Effects of real estate cycles on valuation of U.S. real estate investment trusts (REITs)

This study investigates the relation between accounting depreciation bias and equity valuation in a unique industry setting, Real Estate Investment Trusts (REITs). REITs report funds from operations (FFO), an industry standardized pro forma performance measure that is computed by excluding the depreciation expense of real properties from GAAP net income. Researchers have examined short-period samples and found inconclusive results on the relative ability of FFO and GAAP net income to explain the market value of equity. This dissertation attempts to explain their results by finding that depreciation expense, the largest reconciling item between FFO and net income, has different biases over the phases of real estate business cycles. This study uses modeling techniques to develop an industry-specific valuation model for REITs. In this model, the difference between the valuation coefficients on FFO and depreciation expense captures accounting depreciation bias and varies over the phases of real estate cycles. This model presents a theoretical link between accounting depreciation bias and the relative ability of FFO versus net income to explain the market value of equity. Using the REIT valuation model, this study empirically examines the impact of real estate cycles on accounting depreciation bias and on the relative ability of FFO and net income to explain the market value of equity. This study finds that FFO explains stock prices better than net income does in a market boom and that there is no significant difference in explanatory power between FFO versus net income in a market bust. Further results indicate that the valuation coefficients on FFO and depreciation expense have opposite sensitivities to a state variable that summarizes information on the real estate cycle phase during a year. These results partially reconcile the mixed results of prior studies across different time periods.Business, Sauder School ofGraduat