample, manipulate net income upward to meet certain earnings benchmarks byunderstating depreciation. Alternatively, given that the real estate market was burgeoning
in recent years before the financial crisis, they might want to smooth net income
downward by overstating depreciation.98For example, extraordinary items and results of discontinued operations are typically excluded from FFO
but included in net income. However, a loss of property due to extraordinary factors such as fire or
earthquake implies cash outflows in the foreseeable future for replacement asset. Accrued revenue from an
operating segment to be disposed by the firm in the near future is, in essence, similar to normal accrued
revenue and implies future cash inflows.
9
Previous studies (e.g., Fields, Rangan, and Thiagarajan, 1998) show that both FFO and net income arevalued by investors, thus providing an incentive for managers to manipulate net income. Moreover, manybank covenant provisions are based on the GAAP net income measure instead of FFO, thus providing
incentives for managers to manipulate net income to meet certain earnings thresholds. Also, Teoh, Wong,and Rao (1998) and Teoh, Welch, and Wong (1998) find that initial public offering (IPO) firms usuallyadopt income-increasing depreciation policies. Marquardt and Wiedman (2004) show that firms with equity

10Overall, we expect that the presence of measurement errors in depreciation
expenses lowers the reporting quality of depreciation accruals and introduces noise to themeasurement of net income. This leads to the second hypothesis presented in alternative
form:

H2:

Net income is less dividend-relevant when the reporting quality(measurement error) of depreciation is low (high).

In the spirit of Healy and Wahlen (1999) and Marquardt and Wiedman (2004),10
we decompose depreciation expenses into their normal and abnormal (or discretionary)
portions. We measure the normal level of depreciation equal to depreciation expenses
reported by firms in the previous year adjusted for the proportional increase of property,
plant, and equipment (PPE) in the current year relative to the previous year. 11 The
abnormal component of the depreciation expense is thus equal to(5)

AB_DEPj,t = DEPj,t – (DEPj,t-1×PPEj,t/PPEj,t-1).
Large positive/negative abnormal depreciation (AB_DEP) indicates managers

reporting depreciation expenses that are higher/lower than normal. We then define thereporting quality of depreciation using two alternative measures: The first measure,offerings tend to manage depreciation downwards. Keating and Zimmerman (1999) show that firms that
adopt income-increasing depreciation policy change for all assets exhibit worse performance than firms that
only adopt policy change for their new assets.
10
Healy and Wahlen (1999) report that most earnings management studies use abnormal (or discretionary)
portions of accruals as a measure of earnings management. In particular, Marquardt and Wiedman (2004)
assume that depreciation expenses remain a constant proportion of gross property, plant, and equipment in
the absence of earnings management and view any abnormal level of depreciation expenses as indication of
earnings management activities.
11
As data for property, plant, and equipment is missing for many observations in our sample, we use total
assets as a proxy for property, plant, and equipment. We believe this assumption is plausible for the REIT
industry as REIT properties typically comprise most of the firm’s total assets.

11

DEPR_Q1, is a continuous variable, measured as the absolute value of AB_DEP (scaledby average total assets) multiplied by -1 (i.e., DEPR_Q1 = -|AB_DEP|). Hence, a firm isclassified as having higher reporting quality of depreciation when DEPR_Q1 is closer tozero. The second variable, DEPR_Q2, is a dummy variable equal to 1 when the absoluteabnormal depreciation is lower than the sample median; 0 otherwise. We then augment
the model in equation (1) by including the measures of reporting quality of depreciationand its interaction term with NI_ACC:(6)

DIVj,t= α1 + β1CFOj,t + β2FFO_ACCj,t + β3NI_ACCj,t + β4DEPR_Q1j,t +β5NI_ACC×DEPR_Q1j,t + β6Controlsj,t + εj,tand
(7)

DIVj,t= α1 + β1CFOj,t + β2FFO_ACCj,t + β3NI_ACCj,t + β4DEPR_Q2j,t +β5NI_ACC×DEPR_Q2j,t + β6Controlsj,t + εj,t.
We hypothesize that the accrual component in net income but not in FFO is
dividend-relevant when the reporting quality of depreciation is high (i.e., measurement
errors in depreciation are low). Therefore, our key coefficient of interest is β5, which we
expect to be positive and significant.
Finally, to further investigate the impact of depreciation on the incremental
usefulness of the net income measure, we decompose the differences between FFO andnet income accruals, NI_ACC, into the depreciation expense (DEP) and all other items(OTHER). We define other items as follows:(8)

OTHERj,t = NI_ACCj,t – DEPj,t.
We augment models (6) and (7) by substituting DEP and OTHER for NI_ACC:

12

(9)

DIVj,t= α1 + β1CFOj,t + β2FFO_ACCj,t + β3ADEPj,t + β3BOTHERj,t +β4DEPR_Q1j,t + β5ADEP×DEPR_Q1j,t + β5BOTHER×DEPR_Q1j,t + β6Controlsj,t+ εj,tand(10)

DIVj,t= α1 + β1CFOj,t + β2FFO_ACCj,t + β3ADEPj,t + β3BOTHERj,t +β4DEPR_Q2j,t + β5ADEP×DEPR_Q2j,t + β5BOTHER×DEPR_Q2j,t + β6Controlsj,t+ εj,t.
Although depreciation is a non-cash (accrual) expense, Barth, Cram, and Nelson(2001) argue that depreciation expense is, in fact, a proxy for expenditure on long-term
investments. Because these investments are expected to generate higher cash flows overmultiple future periods, one should expect future cash flows from operations to bepositively related to depreciation. Both Barth, Cram, and Nelson (2001) and Cheng and
Liu (2007) empirically show that depreciation and amortization expenses are significant
in predicting future cash flows in a general market context. In contrast, given themagnitudes and complications of the real estate portfolio generally held by a REIT, thedepreciation expenses in REIT may be more subject to unintentional estimation errors (orintentional management errors). These errors may weaken the correlation between the
depreciation expenses and the one-period-ahead cash flow from operations. The otheritems included in net income but not in FFO accruals should be dividend-relevant as onetime, non-recurring, accrued revenue (expense) nonetheless implies future cash collection(disbursement). Finally, our key coefficients of interest are β5A and β5B [see equations (9)and (10)], whom we expect to be positive and significant. That is, we conjecture thatwhen the reporting quality of depreciation is high, both DEP and OTHER maintain13

implications to a REIT’s future cash flows and that, in turn, motivates REIT managers toconsider these accrued items when determining their current dividend policy.

3

Data and Descriptive Statistics

Our sample consists of all publicly traded REIT firms over the period 2001 to 2008 (wethus avoid the confounding effect of FFO definition change by NAREIT in 2000).
Obtaining our sample firm data from the Capital IQ database, we start with a total sample
of 1464 firm-year observations. 12 Since this study compares the performance of twoalternative measures of the same firm, it is essential that we conduct the analysis on acommon sample, thereby eliminating observations for firms that do not choose tovoluntarily provide FFO information. We further verify that data is not missing for othervariables in our empirical analysis. The final sample consists of 590 firm-year
observations.
Table 1 presents descriptive statistics for the regression variables. The average
dividend per share is $1.636. We scale the financial statement variables by average total
assets to control for the effect of heteroskedasticity. Net income has a mean of 0.036,
which is substantially lower than the FFO mean (0.058). We find that CFO, with a meanof 0.062, is higher than both net income and FFO, indicating REITs generally book more
non-cash accrued expenses than revenues. When we decompose the performancemeasures, FFO_ACC has a mean of -0.004, while NI_ACC has a mean of -0.022.
However, the differences between the two accrual components are mainly due todepreciation. Depreciation has an average of -0.031. This reinforces the fact that12

We elect to conduct our study based on annual data instead of quarterly because data for depreciation isspare in the quarterly database.

14

accounting depreciation represents one of the largest expense items in general and thelargest reconciling item between FFO and net income for REIT firms. The mean value of
OTHER is 0.009, indicating that REITs have on average recorded more one-time revenue
than expenses.
Table 2 presents Pearson correlations for the regression variables. We find thatboth FFO and net income are correlated with dividends (with similar correlation
coefficients, 0.149 versus 0.150, respectively). Also, FFO and net income are, as
expected, highly correlated (0.647). When we decompose the performance measures into
their cash and non-cash components, we find that both FFO_ACC and NI_ACC are
insignificantly correlated with dividends. Interestingly, we also find that FFO_ACC and
NI_ACC are negatively correlated (-0.344). Prior research (e.g., Kolev, Marquardt,
McVay, 2008) shows that companies tend to reclassify expenses when they choose toreport non-GAAP measures. Arguably, the negative correlation coefficient represents theshifting of expenses from recurring to non-recurring items in the calculation of FFO.

4

Empirical Analysis

The outcomes from the estimation of equation (1) are reported in Table 3.13 The firstcolumn reports regression results without the inclusion of control variables. We find thatwhen we decompose the performance measures into the cash and non-cash components,
the cash component, CFO, is significantly related to dividends at the 1% level.
Interestingly, however, the non-cash accrual component in FFO (and common to net
income), FFO_ACC, is also significantly positively related to dividends at the 1% level.

13

We run pooled regressions across all firms and years on a common sample using ordinary least squares
with robust standard errors.

15

The finding indicates that REIT managers consider accrued revenue and expenses thatwill be realized as cash flows in future periods when they determine the level ofdividends for the current fiscal period. We also perform a test of the coefficients on CFO(4.19) and FFO_ACC (3.74) and find that they are statistically insignificantly different
from one another, indicating accrued revenues and expenses (common to both FFO andnet income) are as important as cash revenues and expenses in determining dividends.
Finally, the evidence shows that the accrual component in net income but not in FFO,
NI_ACC, is not related to dividends. This implies that, given the FFO measure, net
income does not provide investors with any incremental relevant information regarding
the firm’s dividend payout.
The second column of Table 3 reports similar results with the inclusion of control
variables. The above outcomes maintain under this specification. Of the control variables,
we find that the coefficient on SIZE is significantly positive, confirming with Bradley,
Capozza and Seguin (1998) that larger firms have more stable cash flows and are likely
to distribute more dividends. We also find that the coefficient on the market-to-book ratio(MTB) is significantly negative, indicating that firms with greater growth opportunities
are less likely to distribute dividends (arguably, to conserve cash for future investment
options).
Finally, we include property type fixed effects by classifying firms into six
categories by the types of properties in which they invest (residential, industrial, office,retail, specialized, and diversified). The third column of Table 3 shows that CFO andFFO_ACC remain positively significant while NI_ACC remains insignificant.14

14

Although dividends are perhaps the most important return component for REIT investors, investors are
obviously also concerned with the security return and price appreciation of a REIT stock. We have16Is it the depreciation item that distorts the reported net income as a qualitative
indicator for dividends? Table 4 reports regression results from the estimation ofequations (6) and (7) with the inclusion of control variables and property type fixed
effects. The first column of Table 4 reports results using DEPR_Q1 (measuring theabsolute value of abnormal depreciation) as proxy for the reporting quality ofdepreciation. We find that CFO and FFO_ACC remain significant in explaining
dividends. More importantly, after controlling for the reporting quality of depreciation,
NI_ACC now becomes significantly related to dividends. The key coefficient ofinterest—the interaction term of DEPR_Q1 and NI_ACC—is significant and positive atthe 1% level. The results imply that, the accrual component in net income and not in FFO
provides incremental information regarding a REIT’s dividend policy when themeasurement errors of depreciation (the abnormal depreciation) are low (i.e., quality ofdepreciation is high).15
We conduct an alternative analysis by using a discrete binary measure of thereporting quality of depreciation, DEPR_Q2 (a dummy variable equal to 1 when theabsolute abnormal depreciation is lower than the sample median; 0 otherwise) and report
the results in column two of Table 4. Once again, we find that the interaction term issignificantly positive in predicting dividends. Moreover, when we compare thetherefore attempted to re-estimate equation (1) after replacing the dividend-payout dependent variable withREIT stock price as well as various return measures (raw returns, abnormal returns measured as raw returns
minus returns from the S&P Index, and abnormal returns using raw returns minus index returns from the
FTSE NAREIT U.S. Price Index). Following, for example, Fields, Ranganm, and Thiagarajan (1998) and
Kang and Zhao (2010), we have also included SIZE as a control variable. Consistent with the results
reported above, however, we find that while FFO_ACC and CFO are positively correlated with the stock
price, NI_ACC is uncorrelated with the price. Similar results are obtained for the return regression, which isalso robust to the alternative return measures. The results of these estimations are available from theauthors upon request.
15
Given that DEPR_Q1 uses the raw measure of measurement errors to proxy for reporting quality indepreciation, the magnitudes of the coefficient for the interaction variable is difficult to interpret.

17

coefficients of FFO_ACC (3.73) and the combined coefficients of NI_ACC and its
interaction term with DEPR_Q2, NI_ACC×DEPR_Q2 (-1.09 + 4.48 = 3.39), we find thatthe coefficients are insignificantly different from one another. This result implies that
accrued revenue and expenses that are included or excluded from FFO are bothsignificant in determining REIT dividends when the measurement errors of depreciation
are low.
Interestingly, DEPR_Q1 and DEPR_Q2 are both positive and significant. We
attribute the findings to the possibility that the reporting quality of depreciation can also
serve as proxy for other omitted factors on reporting quality. Francis, LaFond, Olsson,
and Schipper (2005) show that accrual quality is a priced factor as higher accrual quality
lowers the reporting risks of the firm. When firms face lower risks, it is easier for them tomaintain their operating cash flows and secure debt and equity funding, thereby
improving their ability to maintain a higher level of dividends, such that depreciation
quality and dividends is positively related.
To further investigate whether it is depreciation or the other items in NI_ACC
being dividend-relevant, we divide NI_ACC into DEP and OTHER [see once again
equation (8)] and estimate equations (9) and (10). The first column of Table 5 reports
results with DEPR_Q1 as the proxy of depreciation quality. We find that both OTHER
and the interaction term OTHER×DEPR_Q1 are positive and significant at the 1% level,
indicating that other accrued revenue and expenses included in net income but not in FFO
are dividend-relevant when the measurement errors of depreciation are low.

18

The second column of Table 5 shows similar results. While OTHER now becomesinsignificant, the interaction term OTHER×DEPR_Q2, is significant at the 1% level.16
The results are interesting as they provide a caveat for the superiority of FFO over net
income. Particularly, the findings in Table 5 indicate that the other revenue and expenses
excluded from FFO but included in net income nonetheless maintain dividend
implications. Hence, it is possible that REIT managers have reclassified some important
expenses as non-recurring and have excluded these expenses from FFO.

5

Robustness Analysis

We conduct various additional analyses to test the robustness of our results. We firstestimate two separate equations, one for the association of FFO with dividends(excluding net income from the equation) and another for the association of net income
with dividends (excluding FFO from the equation). We further include the control
variables (SIZE, LEVERAGE, ROA, and MTB) and property type fixed effects. We findthat while FFO is significantly correlated with dividends at the 1% level, net income is
only marginally significant at the 10% level. These results confirm prior studies of, forexample, Gore and Stott (1998) and Hayunga and Stephens (2009).17
Also, as there may be changes in economic factors across our sample period, we
augment model (1) by including a set of year dummies. Fortin, Liu, and Tsang (2009)
also document that the imposition of Regulation G in 2003 as a consequence of the
Sarbanes-Oxley Act improves the reporting of FFO. Hence, we alternatively include a

16

Once again, a test of the coefficients show that the coefficient of FFO_ACC (3.691) is statisticallyinsignificantly different from the combined coefficient of OTHER and its interaction term with thedepreciation quality, OTHER×DEPR_Q2 (-1.522 + 4.494 = 2.972).
17
All outcomes presented in this section are not tabulated and are available from the authors upon request.

19

time dummy that is equal to 1 for observations on or after 2003; 0 otherwise. Finally, due
to the concern that the current financial crisis has created difficulty for REIT firms inmaintaining their dividend payments, we also create a dummy variable that is equal to 1
for observations in 2007 and 2008; 0 otherwise—to control for the impact of the current
financial crisis. We find that the inclusion of these time dummies does not alter our
findings.
Prior research (e.g., Riddiough and Wu, 2009) shows that external financing is an
important source for REITs to obtain funding. We control for the impact of externalfinancing by including a line of credit variable (LOC) and a debt variable (DEBT) thatmeasure the amount of new debt issue. We obtain similar findings on all the income
components when we include these additional variables in equation (1).
In addition, we substitute the dividends per share as the dependent variable inequation (1) with the total amount of dividends of a firm, scaled by average total assets.
We find that the coefficients of CFO and FFO_ACC continue to be positive andsignificant, while the positive coefficient on NI_ACC becomes marginally significant at
the 10% level.
Finally, Harding and Hill (2008) examine the impact of excess FFO over its
expected level on excess dividends declared by REITs over the statutory required level.
Edelstein, Liu, and Tsang (2009) indicate the difficulty of estimating excess dividends
using accounting information and, instead, use low dividend payout ratio as a proxy forfirms facing a dividend constraint. Accordingly, we investigate whether the correlation of
the components of FFO and net income with dividends differs across firms' dividend
payout affordability. We augment model (1) by including a dummy variable that is equal20to 1 if the firm reports a dividend payout ratio lower than the sample median; 0 otherwise.
We also include interaction terms of this dummy variable with FFO_ACC and NI_ACC.
The results show that, by construction, this dummy variable is negative and significant.
However, FFO_ACC and CFO remain positively significant, NI_ACC remains
insignificant, and none of the interaction terms is significantly related to dividends. The
results thus indicate that FFO continues to provide dividend-relevant information toinvestors both for firms with the dividend constraint and for those without it.

6

Conclusions

In this study, we provide novel evidence on the relative usefulness of FFO and net
income as performance measures in REITs subsequent to the increased industry efforts toimprove FFO in 2000. We compare the dividend-relevance of these performancemeasures. We find that, across alternative model specifications, the non-cash accrualcomponent of FFO is significantly associated with dividends. The results show that FFO
provides incremental information (beyond operating cash flows) to investors with regards
to a REIT’s dividend-payout. We also show that the non-cash accrual component in net
income but not in FFO is unrelated to dividends. This empirical result is an imperative
support to the assertion by NAREIT that the reporting of FFO provides incremental
benefit to investors and is in favor for the continual reporting of FFO for the REIT
industry.
We further find that it is the inclusion of depreciation expenses in net income thatparticularly reduces the dividend-relevance of this performance measure. Specifically,
our empirical analysis shows that the accrual component in net income but not in FFO

21

becomes positively related to dividends when the measurement errors in depreciation are
low and reporting quality is high. Moreover, when we decompose the accrual component
in net income but not in FFO into its depreciation and other (non-depreciation) revenue
and expense items, we nonetheless find that the latter correlates with dividend-payout.
Overall, our findings indicate that the extent of measurement errors in depreciation
expenses plays a vital role in explaining the low quality of net income in determining
dividend policy. These findings support the REIT industry claim that depreciation distorts
the information contained in net income as a performance measure.
It should be noted that, beyond the scope of the REIT industry, our evidence adds
to the broader accounting and finance literature on the usefulness of non-GAAP,
voluntary, financial measures. In the last decade, unregulated non-GAAP measures havebeen subject to greater scrutiny. Accordingly, academic research on non-GAAP
disclosures (particularly pro forma and “street” earnings measure) has received enormousinterest.18 To the best of our knowledge, however, our study is among the few to consider
these issues in the context of the REIT framework.

18

See, for example, Bradshaw and Sloan (2002), Brown and Sivakumar (2003), Lougee and Marquardt(2004), and Bhattacharya, Black, Christensenm, and Larson (2003). For studies on evaluating the excluded
components of pro forma measures, see, for example, Doyle, Lundholm, and Soliman (2003), Gu and Chen
(2004), Choi, Lin, Walker, and Young (2007), and Black and Christensen (2009).

22

7

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26

Table 1: Descriptive Statistics of Variables by Firm-Year Observations
Variables

MeanMedianDIVFFONet Income
CFO
FFO_ACC
NI_ACC
DEP
OTHER
SIZE
LEVERAGE
ROA
MTB

1.636
0.058
0.036
0.062
-0.004-0.022-0.031
0.009
6.78
0.538
3.584
0.68

1.625
0.056
0.032
0.06
-0.003-0.025
-0.03
0.005
6.889
0.547
3.42
0.623

Standard
Deviation
0.735
0.03
0.036
0.027
0.023
0.029
0.01
0.027
1.342
0.161
1.57
0.382

Minimum

Maximum

0.05-0.218-0.129-0.025-0.202-0.11-0.086-0.091
2.174
0.003-0.698
0.012

4.08
0.179
0.376
0.237
0.088
0.276
-0.0020.304
10.017
1.019
10.8
2.46

Table 1 reports descriptive statistics for a sample of 590 observations over the period of 2001 to 2008. DIV
is dividends per share. FFO is funds from operations. CFO is cash flows from operations. FFO_ACC is theaccrual component in FFO. NI_ACC is the accrual component in net income but not in FFO. DEP isdepreciation expense. OTHER is the total value of non-recurring items (other than depreciation) excluded
from FFO, measured as the differences between NI_ACC and the depreciation expense. SIZE is measured
as the natural logarithm of market capitalization. LEVERAGE is measured as total debts divided by total
assets. ROA is returns on assets defined in the Capital IQ database. MTB is market-to-book ratio. All
financial statement variables are scaled by average total assets.

27

Table 2: Pearson Correlation Matrix of Variables
1

2

3

4

5

6

7

8

9

10

11

1. DIV
2. FFO

0.149***

3. Net Income

0.15***

0.647***

4. CFO

0.125***

0.696***

0.597***

5. FFO_ACC

0.051

0.512***

0.155***-0.26***

6. NI_ACC

0.033-0.233***0.591***

0.026-0.344***7. DEP

0.035-0.0390.212***-0.135***0.11***

0.311***

8. OTHER

0.022-0.231***0.544***

0.076*-0.402***0.938***-0.0370.556***

0.063

0.121***

0.111***-0.0490.088**

0.037

0.079*

10. LEVERAGE-0.015-0.32***-0.447***-0.395***0.042-0.232***-0.262***-0.149***0.001

11. ROA

0.059

0.73***

0.418***

0.612***

0.25***-0.24***

0.091**-0.285***-0.03-0.133***

12. MTB

0.167***

0.636***

0.65***

0.606***

0.13***

0.156***

0.06

0.142***

0.266***-0.406***

9. SIZE

Table 2 presents Pearson correlations of variables used in the regression analysis.
*** 1% significance, ** 5% significance * 10% significance. See Table 1 for variable definitions.

0.523***

Table 3: Dividend-Relevance of Components of Performance Measures(1)

DIVj,t= α1 + β1CFOj,t + β2FFO_ACCj,t + β3NI_ACCj,t + β4Controlsj,t + εj,tDependent
Variable
FFO_ACC

DIV

DIV

DIV

3.744***

5.049***

3.972***

NI_ACC

1.769

1.416

0.826

CFO

4.187***

4.638***

4.108***

SIZE

0.313***

0.307***

LEVERAGE

0.052-0.121

ROA

0.004

0.031

MTB

-0.224**-0.221**constant

1.43***-0.612***-0.465**

Property Type
Fixed Effects
N
R2

No
590
0.03

No
590
0.33

Yes
590
0.38

Table 3 reports regression results using OLS with robust standard errors. *** 1% significance, ** 5% significance* 10% significance (two-sided tests). See Table 1 for variable definitions.

Table 4: Dividend-Relevance of Components of Performance Measures and Depreciation
Quality(6)

DIVj,t= α1 + β1CFOj,t + β2FFO_ACCj,t + β3NI_ACCj,t + β4DEP_Q1j,t +β5NI_ACC×DEP_Q1j,t + β6Controlsj,t + εj,t(7)

DIVj,t= α1 + β1CFOj,t + β2FFO_ACCj,t + β3NI_ACCj,t + β4DEP_Q2j,t +β5NI_ACC×DEP_Q2j,t + β6Controlsj,t + εj,tDependent
Variable
FFO_ACC

DIV

DIV

3.305**

3.732***

NI_ACC

2.995***-1.088CFO

3.655**

4.9***

DEPR_Q1

28.988***0.152***

DEPR_Q2
NI_ACC×DEPR_Q1

591.416***

NI_ACC×DEPR_Q2

4.475***

SIZE

0.302***

0.308***

LEVERAGE-0.12-0.059

ROA

0.032

0.024

MTB

-0.222**-0.228**Constant-0.311*-0.579***Property Type
Fixed Effects
N
R2

Yes
590
0.39

Yes
590
0.39

Table 4 reports regression results using OLS with robust standard errors. *** 1% significance, ** 5% significance* 10% significance (two-sided tests). See Table 1 for variable definitions.

30

Table 5: Dividend-Relevance of Components of Performance Measures, Depreciation Expense,
Other Accrued Revenue and Expenses, and Depreciation Quality(9)

DIVj,t= α1 + β1CFOj,t + β2FFO_ACCj,t + β3ADEPj,t + β3BOTHERj,t + β4DEP_Q1j,t +β5ADEP×DEP_Q1j,t + β5BOTHER×DEP_Q1j,t + β6Controlsj,t + εj,t(10)

DIVj,t= α1 + β1CFOj,t + β2FFO_ACCj,t + β3ADEPj,t + β3BOTHERj,t + β4DEP_Q2j,t +β5ADEP×DEP_Q2j,t + β5BOTHER×DEP_Q2j,t + β6Controlsj,t + εj,tDependent
Variable
FFO_ACC

DIV

DIV

3.296**

3.691***

DEP

3.783

1.04

OTHER

3.058**-1.522CFO

3.926**

5.5***

DEPR_Q1

24.259**0.197

DEPR_Q2
DEP×DEPR_Q1

508.111**

DEP×DEPR_Q2
OTHER×DEPR_Q1

6.252
650.44***OTHER×DEPR_Q2

4.494***

SIZE

0.301***

0.306***

LEVERAGE-0.093

0.014

ROA

0.028

0.014

MTB

-0.218**-0.214**

Constant-0.301-0.539***Property Type
Fixed Effects
N
R2

Yes
590
0.39

Yes
590
0.39

Table 5 reports regression results using OLS with robust standard errors. *** 1% significance, ** 5% significance* 10% significance (two-sided tests). See Table 1 for variable definitions.

31