Among REIT analysts, the most common way to value of REIT is to calculate the net asset value of the company, or NAV. REIT stock prices tend to have a strong correlation to analyst’s NAV estimates.
If you are familiar with the balance sheets of financial services companies, then you can think of NAV as a way to determine the book value of a REIT. However, GAAP accounting isn’t as friendly to REITs as it is to other sectors, so you cannot simply look at the equity value on the balance sheet to get and idea of where the stock should trade. There are two primary reasons why this doesn’t work.
- GAAP accounting requires that real estate be valued at its historical cost, which is not a significant issue if the real estate was purchased recently, but can be a huge problem if it was purchased decades ago… Which brings up the next problem,
- Real estate tends to appreciate in value over time, and has proved to be a good hedge against inflation. That said, GAAP accounting requires real estate to be depreciated, just like any other long-term asset (generally over a period of 40 year). So, not only is the real estate booked at a historical cost that is likely lower than current market value, but it is also being depreciated down to nothing.
So how do we fix these issues? We need to use data outside of the balance sheet to calculate the true market value of the real estate properties, and then we can add other assets and subtract liabilities to get a true NAV, or book value.
The first step is to figure out the cash net operating income, or NOI, of the real estate assets. NOI is the total real estate revenue minus real estate operating expenses and real estate taxes. For property types with shorter term leases, such as hotels and apartments, then you can use the number given on the income statement. For REITs that own properties with leases longer than one year (retail, office, warehouses, etc.) then GAAP accounting gets in the way again. Longer-term real estate leases tend to include a provision for periodic increases in rent, which can be a fixed percentage or tied to inflation, and can happen annually or every few years, depending on the property type and market. GAAP accounting requires that the revenue reported on the income statement be the average annual rent over the entire lease, which means that revenue is overstated in the earlier years of the lease, and understated in the later years. To get to a “cash” NOI number, then we need to make a “straight-line rent” adjustment, and all REITs will disclose what that adjustment needs to be. Finally, if the company owns any properties in joint ventures, then the NOI will not be included on the income statement and we will need to add the REIT’s pro forma share of any real estate interests in properties.
The next step is to take the cash NOI number we just calculated and divide it by a capitalization rate (cap rate). A cap rate is a commonly referred to number when talking about real estate transactions. The cap rate is the NOI of a property divided by the total purchase price of a property. Whenever there is a big real estate transaction, everyone in the industry wants to know what the cap rate was. The lower the cap rate, the higher the value of the property (just like the relationship between interest rates and bonds). Cap rates are highly dependent on markets, property type, the quality of the property, and how replaceable the property is. Determining the right cap rate for a REIT’s portfolio requires another in depth explanation, but generally speaking, the appropriate cap rate should reflect what recent comparable properties sold for. Once you’ve determined the cap rate, you can divide the NOI by that number and we get the “gross value of real estate.”
The rest is fairly straight forward. Pull up the balance sheet and add any non-real estate assets, such as cash, accounts receivable, and raw land. If the REIT has a development pipeline you should also add the construction-in-progress line on the balance sheet. Now, subtract all tangible liabilities, including preferred income, and you’ve arrived at the net asset value of the REIT.
Finally, divide that number by the share count (use the share count for calculating funds from operations, or FFO), and we’ve arrived at the appropriate NAV per share. If that number is above the current stock price, then the REIT’s shares are undervalued, and there may be an investment opportunity. Generally speaking, most REITs trade within about 15% of their NAV, and the “blue-chip” REITs with good track records tend to always trade at a premium to NAV, while small cap REITs tend to trade at a discount.
For illustration purposes and estimate NAV for Highwoods Properties (HIW) is found below. The spreadsheet below is dynamic, so feel free to change the cap rate and see what impact it has on the NAV.