The effect of industry business cycles on the information in pro-forma earnings: evidence from U.S. REITs

Abstract

This paper investigates whether the valuation of the cash flow and depreciation components of net income vary over time for Real Estate Investment Trusts (REITs). The estimated model derives from the Feltham and Ohlson [1996] (FO96) framework, reinterpreted for the REIT sector. We show how the interaction of model coefficients with a continuous measure of demand for real estate reveals time-varying persistence in cash flows from operations and investing (economic fundamentals), versus time-varying depreciation accounting bias (an accounting fundamental). Our empirical application of the model suggests, as expected, that the persistence of the cash flow component of earnings is pro-cyclical, while the depreciation bias component is counter-cyclical. This result is new to the literature. An implication of this finding is that changing valuation weights on depreciation expense leads to variability in the ability of summary measures, such as net income or funds from operations, to explain firm value. This implication is true whether an investor focuses on GAAP net income, or a pro-forma measure such as Funds From Operations (FFO).