By Ralph Block

If it ain't broke, don't fix it." Fair enough. But what if it is broken? I am referring here to Generally Accepted Accounting Principles (GAAP) as applied to organizations, including REITs, that own investment real estate. REIT investors have struggled with the utility of GAAP rules for many years, and many wonder whether it's time to change them.

Current GAAP financial statements do not report the true profitability of companies that own investment real estate, nor do they reflect the current fair value of real estate assets held for investment. "Real estate depreciation" is based on a "one-size-fits-all" assumption that's often wide of the mark. Accounting trends are moving in the direction of determining and reporting market values for liabilities such as financial obligations, but market values for liquid assets such as commercial real estate are GAAP-irrelevant. Thus reported profits and asset values under current rules are routinely ignored.

NAREIT has formulated supplemental performance measurements such as FFO to make operating results more meaningful to investors. Yet FFO is not a GAAP number, is calculated differently by different REITs, and doesn't recognize that capital must be committed to real estate to enable it to hold its value. Although many analysts and investors have developed additional concepts such as "adjusted funds from operations" (AFFO) in their efforts to calculate the profitability of REIT organizations, there is no uniformity in these measurements.

Many REIT investors have thus concluded that prevailing GAAP rules are truly broken, and dream of fixing them. The dream may become reality sooner than most expect. Today, International Financial Reporting Standards, applicable in more than 100 countries, require or allow "fair value" accounting. These rules provide that the market value of investment property be reported—on the balance sheet or in financial statement footnotes. Changes in such valuations are also reported. The sentiment among accounting policy-makers in the U.S., including FASB and the SEC, is increasingly to conform U.S. GAAP accounting rules to global accounting standards.

Given the interest in global real estate investing and the increasing flows of capital around the world, this trend is likely to accelerate. An opportunity to address these issues is closer at hand than many believe. On Feb. 27, FASB announced its commitment to examine the accounting for investment property in the context of its current "Fair Value Option" project. FASB will thus now ponder whether some investment real estate can or should be reported at fair market value. This examination could hasten the convergence of U.S. GAAP with the international standard that requires that investment property be reported at fair value.

The REIT industry will therefore have a unique opportunity to help formulate new GAAP rules that not only will converge with international rules, but also make GAAP accounting much more meaningful to REIT investors. The task won't be easy. But we do have experience with fair value accounting in developed countries around the globe; and, given the greater liquidity and transparency of today's real estate markets, valuations should be reasonably accurate.

If implemented, investors would find GAAP numbers more relevant, and perhaps ultimately dispense with supplemental measures such as FFO. Fair value rules would eliminate depreciation expense related to investment property, resulting in GAAP reporting that would be meaningful in assessing performance over various time periods, as well as a REIT's enterprise value. The thorny issue of maintenance capital expenditures will still need to be sorted out, but perhaps new GAAP rules can be structured to move us in the right direction. Investors may still develop their own NAV estimates, but at least would have GAAP-sanctioned figures to work with.