VALUATION: NET ASSET VALUE APPROACH
5.3 Net Asset Value Per Share: Application
REITs have a relatively active private investment market for their business assets;
namely, the direct investment property market. This market facilitates the estimation of a REIT’s or REOC’s net asset value: an estimate of the value of their underlying real estate if it were sold in the private market, debt obligations were satisfied, and the remaining capital—the net asset value—was distributed to shareholders. This approach is unique to REITs and REOCs because commercial real estate assets trans- act relatively frequently in the private market, and as a result an investor can make observations about how such properties trade on the basis of the capitalization rate (the rate obtained by dividing net operating income by total value) or on the basis of price per square foot, and apply these valuations to the assets of a public company. In fact, in the United States, it is estimated that only 10–15 percent of commercial real estate is held by publicly traded REITs, thus making the private market far larger than
the public market, although less active. To draw a parallel, using a NAV approach to value REITs is much like using the sum- of- the- parts approach to valuing a company with multiple business lines.
The NAV approach to valuation is most often used by sector- focused real estate investors that view REITs and REOCs primarily as liquid forms of commercial real estate ownership. Value- oriented investors also tend to focus on NAV when stocks are trading at significant discounts to the underlying value of the assets. In addition, NAV analysis becomes particularly important when there is significant leveraged buyout (LBO) activity in the broader market. At such times, LBO sponsors attempt to buy REITs trading at large discounts to NAV to realize their underlying real estate value.
Conversely, when REIT stocks trade at large premiums to NAV, IPO activity and stock issuance activity increases because the public markets are essentially ascribing more value to the real estate than the private markets are. Over time, REITs and REOCs in the United States and globally have at times traded at premiums- to- NAV of more than 25 percent and at other times at discounts from NAV exceeding 25 percent. Thus, if the NAV of a REIT were $20/share, the stock might trade as low as $15/share or as high as $25/share, depending on a range of factors.
5.3.1 Important Considerations in a NAV- Based Approach to Valuing REITs
Although NAV estimates provide investors with a specific value, there are a number of important considerations that should be taken into account when using this approach to value REITs and REOCs. First, investors must understand the implications of using a private market valuation tool on a publicly traded security. In this context, it is useful to examine how NAVs are calculated.
The methods most commonly used to calculate NAV are (1) using a capitalization rate or “cap rate” approach to valuing the NOI of a property or portfolio of properties;
(2) applying value per square foot (or unit) to a property or portfolio of properties;
and/or (3) using appraised values disclosed in the company’s financial statements (permitted under IFRS but not hitherto or currently under US GAAP).8 An analyst may adjust these appraised values reported by the company if he or she does not agree with the underlying assumptions and if there is sufficient information to do so. In the first two instances, the cap rates and values per square foot are derived from observing transactions that have occurred in the marketplace. In contrast, most sophisticated direct purchasers of commercial real estate arrive at a purchase price after doing detailed forecasting of the cash flows they expect to achieve from owning and operating a specific property over their investment time horizon. These cash flows are then discounted to a present value or purchase price. Whatever that present value or purchase price is, an analyst can estimate value by dividing an estimate of NOI by the cap rate, essentially the required rate of current return for income streams of that risk. In addition, an analyst can take the present value or purchase price and divide by the property’s rentable area for a value per square foot. The point is that cap rates and values per square foot result from a more detailed analysis and discounted cash flow process. The discount rate used by a private owner/operator of commercial real estate could be different from the discount rate used by investors purchasing shares of REITs.
NAV reflects the value of a REIT’s assets to a private market buyer, which may or may not be the same as the value that public equity investors ascribe to the business.
This fact is one of the reasons for the wide historical premium/discount range stocks trade at relative to NAV estimates. Another reason is that the stock market tends to focus more on the outlook for short- term future changes in income and asset value than the property market, which is more focused on long term valuation. As alluded
8 At the time of this writing, US GAAP requires property assets to be carried in financial statements at depreciated cost.
to earlier, it is possible that REITs and REOCs can trade at some premium or discount to NAV until the premium/discount becomes wide enough for market forces to close the arbitrage gap.
Another factor to consider when using a NAV approach to REIT/REOC valua- tion is that NAV implicitly treats a company as an individual asset or static pool of assets. In reality, such treatment is not consistent with a going concern assumption.
Management teams have different track records and abilities to produce value over time, assets can be purchased and sold, and capital market decisions can add or sub- tract value. An investor must thus consider how much value a management team can add to (or subtract from) current NAV. For instance, an investor may be willing to purchase REIT A trading at a 10 percent premium to NAV versus REIT B trading at a small discount to NAV because the management team of REIT A has a stronger track record and better opportunities to grow the NAV compared with REIT B, therefore justifying the premium at which REIT A trades relative to REIT B.
NAV estimates can also become quite subjective when property markets become illiquid and few transactions are observable, or when REITs and REOCs own hun- dreds of properties, making it difficult for an investor to estimate exactly how much the portfolio would be worth if the assets were sold individually. There may also be a large- portfolio premium in good economic environments when prospective strategic purchasers may be willing to pay a premium to acquire a large amount of desired prop- erty at once, or a large- portfolio discount when there are few buyers for the kind of property in question. In addition, such assets as undeveloped land, very large properties with few comparable assets, properties with specific uses, service businesses, and joint ventures complicate the process of estimating NAV with accuracy and confidence.
5.3.2 Further Observations on NAV
Among institutional investors, the most common view is that if REIT management is performing well in the sense of creating value, REITs and REOCs should trade at premiums to underlying NAVPS. The rationale is based on the following:
1 Investors in the stocks have liquidity on a day- to- day basis, whereas a private investor in real estate does not, thus warranting a lower required return rate (higher value) in the public market than the private market for the same assets.
2 The competitive nature of the public markets and size of the organizations should attract above- average management teams, which should produce better real estate operating performance and lead to better investment decisions than the average private real estate concern.
In conclusion, although NAV is by its nature an absolute valuation metric, in prac- tice it is often more useful as a relative valuation tool. If all REITs are trading above NAV or below NAV, selecting individual REITs could become a relative exercise—that is, purchasing the REIT stock trading at the smallest premium to NAV when REITs are trading above NAV, or selling the REIT trading at the smallest discount to NAV when REITs are all trading at a discount to NAV. In practice, NAV is also used as a relative metric by investors looking at implied cap rates. To calculate the implied cap rate of a REIT or REOC, the current price is used in an NAV model to work backward and solve for the cap rate. By doing so, an investor looking at two similar portfolios of real estate could ascertain if the market is valuing these portfolios differently based on the implied cap rates.