REITs and REOCs generally return a significant portion of their income to their investors and tend to be high- dividend paying shares. Thus, dividend discount mod- els for valuation are applicable. Discounted cash flow approaches are applied in the same manner as they are for companies in other industries. Most typically, investors use two- or three- step dividend discount models with near- term, intermediate- term, and/or long- term growth assumptions. In discounted cash flow models, investors will often use intermediate- term cash flow projections and a terminal value based on historical cash flow multiples.
7.1 Considerations in Forecasting Longer- Term Growth Rates
In looking at the specific drivers of growth for REITs and REOCs, four key consid- erations are generally taken into account when forecasting longer- term growth rates in these models.
1 Internal growth potential that stem from rent increases over time. In general, companies with portfolios of real estate located in supply- constrained markets with robust demand have a better ability to raise rents and increase cash flow.
The opposite is true for portfolios in more supply- saturated markets or markets with tepid tenant demand conditions and prospects. Over the long term, well- managed property portfolios in good markets tend to generate cash flow growth at a level slightly above inflation.
2 Investment activities, such as acquisitions, new development, re- development, or dispositions of assets, have an impact on long- term growth. Successful development- oriented companies have shown better growth over time because returns on invested capital are generally higher on development than on acqui- sitions. Somewhat counter- intuitively, dispositions of weaker assets with below- average growth prospects are often dilutive to earnings because the cap rates at which such properties are sold are higher than the yields at which proceeds are re- invested, which reflects lower risk premiums. Thus, a REIT or REOC that undergoes a repositioning of a material portion of its portfolio into higher- quality properties could face cash flow growth pressure in the near term.
3 Capital structure can have an impact on growth, particularly in the short term as companies raise or lower their leverage. This is because of the positive lever- age spread enjoyed by most REITs and REOCs; that is, going- in cap rates on property investments exceed the cost of debt. These benefits, however, can be reversed by adverse changes in the capital markets or missteps by management on acquisitions or operations. In general, REIT investors tend to be conser- vative and oriented toward stable, recurring income and to be averse to high leverage in REITs.
4 Retaining and reinvesting a portion of free cash flow can make a contribution to the growth rate. Although REITs often pay out the majority of cash flow to investors in the form of dividends, the high rates of depreciation allowed under most countries’ tax laws allow companies, including REITs, to retain enough cash flow without incurring current income taxes to add 1 to 3 percentage points to annual growth.
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7.2 Some Perspective on Long- Term Growth Rates
If the previously mentioned components of growth are added together, an analyst can derive a long- run growth rate. For successfully managed REITs and REOCs with good portfolios, the resulting growth rate should be in the high- single- digit percent- age range. Given core cash flow growth of about 3–4 percent, 1–2 percent growth from investment activity over time, 2–3 percent growth from the financial leverage that magnifies the two growth drivers, and another 0–1 percent from reinvesting free cash flow, the long- run growth rate estimate ranges from 6 to 10 percent and the averages of the components would add up to an 8 percent long- run growth rate.
The long- run growth for the average US REIT from the mid- 1990s through 2010, however, was barely more than 0 percent per year, with only the top companies achieving 4–7 percent average annual cash flow growth. So, although in theory REITs and REOCs should show higher growth rates, in reality the impact of the business cycle, operational and investment missteps, and a highly dilutive process of balance sheet strengthening through equity issuance after the credit crisis of 2008 and 2009 all have had a negative effect on growth.
The other key component in discounted cash flow models and dividend discount models is required returns. Although a detailed discussion about deriving required returns is beyond the scope of this reading, most rates used in practice have ranged widely from 7 percent to 13 percent. The conventional argument is that the risk premium—and thus the discount rate—associated with REITs and REOCs should be lower than the average stock in the broader market because the underlying business of owning income- producing real estate should be less volatile because of contractual revenue streams from leases. A long- term look at the betas of REIT shares suggests values tend to be less than 1.0, which supports this view.
Considering the points just outlined, the key drawback to using dividend discount models and discounted cash flow models for valuing REITs and REOCs is the high sensitivity of these valuation models to the key inputs of growth and discount rates.
EXAMPLE 8
Valuation (I)
1 When using a relative P/AFFO or P/FFO multiple approach in the valua- tion of a REIT or REOC, which of the following considerations is the most important to take into account?
A The discount rate
B The NOI capitalization rate
C Relative AFFO or FFO growth rates and different leverage levels 2 Which of the following is the most significant contributor to P/FFO and
P/AFFO valuation multiples for REITs and REOCs?
A The average age of the management team B The exchange on which the REIT stock is listed
C The geographic location of properties in a REIT’s portfolio 3 Which of the following is not a challenge in accurately estimating net
asset value (NAV)?
A Estimating the value of goodwill and intangible assets
B Identifying the capitalization rates on comparable properties trading in the property market
C Ascribing an accurate value to a REIT’s land holdings, projects under development, and joint ventures
4 Which of the following is least likely to cause persistent differences between estimated NAVs and stock prices?
A A surplus of takeover arbitrage capital in the markets
B Different discount rates being applied to privately held assets versus a liquid security
C A strong history of growth that prompts stock investors to pay a pre- mium to the real estate value for a good management team
5 Which of the following are important in using a discounted cash flow model to value REITs?
A The capitalization rate B The net asset value discount
C The payout ratio and the amount of financial leverage used by the REIT
Solution to 1:
C is correct. The main drivers of a relative multiple approach to valuation are risks associated with capital structure (leverage) and underlying real estate as well as expectations for growth (relative AFFO or FFO growth rates), so both should be considered.
A and B are incorrect because they relate to the dividend discount model and NAV approaches to valuation, respectively.
Solution to 2:
C is correct. Geography determines expectations for growth and risks, two main drivers of a relative multiple approach to valuation.
A is incorrect because although management skill may contribute to expected growth, management age does not. B is incorrect because the REIT’s listing exchange is largely irrelevant to its investment value.
Solution to 3:
A is correct. These “soft” assets are ascribed no value by analysts in a net asset value calculation.
B is incorrect because estimating cap rates is a challenge in that they can be somewhat subjective when the properties sold differ significantly and/or few transactions are observable. C is incorrect because such assets as undeveloped land, buildings under construction, large properties with few comparable assets, service businesses, and joint ventures complicate the process of estimating NAV with accuracy and confidence.
Solution to 4:
A is correct. A surplus of takeover arbitrage capital in the markets is likely to close the gap between share prices and net asset values by generating takeovers.
B is incorrect because different discount rates may be used to reflect dif- ferences in liquidity, which persist until both securities are either publicly or privately traded. C is incorrect because the management’s reputation and its effect on security value persist as long as the management remains.
Solution to 5:
C is correct. The payout ratio or level of retained cash flow affects long- term growth rates and the REIT’s financial leverage is a determinant of its overall risk exposure and thus discount rate. Both growth and discount rates are key components of the discounted cash flow model.
A and B are incorrect because they both relate to the net asset value approach to REIT valuation.