One of the most important questions facing prospective REIT investors is whether the units are fairly priced. REITs present special challenges in this regard compared to regular corporations. That’s because REITs are essentially a collection of real estate properties that throw off rental income, making them closer to bond mutual funds than to stock funds. But bond values are easy to determine – real estate values, not so much. Net asset value (NAV), while not perfect, is probably the best indicator of REIT unit value.
The Problems with Book Value
Value investors often look to book value when evaluating regular corporations. To review, book value is the cost of the assets on the balance sheet minus the company’s liabilities. Book value is therefore equal to stockholders’ equity, with perhaps a few adjustments.
Regular corporations have a wide variety of assets, of which fixed, depreciable assets are only a part. Depreciation distorts book value, but unless the corporation’s assets are mostly fixed, investors can overlook depreciation, or add it back to recover the original cost of the fixed assets.
REITs present an extreme case, in which virtually all the assets are real estate. Properties other than land are depreciated, which reduces book value. But another problem is that book value doesn’t reflect any property appreciation, due to inflation, changes in supply and demand, and other reasons. Furthermore, since the mission of a REIT is to deliver rent-based income, book value includes non-productive assets (i.e., land, properties under construction) that don’t provide cash flows. A unit’s fair price is the net present value (NPV) of future cash flows discounted by the weighted average cost of capital, divided by the number of outstanding units. Book value, depreciation, and non-productive assets create values that often vary substantially from NPV calculations.
Calculation of Net Asset Value
If the book value of a property is an unreliable indicator of value, how should we evaluate the real estate in the REIT portfolio? One answer is to reappraise each property based on its operating income (i.e., revenues minus operating expenses) divided by the capitalization rate (i.e., rate of return) required by investors. This is called the income approach to valuation.
Recall that the cap rate is net operating income / current market value. We can’t use the current market value of the property, because that’s what we are trying to determine. Rather, we use an average cap rate based upon nearby comparable properties.
To review, the value of each property is:
Current market value = net operating income / cap rate
Notice how this equation ignores book value and capital appreciation. Thus, land and other unproductive properties are excluded from the value calculation.
The next step is to sum the current market values of all the properties held by the REIT and divided by the weighted average cap rate:
REIT asset value = (Σ current market values) / weighted average cap rate
The weighted average cap rate is the sum of the cap rate of each property multiplied by the property’s market value, divided by the total market value of all properties.
Next, subtract the REIT’s liabilities from the total asset value to get the NAV:
NAV = REIT asset value – REIT liabilities
Finally, divide NAV by outstanding units to get NAV/unit:
NAV/unit = NAV / outstanding units
Theoretically, this NAV/unit should be closely aligned with unit price. That’s not always the case.
Our calculations are solid, but leave out a lot of details that affect NAV. These include:
- You could add in your best value estimates for land, unproductive real estate and non-real-estate assets, perhaps using comparables for land and NPV of estimated future revenues from properties under construction or reconstruction. You always exclude accumulated depreciation and intangibles from this calculation. Typically, these values have a small effect on NAV.
- Current assets and non-property fixed assets should be added in using your best estimate of their current value.
- Sometimes, the market value of some debt might differ from its balance sheet value, requiring an adjustment to the total liabilities.
- REIT asset value should be reduced by claims to the REIT’s income by non-common-unit-holders. These include non-controlling interests (members of an operating partnership, or OP), joint ventures, real estate funds and holders of preferred stock. These claims reduce the earnings available for distribution to holders of common units and therefore should be excluded from unit NAV.
NAV vs Unit Price
However we get to NAV/unit, the payoff is to compare it to price/unit. If the price is below the NAV, you might be looking at a bargain (or a turkey). When price/share significantly exceeds NAV/share, your task is to ascertain why, and whether it bespeaks price momentum that you find compelling. If the NAV/share and price are about equal, then you have some confirmation that traders value the units similarly to the way you did when applying the income approach.