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REITs and MLPs: Look Beyond the GAAP

Josh Peters, CFA

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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Glaser: Let's start by taking a closer look at REITs, then. Is FFO the right metric to be looking at to determine if a dividend is safe, for example?

Peters: It's almost the right number. I prefer a statistic that's called AFFO, or adjusted funds from operations, and I'll just run through the reasons why. AFFO is a statistic that has been around for a long time. It's not in generally accepted accounting principles, but there are standardized ways of calculating it that have been prepared and published by an industry trade body. So, you tend to have reasonable consistency across companies with this number. It takes into account lots of REIT-specific economic effects that aren't perhaps captured very well in GAAP, the most important of which, by far, is it adds depreciation and amortization back to earnings.

Now, you think, well, even buildings depreciate over time, but they don't depreciate in the same way that, say, a piece of equipment that stamps out widgets will, where you could buy that machine and, over a 20-year life, you want to recognize that its value is going to zero because eventually it's going to be sold and broken down; you can't produce any more widgets. For the most part, real estate values tend to trend higher.

Now, it's not that case for every piece of real estate in every part of the country and every property type, but it's going to be more a function of how well the property has been maintained and what's going on in the area around it--the old line "location, location, location." And in general, you expect the value of real estate, especially land, rise over time.

So, with that, why would you want to record depreciation and reduce the earnings of the real estate investment trust to reflect something that really doesn't apply for that industry? But with that adjustment, that gets you to FFO; you also, I think, then have to deduct maintenance capital expenditures, whatever the REIT has to spend on upkeep for its properties. Because if they don't maintain the properties, then eventually they are not going to have tenants or their tenants are going to want to pay much lower rents. And then you see a loss of earning power.

So, the depreciation and amortization adjustment is just one of the largest adjustments. There are other things that factor into FFO. But that AFFO number, I think, is really the best, most representative number of what the ongoing cash generation is, the ongoing cash earning power of a REIT is over time. I would say that it is much more relevant than GAAP net income for that industry.

Glaser: If this kind of metric makes sense for REITs, how do you think about them for master limited partnerships?

Peters: Here, I tend to be just a little bit more skeptical. I mentioned earlier that FFO is a statistic and a concept that's been around for a long time. You've had the opportunity to see that if REITs were artificially inflating their earning power and cash generating-power using FFO or AFFO, then at some point in the last, say, 20 or 30 years you would have seen that stopped working. There would be some evidence that it was an inflated statistic that did too good of a job prettying up the numbers that start with GAAP.

With master limited partnerships, we don't have that much history, and we also don't have a standardized approach. There is no industry trade body in the MLP universe that sat down and say, "OK, here is how we're going to all define--all of us in the industry--distributable cash flow so that investors can determine what the statistic is." Instead, it's up to individual partnerships, and they will define it differently from partnership to partnership. Some are, frankly, aggressive in how many charges and nonrecurring items that have a way of reoccurring that they exclude, and it makes me a little less comfortable.

Plus, depreciation, as I said earlier, is a concept that doesn't work really well for a piece of real estate that's lent out. In the universe of pipelines and storage assets, gathering and processing assess, processing plants, things like that, I think depreciation is a relevant concept. And if you have a pipeline that you build and you figure it's going to last 50 years, to write off one fiftieth of the value of that pipeline each year actually does make some sense.

So, to just say depreciation and amortization is noncash, that it's not really a charge, these are assets that do lose value over time unless you spend money maintaining them. And what the partnerships typically do is they subtract maintenance capital expenditures even as they are backing out the depreciation and amortization. So, they are giving a nod in this direction. But the assets don't necessarily last forever, and I think that's especially true the closer you are to the wellhead, where you have a gathering pipe, say, from a well to a processing facility.

In this case, the well might last for 10 or 15 years, and while the well is flowing, you're collecting cash. It's depreciating, maybe you're backing that out of your distributable cash flow because it's a noncash statistic. But what are you going to do, then, when the well is dry and there's no more natural gas or oil flowing through it and there's nothing more to charge? Maybe you spent some money maintaining it along the way and you recognized that cost, but didn't recognize the fact that the asset was eventually going to become worthless.

So, the closer you are to the wellhead, again, to producing basins and the activities in the energy industry that take place there, I think the more you have to think of depreciation as maybe being a relevant expense even if at any one point in time it's noncash. There isn't a specific cash outflow associated with it.

So, the bottom line here is look at distributable cash for these partnerships, but look at net income, too. GAAP doesn't do a terrible job of reflecting the economics of these businesses, and I think ideally what you want is to find partnerships that have good coverage of their distributions with distributable cash flow but also could cover under the net earnings concept. And two of my favorite partnerships, Magellan Midstream (MMP) and Spectra Energy Partners (SEP), both meet that qualification.

So, when I see partnerships that maybe claim $4 a unit of distributable cash and pay out $3.50, but then I look and the GAAP net earnings are $1 a unit, that makes me think that the distributable cash flow, long term, may not be sustainable because the assets are depreciating in economic terms over time and there may not be resources left at the end of those useful lives in order to replace them.

Glaser: Josh, I certainly appreciate your take on this topic today.

Peters: Thank you, too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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