Net Asset Value: An Informational Advantage in Real Estate Markets
Real estate differs from many other industries in that the value of the assets owned by a company can be estimated with reasonable precision. Net asset value, or NAV, is simply the marking to market of the assets and liabilities of a company to today’s market value, presented on a per-share basis. NAV is the backbone of Green Street’s valuation methodology. There are substantial benefits to understanding why NAV is important and how it can be used to gain an informational advantage in the public and private real estate markets.
Why use NAV for REIT analysis?
First of all, REITs are real estate. Over the long-term, U.S. REITs have, on average, traded at the value of their underlying real estate. The commercial real estate industry has the luxury of benefitting from the insights NAV provides. In many industries, the value of a company’s hard assets has little resemblance to the value of the corporate entity. For example, consider Facebook or Google, where the intellectual capital dominates and therefore the balance sheet does not demonstrate the ability to create cash flow and cash flow growth. In the case of companies where real assets represent the vast majority of the underlying value, a proper estimate of the value of these assets gives a solid foundation for arriving at the value of the company. This type of analysis, applied to REITs, is possible because similar assets trade regularly in the private market. If an office building on Park Avenue trades, that transaction provides a valuable data point to the value of similar office buildings in midtown Manhattan.
Good NAVs don’t come easy
In reality, a well-crafted NAV estimate requires significant time and extensive market knowledge. Green Street’s research team is intentionally structured to support these needs, with a ratio of approximately four covered companies per REIT-dedicated analyst. Some of the challenges in building an NAV include:
- Proper derivation of current cash flows (often complicated by development, acquisitions and dispositions), and identifying cash flow growth prospects
- Detailed assignment of these cash flows to their respective real estate assets (difficult with companies that have hundreds of properties across dozens of markets)
- Solid valuation of non-income producing assets like land and development
- Identifying the precise cap rate to use in real estate valuation (requires deep market knowledge and relationships with brokers and private investors)
From NAV to the NAV-based pricing model
A high-quality NAV is essential to laying the foundation for valuation; however, a REIT is more than just the real estate it owns. Future total returns for any REIT are a function of how its real estate portfolio is likely to perform, as well as the value that its management team is likely to add or detract. Green Street’s NAV-based pricing model includes a systematic assessment of four key variables, which help determine relative valuation for a company compared to its sector-level peers. The model identifies the REITs that are most- or least-attractively priced, and lends support to analysts during their stock selection process.
Signals for direct investors
More broadly speaking, using NAV allows for a key comparison between the real estate value in the public market and the value in the private market as REITs can trade at a premium or discount to their private market values.
The historical core sectors (e.g. malls, strip centers, office) tend to trade at big discounts to private-market asset value, whereas the sectors that were not considered institutionalized real estate as of a decade or two ago (e.g. manufactured homes, data centers), still tend to trade at big premiums to net asset value. A premium to NAV does not mean a sector is overpriced, however. Green Street has found that over the long-term, the REIT premiums and discounts to NAV by sector are predictive of future changes in private market values. The public market is ahead of the private market, and this presents an opportunity for real estate investors who pay close attention to both markets. By using signals from the public market, investments can be made that create favorable returns versus other private players. Buying assets that trade at big premiums to NAV in the public market should turn out to be a winning strategy for direct investors, as high-premium sectors usually experience superior private-market real estate price appreciation in the near term.
Valuing the REIT industry
Viewing real estate as part of the capital markets creates a framework to look at the direction of real estate pricing. Green Street’s Commercial Property Price Forecast combines signals from the corporate bond market with signals from the REIT market to gain insight about the direction of property prices over the next six to 12 months. This indicator is helpful to assess how attractively priced commercial real estate is in the private market compared to alternative asset classes such as investment-grade bonds, high-yield bonds, and REITs. In addition, by taking the private market values of real estate versus bonds and then adding the long-term relationship of REITs versus other equities, it is possible to derive a fair value for the REIT sector. For instance, REITs today sit at the inexpensive end of a fair range, suggesting this is a decent entry point versus investing in other asset classes.
What about earnings multiples?
Green Street’s research team focuses heavily on NAV, but analysts examine earnings as well. REITs with the lowest cap rates tend to trade at the greatest discounts to net asset value. While there are several explanations for this trend, one of the biggest drivers is the ceiling on the earnings multiples investors are willing to ascribe to REITs. Additionally, a changed market environment resulting from both low interest rates and heavy foreign capital flows has also caused NAV signals to be harder to interpret in recent years. This new set of circumstances makes life for investors a lot more difficult, and forces analysts to be far more nimble with stock picking. Green Street incorporates many other analytical and quantitative tools to second-guess and enhance the output of the NAV-based model in making investment recommendations. Information about one new approach to the toolkit – implied IRRs derived from market-level growth rates – can be found in Heard on the Beach: Reality Check.
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