The Effect of Industry Business Cycles on the Information in Pro Forma Earnings: Evidence from U.S. REITs

Abstract

Real Estate Investment Trusts (REITs) report funds from operations (FFO), an industry-standardized, pro-forma earnings measure which adds back depreciation expense and gains and losses on real properties to GAAP net income. Researchers have examined short sample periods and found inconclusive results on the relative ability of FFO and GAAP net income to explain stock prices and returns. This study expands the prior models to incorporate a Feltham and Ohlson (1996) valuation framework which formally accommodates accounting biases. Using this more general framework, we explore how real estate cycles influence the relative ability of FFO and net income to explain stock prices over a relatively long sample period spanning a variety of economic conditions. This study finds that FFO explains stock prices better than net income does in market booms, but there is no significant difference in explanatory power between the two performance measures in bust periods. When the real estate business cycle is interacted with earnings components, the valuation weight on cash flows is increasing in cycle, while the weight on depreciation expense is decreasing. These results suggest that investors perceive accounting depreciation to be more conservatively biased in market booms than in market busts, and adds helps to explain differences in explanatory power of FFO versus net income that exist in the literature.