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By Josh Peters, CFA | 10-22-2014 10:00 AM

REITs and MLPs: Look Beyond the GAAP

Investors should consider additional metrics when sizing up real estate investment trusts and master limited partnerships, says Morningstar's Josh Peters.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Josh Peters. He is the editor of Morningstar DividendInvestor newsletter and also our director of equity income strategy. We're going to talk today about how investors should think about the adjusted earnings that management teams often report alongside the GAAP earnings.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: First off, why should dividend investors or investors generally care about these adjusted earnings that are coming out versus the GAAP earnings? What's the best way to think about that?

Peters: Well, in part, this applies to any investor because a huge portion of companies will routinely report adjusted earnings per share or operational earnings per share, pro forma earnings per share, and so on and so forth, where they're taking the numbers that the accountants have signed off on that conform to generally accepted accounting principles, or GAAP, and say, "Well, this in the GAAP numbers doesn't really count, and this thing over here doesn't count either." And invariably, you wind up with numbers that in general are higher under these alternative metrics than they would be under GAAP.

That's not always the case. Sometimes a company, say, sells a business and records a large gain. That's not going to be repeated. You'd rather have that backed out of the numbers. That's a good adjustment to make. But where you have routine expenses or, frankly, just things that embarrass companies that are being added back to earnings, you have to remember that what earnings are is really an expression of the change of the net worth of the company over a period of time from its operations.

So, the company has had to spend a lot of money on restructuring or it's had to take write-offs related to acquisitions even if there's no cash associated with these. It's still reflecting that perhaps the business hasn't performed as well or management hasn't performed as well as they'd like people to think. So, you need to be somewhat skeptical of these numbers.

And then, in specific, you've got two very large, very important, very relevant groups of higher-yielding securities that appeal to dividend investors where those GAAP earnings are routinely just discarded by professional and individual investors alike. And that's the real estate investment trust, or REIT group, and master limited partnerships, or MLPs. For REITs, people focus more on funds from operations, or FFO. And in the MLP universe, people focus more on a statistic called distributable cash flow, or DCF.

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