Funds from Operations Versus Net Income: Examining the Dividend-Relevance of REIT Performance Measures

While the Real Estate Investment Trusts (REITs) industry is traditionally viewed as a cash flow business, REIT investors have also relied on Funds from Operations (FFO) and net income to evaluate company performance. In this study, we compare FFO and net income by examining how well these two performance measures explain dividend policy of REITs beyond operating cash flows. Our investigation extends over the period of 2001-2008, subsequent to the provision of the new FFO definition by the National Association of Real Estate Investment Trusts (NAREIT). Specifically, by decomposing the performance measures into their cash and non-cash (accrual) components, we find that, while the non-cash component that is common to both FFO and net income is significantly associated with the level of dividends distributed by REITs, the additional non-cash component contained in net income but not in FFO has no association with dividends. We further find that the non-cash component in net income becomes significantly associated with dividends only when measurement errors in depreciation are low (i.e., reporting quality in depreciation is high). By suggesting that the inclusion of depreciation distorts the dividend-relevance of REIT net income, this paper provides further support to the dominance of FFO over net income for financial reporting in the REIT industry.